On a panel called ‘What Keeps Regulators Up at Night’ held at the Money Transmitter Regulators Association conference in Boston last November, three experienced state examiners from Virginia, Wisconsin and Texas laid out in clear terms the key issues they face when vetting money transmitters in their states. Their primary concern: the accuracy and integrity of a license holder’s financial and accounting reports, which are the basis for ascertaining a company’s true financial condition and for ensuring there is sufficient liquidity to meet “transmission obligations.” That’s right, we’re in the second decade of the 21st century, and regulators still rely on after-the-fact, paper-based reporting. Further, regulated financial institutions seem incapable of providing unimpeachable transactional and financial reports to ultimately demonstrate their solvency.
It is a widely known fact that regulation always lags behind technological innovations, especially in the realm of financial service design and delivery. How to bridge that gap is one of my ongoing research interests, and my goal here is to focus on an (up-to-now overlooked, but critical) approach to financial oversight that could address the core purpose of prudential financial regulation.
The Current Oversight Paradigm
The main mission of a financial services prudential regulator is to ensure the safety and soundness of service providers, thus maximizing to the extent possible the protection of consumers’ rights. This includes the right to have their funds delivered to the intended beneficiary in the promised timeframe, or the right for funds to be stored safely. In other words, the primary purpose of regulatory oversight is the protection of consumer funds against loss and mismanagement by financial intermediaries. How do regulators go about accomplishing this goal today? The traditional mechanism whereby regulators execute their mission is licensing, a rigorous due diligence process whose purpose is the “credentialing” of the entities and individuals seeking to engage in a particular financial service activity that has been deemed risky enough to warrant this vetting process.
Licensing is an invasive and heavily front-loaded process. In fact, the applicant needs to submit reams (yes literally, paper reams, in some states) of data about business plans, service and product descriptions, actual and projected financial statements, personal financial information of officers and directors, multiple disclosures and affidavits, and, most importantly, the methodology for calculating and demonstrating that the company has sufficient liquidity to cover any “outstanding obligations” — what is known as proof of solvency, the ultimate guarantee that consumer funds are safe. As is famously known, in the United States, all of this is required to be done forty-eight times, one for each jurisdiction requiring licensure of non-bank financial services providers.
Apart from the cumbersome nature of this whole affair, the problem with this oversight paradigm is that once this intensive review is executed, nothing much really happens afterwards, throughout the rest of a company’s life cycle. There is an annual renewal of the license, which usually consists of the payment of a renewal fee, and there are examinations of course, which occur in approximately eighteen-month cycles, are mostly conducted on site, and are paid for by the license holder. Examiners send a laundry list of requests for disclosures and documentation ahead of time and then show up to the head offices of a license holder where they stay for about a week, in what some have cynically called “paid vacations for regulators,” examining books and records and interviewing employees. In sum, the first problem with this paradigm is that actual, effective oversight during the ongoing operation of the company is often cursory and always after-the-fact. Months and even years may pass before a regulator finds out that a company is in dire straits.
So, what else is wrong with this oversight paradigm? Naturally, it is based on mandatory or compulsory transparency: applicants are literally coerced into disclosing information and documentation that supervisory agencies use to determine their fitness and properness. And what’s wrong with compulsory transparency? Well, just as the mere existence of a rule may create the Hawthornean counter effect of a defensive attitude, the coercion itself may actually induce companies to produce and submit less than accurate reports. In fact, that is very often the case. And if the information provided by the company is inaccurate or incomplete, regulators have no way to determine the true financial condition of a license holder and the ultimate purpose of prudential regulation -consumer protection- basically vanishes into thin air.
In a world where a click on a “Like” button in Japan propagates to every corner of the globe in milliseconds, it is hard to understand why neither government nor industry do anything to change this state of affairs.
From Compulsory to Voluntary Transparency
Let’s now consider an alternative scenario. Imagine that, instead of having to provide information and reports on an ex-post-facto basis, financial institutions openly, yet securely and in real time, published an anonymized and immutable record of all movements of incoming, transferred and outgoing value. If companies publicly and voluntarily disclosed their database of transactions, prudential regulators would have the ability to reconstruct in real time, or at any moment in time, a company’s financial statements, and thus be able to verify their integrity. The result? No more sleepless nights second-guessing the accuracy of coercively submitted reports.
In addition, imagine that financial institutions of any kind -not only blockchain-based ones, which are transparent by design- voluntarily published their internal ledgers, displaying their current financial obligations and side-by-side, also in real time, the liquid, real assets matching those obligations. An open and real-time mechanism like this would provide regulators and the public at large with an early-warning system that would spring into action when an asset-mismatch has occurred. The result? Incontrovertible proof that the company is solvent enough to cover any “outstanding obligations.”
Many headaches experienced by regulators and license holders would just go away if institutions embraced transparency tactics like these as a self-regulatory mechanism. It would be a win-win-win. Regulatory oversight would be less costly and more effective. The shared responsibility among regulators and transmitters to preserve safety, verify compliance and ensure consumer protection would be greatly enhanced. Most importantly,consumers themselves would have the peace of mind that their funds are protected, and that the company where they bring their business and the regulators whose salaries they pay as taxpayers are really doing their job.
Operating in real-time is still a dream for financial services providers, even if they are introducing innovative digital platforms. For regulators, who either by choice or circumstance have historically monitored the operations of these companies on an ex-post-facto basis, it is an even remoter possibility. However, we are not too far from making real-time financial auditing possible. While these techniques will probably take some time to evolve and be adopted as industry standards, a move toward technology-enabled transparency and proof of solvency would indeed be a positive step forward.