Responsible Innovation in the Financial Industry: A Comprehensive Approach
Federal Reserve Vice Chair for Supervision Michael S. Barr recently gave a speech titled “The Federal Reserve’s Role in Supporting Responsible Innovation.” Focusing on the payments system, Barr acknowledged that banks and their service providers are thinking creatively about how they can leverage new payments rails to meet customer needs for immediate funds availability. He noted that the Fed is excited to engage with banks about how they could advance financial inclusion objectives with faster payments services utilizing emerging technologies.
Barr recognizes that private and public sectors, both domestically and internationally, are experimenting with programmable payments platforms, including those built on distributed ledger technology (DLT) and blockchain technology, and new forms of digital assets, such as cryptocurrencies, stablecoins, and central bank digital currencies.
There are indeed benefits in these technologies, but to support a safe and efficient system in the future, the Fed's engagement with innovation and its understanding of these developments is crucial.
In August, the Fed announced a supervision program that focuses on supervising the risks posed by novel technology-driven activities at banks. The Fed wants these institutions to continue innovating while supporting their ongoing safety and soundness. Currently, these activities include those involving crypto-assets, DLT, and complex technology-driven bank partnerships with nonbank Fintech providers, and will include others as new technologies emerge.
The Fed's initiative is very welcome. But looking at the above, it seems that it only supports Web3 initiatives. What about Artificial Intelligence (AI)? AI has already been utilized, for decades, in the financial industry, and more so now, with the latest advances in Generative AI.
Fed Governor Christopher J. Waller recently gave a speech titled “Innovations and the Future of Finance” explicitly focusing on Tokenization (Web3) and AI, discussing their benefits and risks. Why, then, doesn't the Fed's supervision program support AI?
The recent Lummis-Gillibrand Responsible Financial Innovation Act (more on that below) proposal focuses on digital assets. It seems that when it comes to financial services, the term “responsible innovation” implies Web3 innovation, and neglects all other emerging technologies, including AI.
Legislators have created a dichotomy when it comes to Responsible Innovation – there is “responsible AI” focusing on tech companies, and “Responsible Innovation” focusing on financial services utilizing Web3. But shouldn’t “responsible innovation” take a comprehensive approach and encompass all emerging technologies? This is especially needed in the financial industry.
Below, we'll define what “responsible innovation” looks like, and examine some examples of regulator and legislator approaches to responsible innovation in the financial industry.
What is responsible innovation?
The concept is relatively new with many attempts to define it. One of the most cited definitions is by Reene Von Schomberg, team leader of science policy at the European Commission: “Responsible Research and Innovation is a transparent, interactive process by which societal actors and innovators become mutually responsive to each other with a view to the (ethical) acceptability, sustainability and societal desirability of the innovation process and its marketable products (in order to allow a proper embedding of scientific and technological advances in our society)."
Another broader and simpler definition comes from Jack Stilgoe, Richard Owen, and Phil MacNaghten: “Responsible innovation means taking care of the future through collective stewardship of science and innovation in the present."
Bottom line: Responsible Innovation is making new technologies work for society without causing more problems than they solve; this applies to all technologies, all innovations, across all organizations, industries, and regions.
Examples of regulator and legislator approaches to responsible innovation in the financial industry
In addition to the Fed initiative mentioned above, other regulators have addressed responsible innovation in financial services:
FinCEN
FinCEN, the Financial Crimes Enforcement Network, has launched an Innovation Initiative to promote innovation and enhance national security through responsible financial services innovation that furthers the purposes of the Bank Secrecy Act (BSA) as amended by the Anti-Money Laundering Act of 2020.
To foster a better mutual understanding between the public and private sectors of the opportunities and challenges associated with innovating in the financial services sector, including AML/CFT-related (Anti-Money Laundering and Combating the Financing of Terrorism, respectively) products and services, FinCEN offers financial institutions and other financial services an opportunity to discuss and showcase products and services.
OCC
The Office of Comptroller of the Currency (OCC), an independent bureau within the U.S. Treasury, approaches responsible innovation with respect to how these innovations may impact the risk profile of the organization, ranging from compliance to operational to reputational.
The OCC published guiding principles for ensuring all new, expanded or modified existing products or services are developed and approved in accordance with sound business and risk management practices, urging organizations to conduct a detailed risk assessment early in the planning process to allow consideration of controls and monitoring tools needed to mitigate any risk.
