This post is part of a series inspired by Bo’s panel presentation at the American Bar Association’s 2022 Business Law Section Spring Meeting.
The term “fintech” is ubiquitous in financial services. Fintech represents a paradigm shift within the industry. Financial services firms are no longer relationship-driven; they are data-driven. As financial services firms learned that they were sitting on treasure troves of data, they began to leverage that information to drive growth and profitability. Financial services firms harnessed the scalability of technology to mine their data sets and transform that information into profits, resulting in the rise of financial technology, or fintech.
The purpose of fintech is to reorganize how firms in the financial services sector leverage technology to capture the demands of customers. Fintech started by consuming decades of manually created customer data (e.g., paper forms) and evolved into producing and capturing new types of customer data (e.g., mobile and internet data, video, and user-generated feedback).
Today, “[a]t least, one fintech technology is used by 50% of financial customers globally.” The rise of mobile technology has placed a computer in the pockets of millions of financial consumers. The result has been an exponential growth in the amount of data that a firm manages. In fact, “[n]early 2.5 quintillion bytes of data is being generated every day in the globe at our current speed, [and] this trend is estimated to increase in the coming years.” The sheer volume of data produced by consumers has grown beyond the ability of humans to effectively categorize and analyze it.
Regtech is the application of emerging technology to improve the way businesses manage regulatory compliance. The regtech sector relies on a few key technologies, with about 66% of the sector using cloud-based software, “56% of vendors employing machine learning[,] and 43% using predictive data analytics to describe patterns or predict behaviours.” Currently, the hottest areas of regtech include machine learning, natural language processing (NLP), and blockchain (or distributed ledger technology). Over 35% of vendors are currently leveraging NLP as a core technology.
Rapid Growth to Meet Regulatory Demands
The growth in regtech is fueled by favorable market conditions, including increased regulation of certain industries such as financial services. According to Thomson Reuters, rule changes have increased 500% in the last decade alone.
As a result, keeping up with regulatory changes is the primary concern of compliance officers, as compliance staff need to spend more time monitoring regulatory changes and implementing program updates. And the pace is only increasing. According to the Thomson Reuters 2018 Cost of Compliance report, a new regulatory update is implemented every 7 minutes!
The sheer pace of regulatory change is forcing many compliance departments to adopt regtech solutions that can free up their most precious resource: people. By 2021, Thomson Reuters reported that 34% of survey participants expect regtech solutions to affect compliance management. But the pace of regtech adoption remains muted, as only 16% of firms have implemented a regtech solution.
Slow Adoption Despite Increasing Complexity
The financial services industry is characterized by an ambivalence toward innovative technology, with many financial services firms embracing its use for business purposes, while many regulatory compliance professionals resist it. To date, most financial services firms have adopted fintech to drive business development but have focused on human resources to address the compliance needs of their evolving businesses. Although fintech adoption continues to increase, fewer firms are expecting to add to their compliance teams in 2022 versus prior years, marking a three-year decline in the expected growth of compliance firms.
One reason for the slow technology adoption is the sector’s historical reliance on outsourced services. Compliance departments still rely on outsourcing of compliance functions to service companies. But the increasing availability of regtech solutions at service firms is driving some firms to transfer regtech implementation to service providers. Today, 34% of firms outsource compliance functions versus 24% in 2018.
Financially, most compliance departments are dealing with static budgets, with only about half of firms expecting to increase their compliance budget. With the slow adoption of regtech by financial services firms, it appears that most of the new money spent on compliance will go to hiring senior skilled officers.
So with most firms continuing to rely on human resources as opposed to technology, what skills are in highest demand? Subject matter expertise, meaning firms want to hire people with deep understanding of current regulations to address new regulations. Interestingly, digital technology understanding is about seventh on the list, which suggests compliance departments will need to rely on other internal departments or vendors to assist with regtech adoption.
Interestingly, risk management is also low on the necessary skills list, even though most firms believe they will spend more time and money managing risks.
The Path Forward
While financial services firms are increasingly realizing the benefits of adopting modern technology such as artificial intelligence (AI), machine learning (ML), and blockchain, these technologies are being deployed outside of compliance departments, as evidenced by the slow adoption of regtech. The reasons for this disparity range from a lack of resources in compliance departments (both people and money) to a fear or misunderstanding of innovative technology. With the right tools in hand, compliance officers can leverage regtech to improve their firm’s compliance processes and capitalize on the wealth of data flowing through their systems.
In 2017, the Financial Stability Board (FSB) issued a white paper discussing the adoption of AI/ML by financial institutions. At the time, the FSB realized that while adoption was still in a nascent stage, it was rapidly evolving into today’s environment where AI/ML is used regularly by most financial institutions. At the time, the FSB noted that financial institutions were already using AI/ML to assess credit quality, asset prices, and market insurance contracts; automate client interactions; back-test investment models; search for trading signals; and optimize trade execution. The FSB opined that future uses would include regtech, market surveillance, data quality assessment, and fraud detection. But five years later, we still see slow adoption of regtech, particularly among small to middle-sized businesses.
The lack of adoption is not due to a lack of product availability. On the contrary, technology firms and investors have poured time, money, and effort into developing the regtech space. In our next post, we’ll discuss the regtech market and how investors see the future of regtech.