Paper

China’s RegTech Development Path
Sun Guofeng
CF40 member;
Director, Financial Research Institute, the People’s Bank of China
2018-01-18

Abstract

There are different definitions for RegTech. The UK's Financial Conduct Authority (FCA) has described RegTech as “technologies that may facilitate the delivery of regulatory requirements”. More broadly, RegTech can be defined as “the organic combination of technology and regulation”, that is, the application of technology to regulation. RegTech involves three main bodies: the first is the regulatory agencies responsible for the formulation of regulatory rules; the second is the financial institutions, including financial technology companies, whose behavior need to meet regulatory compliance requirements; the third is professional RegTech companies which provide services for financial institutions and financial technology companies to meet the regulatory compliance requirements. RegTech can use specific technologies such as big data, cloud computing, artificial intelligence, and machine learning, etc.

Background for Chinese and International RegTech Development

There are two factors influencing the development of RegTech internationally.

1. On the demand side, after the financial crisis, regulatory authorities gradually tightened the supervision of financial institutions, thus the cost for financial institutions to comply with regulatory decrees increased. Many banks hired a large number of staff and increased spending in order to meet the regulatory requirements and avoid huge fines. They also introduced technological means to promote their own compliance capability. This is the context of RegTech from the demand side.

2. On the supply side, in recent years the development of big data, cloud computing, artificial intelligence, and machine learning has reached a new level. RegTech has also released its own development potential. In particular, there are many RegTech companies that provide more professional services.

In contrast, China’s RegTech development has its unique features.

1. There is a need to develop RegTech. From the experience of foreign development, the need to development RegTech mainly comes from companies that must meet regulatory requirements. In China, in addition to that, there is also a very important and real problem. China's financial market is relatively large and its development is fast, with new cross-industry, and cross-market products emerging. These innovations bring financial risks along with them. In order to cope with these financial risks, financial regulation needs to be strengthened, and the human resources investment and cost needed for financial compliance is now increasing. In the face of such a large market with so many products, financial institutions, and financial data, relying solely on human supervision can hardly produce the desired regulation results. So, in China, RegTech can not only be used to monitor the development of FinTtech, but also to meet the regulatory authorities’ need to identify and prevent financial risks.

2. From this perspective, the driving force behind the development of RegTech is also different in China. Outside of China, RegTech development is mainly manifested by financial institutions’ adoption of new technology to meet the regulatory requirements. The driving force behind RegTech development involves both the financial institutions and the regulatory authorities. In China, financial regulation is the most inclusive, financial institutions and financial technology companies do not necessarily have sufficient incentive to develop RegTech technology. So in China it may be more important for the regulatory authority to promote the development of RegTech.

3. The specific application of RegTech technology is also different in China. From the international perspective, it is mainly applied in the field of regulatory compliance, including anti-money laundering and cyber security. In China, in addition to these aspects, enhancing the capability to guard against financial risks is also an important field of application.

RegTech uses big data technology to analyze massive amounts of financial data. Through cloud computing, regulators can improve the regulatory rules, and flexibly adjust calculation methods. In particular, artificial intelligence which has made important breakthroughs this year is also an important technology used in RegTech.

The Core of RegTech: Regulation Using Artificial Intelligence

Artificial intelligence is likely to be the center of RegTech’s development. The use of artificial intelligence in regulation has several advantages:

First, it can solve the incentive restraint problem from regulators. What motivates regulators is in itself an issue of incentives and restraints. With the development of artificial intelligence regulation in the field of RegTech, this issue can be solved, thus avoiding problem of insufficient regulation due to the lack of necessary incentives and constraints.

Second, the introduction of artificial intelligence can improve and optimize the computing ability of regulation. In the recently concluded chess game between AlphaGo and Ke Jie, it can be seen that artificial intelligence can make progress very fast through self-learning, and its computing and overall optimization ability is very powerful in finding potential risks, loopholes, and hidden dangers. Financial risk is the uncertainty of future losses. Since it is uncertain, it implies that human beings’ understanding of the future is flawed. This defect now seems to be able to be compensated by artificial intelligence. Financial risks that human beings cannot find can be discovered by artificial intelligence.

Third, artificial intelligence has a unique advantage in dealing with systemic financial risks. The so-called systemic financial risk is financial risk which may seriously impact the real economy and damage the operation of the financial system. What level of financial market volatility will lead to systemic financial risks? In this regard, our understanding is still not enough. It is difficult to predict most of the systemic financial risks before they occur, and sometimes it is even hard to assess them after the fact.