California 'BitLicense' Bill
In mid-October California Governor Gavin Newsom signed a crypto bill, considered an answer to New York's BitLicense Bill. The bill requires California's Department of Financial Protection and Innovation (DFPI) to create a regulatory framework for crypto, which includes a licensing regime and gives the department enforcement and rulemaking authority over the sector.
Newsom said in the announcement, "It is essential that we strike the appropriate balance between protecting consumers from harm and fostering a responsible innovation.”
Lummis-Gillibrand Responsible Financial Innovation Act
In July, Senators Cynthia Lummis (R-WY) and Kirsten Gillibrand (D-NY) reintroduced their comprehensive legislation addressing regulatory gaps in the digital asset sector. Under the Lummis-Gillibrand Responsible Financial Innovation Act of 2023, the goal is to create a federal framework to ensure consumer protection while allowing innovation in digital assets.
This comprehensive legislation would provide a regulatory structure for crypto exchanges which currently operate largely on piecemeal state regulations. Crypto exchanges will be required to register with the Commodity Futures Trading Commission (CFTC). Stablecoins would be regulated as depository institutions like federal banking regulations. A new interagency law enforcement group will be launched to help combat abuse and attempts at fraud.
This proposed bill, although called “Responsible Financial Innovation Act,” merely focuses on Web3 and digital assets. In a recent interview to the Financial Times, Gary Gensler urged regulators to tame AI risks to financial stability, indicating that without swift intervention it would be “nearly unavoidable” that AI would trigger a financial crisis within a decade.
But Gensler is also concerned about the implications of digital assets, specifically stablecoins. During a House Committee on Financial Services hearing, Gensler mentioned that he viewed stablecoins as a systemic risk to the economy.
It seems that from Gensler's perspective, all emerging technologies pose substantial risk to financial markets and the global economy. There might be some truth to that: All emerging technologies have benefits and risks, and if these innovations are not developed and implemented responsibly, they might imperil global financial stability.
This calls for a need for a comprehensive approach to responsible innovation in the financial industry.
A comprehensive approach to Responsible Innovation
The financial industry has been known for its continued exploration and implementation of innovative applications. This applies not only to FinTech startups but also prominent financial players such as JPMorgan, PayPal, or FICO, which have been pushing boundaries with cutting edge technologies including Web3, AI, quantum computing, and others. A comprehensive approach to responsible innovation would be the most suitable approach for the following main reasons:
Full-system solution
Most, if not all, solutions require the integration of several emerging technologies. If we have separate guidelines and regulations for each technology, then how do we make sure that the product/service is compliant? Where does one rule start and the other end? Separate guidelines would introduce more complexity, errors, and misinterpretations, which eventually might result in more harm than good. If the implementation of technologies is all-encompassing and comprehensive, then so should the regulatory approach.
Different technologies have different strengths and weaknesses
All technologies have strengths and weaknesses, and quite often the strengths of one technology can support the weaknesses of the other. For example, AI can support Web3 by enhancing the accuracy and efficiency of smart contract execution, as well as blockchain security and monitoring. Blockchain technology, in turn, can assist in manifesting responsible AI, as blockchain is everything that AI is not: transparent, traceable, trustworthy, and tamper-free.
When AI supports Web3 and vice-versa, we implement a comprehensive safe, secure, and trustworthy solution. Would these solutions be AI compliant? Or Web3 compliant? With this type of solution, it would be difficult to dichotomize compliance. The solution in its entirety should be compliant and adhere to all guidelines/policies. Thus it would be best if these guidelines/policies encompass all technologies, including their integration.
Forward-looking
Technology advances exponentially. More technologies will emerge, and existing ones will evolve and advance. They all come with their benefits and challenges, and require the implementation of responsible innovation. Regulation and legislation, though, will not be able to keep up with the pace of innovation. It would be best if regulation applies generic, all-encompassing principles that no matter what technology is implemented, the solution will always be safe, secure, and trustworthy, and benefit the greater good.
Innovation never stops. It has great potential to benefit our global economy and society, but also brings the potential of substantial risk to the safety and stability of financial markets. It is in our best interest if legislation governing Responsible Innovation encompassed all technologies, including those yet to emerge.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
Merav Ozair, PhD
Dr. Merav Ozair is a global leading expert on Web3 technologies, with a background of a data scientist and a quant strategist. She has in-depth knowledge and experience in global financial markets and their market microstructure.
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