Leveraging Innovation in RegTech

Theres a perfect storm brewing in the RegTech industry. There are new regulations that need to be adopted and existing ones that still need to be complied with. And there are innovative new technologies that are being touted as the solution to compliance and regulatory reporting issues. Its no secret that many firms are eager to combine their regulatory compliance requirements with new innovations such as artificial intelligence, machine learning, predictive analytics, cloud, or distributed ledger technology (DLT). But the kind of solutions that are required are still largely unproven.

When it comes to regulatory compliance, firms of all shapes and sizes want a proven solution. When a new regulation comes down the line with two to three years to comply, firms dont, unlike other areas of fintech, engage in a project for the learning experience. While that is positive because there is a readymade business case for a RegTech solution, it also suggests that the well-worn incubator and lab path to scale business will not suffice.

Firms dont have the time or the risk appetite to fail fast, iterate and repeat when the stakes are so high. The cost of failure is not a failure to learn as it is in other aspects of innovation; its a potential delay that could mean noncompliance, substantial fines, lost revenue, lost clients, reputational damage and even the loss of entire business lines if they are barred from transacting certain instruments or in certain jurisdictions.

RegTech firms that offer solutions around a specific regulation tend to get airtime as organizations devise roadmaps and orchestrate resources. However, the sales cycle is longer than elsewhere and procurement teams are even trickier to navigate, precisely because of that risk of failure. Procurement check lists and due diligence checks are exacting and exceptionally hard for a startup to negotiate without active and deliberate support in the form of a sponsor willing to underwrite the risk of doing business with firms that dont meet the requirements the company deliberately put in place to minimize risk and exposure.

Examine the compliance requirement before the tech

Before firms decide how or what to adopt into their organization, its worth examining the two biggest challenges banks are facing in their compliance efforts. First is the need to understand, jurisdiction by jurisdiction, exactly what needs to be complied with. Among other things this is based on where offices and clients are located, where around the world they are executing trades, and what exactly they are trading. The second challenge is how to bring together all of your data and information into a unified book of record. Today, there are multiple business lines within an individual organization, each with its own book of record, and spanning different geographies. Pulling these together is no easy task, but without a centralized record, reporting is made even more difficult. While regulators advocate caution, because of relatively unknown terrains in RegTech, the solutions offered can help make sense of these challenges, by automating, streamlining, and simplifying processes, mitigating risk, and making compliance obligations clearer.

That is one reason why the RegTech firms seeing the most success are those focused holistically around the compliance function rather than those aligned to a specific regulatory mandate. Firms such as Suade and Quantexa are offering innovative ways to tackle issues in KYC and AML where legacy processes and approaches are ripe targets for change and evolution.

Evaluating RegTech approaches

So where should you start if you are looking at technology as a way to ease your regulatory obligations? One point to consider is that more and more, regulators are focusing on rules related to data management, technology and innovation, as opposed to straight rules around trading and operations. This opens up a number of possibilities.

The first is applying technology to help not only understand complex regulations, but to translate exactly how they apply to your firm, enhancing flexibility in compliance efforts, and moving towards greater collaboration, both within a company and with peers across the industry. In understanding how incoming regulations impact you, and which regulations you need to abide by for which trades in which parts of your company, artificial intelligence and predictive analytics will serve a real purpose.

For example, a leading US financial institution is proactively assessing risk by using AI to review all of the activities undertaken by traders to reveal any suspicious trades. Machine learning has already proven particularly useful forvalidating the models built for regulatory stress tests, such as the Federal Reserves Comprehensive Capital Analysis and Review (CCAR). Because stress-testing models are based on projections of how a bank will fare in hypothetical stress scenarios, rather than historical data, building and validate their own challenger models with machine learning can accelerate model building and testing.

Another application of new technologies is in the settlement of trades and in actual reporting to regulators. Robotic process automation (RPA), for example, can offer support for the most physical, manual processes that people are currently undertaking, namely the creation of reports, the resolution of breaks, and management of reconciliations, through automated processes that are digitally defined and stored.

Blockchain on the other hand, can bring together industry peers for greater collaboration and quicker reconciliations, by updating and futurizing trade repositories. In this instance, if you can visualize a trade repository that is real-time and two-way, then it would evolve from something that is inherently batch-processing and reconciliation-based to something that is real-time and more verification or synchronization-based. The industry could have almost instant insight into information that companies are sharing to ensure the information is the same on both sides of the trade, no matter who is verifying or reconciling it. It could offer the ability to do that at scale and in a normalized fashion across a process.

Identifiers and other kinds of reference data used in regulatory reporting could also be issued onto a blockchain network to be consumed by end users. That could mean legal entity identifiers (LEI), International Securities Identification Numbers (ISINs) and perhaps instrument reference data would appear on a blockchain, which could then be accessed by firms. This kind of application could mean savings for firms which constantly have to upgrade their reference data platforms.

The local operating units (LOUs) which issue LEIs might become redundant if there were a large scale DLT process backing LEI generation. With the concept of oracles and nodes automating these processes youre not dependent on one governing body or one group. You could have multiple groups issuing IDs onto a blockchain and multiple consumers of that information all having equal access to it.

However, the complexity of these processes means that is still years away from fruition. The next few years are likely to see smaller scale development and the delivery of applications that further showcase the benefits this technology can provide. The DTCCs announcement of a large scale pilot to “re-platform” theexisting Trade Information Warehouse (TIW), which automates record-keeping, lifecycle events and payment management for approximately $11 trillion of cleared and bilateral credit derivatives, is another milestone on this journey. The challenge now will be if it can deliver significant cost and operations savings, as well as support more efficient operational processes as outlined above.

From concept to reality

The key consideration for anyone evaluating innovative new RegTech applications is that that rules are continually being developed, changed and implemented globally. And that we have not yet overcome the regulatory arbitrage issues associated with multiple jurisdictions. Its important to take into account the current state of the regulatory road map, but to build in allowances for future regulations, or even new products and jurisdictions you may need to consider as your organization grows.

In short RegTech is not going to go away. The new solutions being discussed have the potential to mitigate risk, through a clear understanding of how to meet which obligations to help reduce overhead and costs related to operational and technical support, and for special client reporting requirements that may need to be met, or new jurisdictions that are traded in in the future. It would be beneficial enough if you can address even one of these issues. But imagine a world where your technology stack can handle them all.

Joshua Q Israel Satten is a Director and head of the emerging technologies practice at Sapient Consulting, based in San Francisco.