For example, before the global financial crisis, few people predicted that the US subprime mortgage crisis will lead to the global financial crisis. Even after the US subprime mortgage crisis, many in the economic community, regulatory circles, and the financial sector were not aware that the subprime mortgage crisis would eventually become a global financial crisis. This also shows that human understanding is with some flaws. Of course, after the crisis national regulatory authorities have done a lot of research on how to establish an early warning system. For example, the Bank for International Settlements developed credit-to-GDP measures. Of course, this indicator also has its problems. It is based on past experiences, 2/3 of the economies that reached a certain threshold level experienced systemic financial crises, but the other 1/3 did not. The problem is that we do not know whether a country belongs to the 2/3 or the 1/3. Therefore, trying to identify systemic financial risks using simple indicators is difficult. Artificial intelligence can conduct powerful computation based on big data and may find the potential systemic financial risks that we are not aware of.

Of course, artificial intelligence can apply many different styles of reasoning to financial regulation, it is not limited to rules based reasoning, like the rules governing a game of chess. Since financial rules are changing, it may use contextual case study reasoning, or even fuzzy reasoning to analyze uncertain events. In short, it is possible for artificial intelligence to simulate human thinking in a variety of ways and computational methods, and can play special role because its powerful computing ability far exceeds human beings.

How Should China Develop RegTech?

First, China should improve financial regulation under two pillars. On the one hand, it should conduct micro functional regulation. We should establish FinTech industry regulatory rules, achieve full coverage of risk regulation, and avoid regulatory gaps. We should carry out penetrating supervision and link the source of funds with the final destination. We should also determine the business attributes and risk characteristics using information from the whole chain, and implement corresponding regulatory rules. We can actively explore hierarchical supervision. For institutions with different scales of operation, technologies, and risk capacity, apply different business access and innovation rules to improve regulatory efficiency.

On the other hand, we should improve macro-prudential regulation. We may find that if financial institutions all use artificial intelligence and self-learning to manage risks, the micro-level financial risks may decrease, but pro-cyclical behavior may increase. Now a lot of financial technology companies use big data to judge customer risks in real time, their reaction time may be milliseconds after a shock. If all financial institutions and financial technology companies take the same action at the same time, such as shrinking the credit in response to negative risks, there will be a very big shock to the financial industry. So from this point of view, macro-prudential regulation should be implemented taking into account counter-cyclical operations to avoid the pro-cyclical risks.

Second, promote the standardization of financial data. Standardized and real financial data is the basis for big data analysis using artificial intelligence. Financial regulators should lead the development of financial data standards for the entire FinTech industry, and integrate the financial data.

Third, the regulatory authorities should develop relevant rules and standards, including industry technical standards, effectively regulate market access and exit, and thus provide an orderly and fair competitive environment for financial institutions and financial technology companies.

Fourth, who will develop China’s RegTech? I think there are a few approaches.

Path 1: The financial regulator itself independently studies and develops the RegTech system.

Path 2: Financial regulators outsource the research and development of the RegTech system. Financial regulators can state the requirements for professional RegTech institutions to develop and design the RegTech system.

Path 3: Financial institutions or FinTech companies develop the RegTech system, which is then selected, integrated, and assessed by the financial regulator or by a third party. On this basis, the RegTech system is applied to the entire industry.

Fifth, build a sustainable RegTech development mechanism. RegTech development requires substantial capital. This is different from the past. In the past, regulation mainly involves human costs, so it depends on whether the regulatory authorities can hire high-quality regulatory personnel. Now with the development of RegTech, to build an efficient system which utilizes artificial intelligence requires more capital investment. In this context, if RegTech itself does not have a very good self-development mechanism, there may be an imbalance between the regulatory development and the development of the financial technology industry. So it is necessary to promote an appropriate degree of internalization of the regulatory costs. That is, the FinTech industry (of course, including financial institutions) should bear a certain share of the regulators’ cost for developing RegTech. From the point of view of the FinTech industry, it is also necessary for it to pay for some of these costs in order to have a good regulatory environment for the long-term, sustainable, and healthy development of the FinTtech industry. At the specific operational level, organizational and mode innovations may be employed for them to contribute their own strengths. Some degree of internalization of the regulatory costs can help solve the problem of incentive and restraint in regulation, and can alleviate the problem of unfairness in financial regulation and help build a new fair, orderly and competitive ecology for the FinTech industry.

Sixth, strengthen international cooperation on RegTech. On one hand, China can exchange and collaborate with other regulators on RegTech technology, introducing new technologies or sharing experiences. On the other hand, strengthening international regulatory cooperation can prevent cross-border regulatory arbitrage and prevent systemic financial risks.