Innovation as a Challenge to Regulation
What if the greatest challenge facing regulation today is not erratic executive action, lack of political will, or under-resourcing (though, of course, these matter)? Instead, what if the most profound and significant challenge facing regulation—not only today, but continually—is private-sector innovation?
Innovation is the product of that most cherished good, human creativity. Innovation carries with it the prospect of problems solved and diseases eradicated, of fresh adventures, and ultimately of a proverbial larger pie. Sometimes the debate is more nuanced, but, for most people most of the time, to be anti-innovation is still to be unenlightened, fearful, backward, and blind to possibility. Public policy choices and public dialogue endlessly reflect this, often speaking of innovativeness as if there could be no higher compliment.
Yet we should also consider innovation’s unpredictable effects on the regulatory landscape it occupies. Sometimes we fail to see the effects of innovations until they collect, as if suddenly, in unexpected locations—for instance, the risk collected in derivatives markets before the financial crisis. In fact, those innovations may have built up over time, but only registered with regulators after they had reached a certain critical volume.
In this way, innovation is like water: A single droplet may be unremarkable on its own, but many droplets together matter quite a lot. Moreover, innovation runs down avenues of opportunity, whether or not outsiders to the process recognize those avenues. Innovation will run under, around, and over obstacles, including seemingly clear regulatory requirements.
Innovation is also like water in its potentially corrosive effect. In the language of the business scholars, it is “disruptive.” Decentralized, private-sector innovation creates its own opportunities. It can open up novel and unexpected ways of working that challenge existing divisions of responsibility between regulators. It can destabilize or swamp regulatory structures, sometimes in obvious ways but sometimes in latent or inconspicuous ones.
Even innovation that undermines and disrupts core components of regulation can sometimes be hard to track until it is very far along, by which point it will have gained momentum, and interests and defenses will have coalesced around it to a point where it may be hard to contain. If the regulatory obstacle is a rigid rules-based requirement, then running around that obstacle is relatively straightforward. For example, Enron, the failed energy company, had no difficulty skirting U.S. accounting rules. But more flexible or market-based regulatory regimes, like those underpinning the Basel II capital adequacy regime or the (asset-backed) commercial paper exemption from securities disclosure rules, are hardly immune from being skirted.
If we want to improve regulatory effectiveness in the face of innovation, the first step must be to gain some distance from the romantic, almost magical, conception, of innovation that dominates popular and academic discourse. We need to recognize that innovation, almost by definition, is a profound and direct challenge to regulation in all its forms. This is the project I tackle in my recent book, Innovation and the State: Finance, Regulation, and Justice.
A familiar dichotomy between radical versus incremental innovation is a useful, if imperfect, place to start to think about the phenomenon. “Radical” innovations are thought to represent fundamental breaks, step changes, or paradigm shifts. In contrast, “incremental” innovations are the product of iteration, tweaking, and diffusion—changes that produce gradual evolution.
Accepting this distinction for a moment, the velocity and magnitude of change that a particular innovation brings with it will change the regulatory challenges it presents. For example, when a radical, or what I call “seismic,” innovation occurs (the existence of which will always be a matter of degree), the main regulatory problem will stem from a lack of data, lack of comparators, and what economist Frank Knight in 1921 described as “genuine uncertainty”—a nuanced version of Donald Rumsfeld’s famous “unknown unknowns.”
Consider the growth of deepwater oil drilling starting in the late 1990s, or the sudden explosion of cryptocurrencies and cryptocurrency markets today. These seismic innovations will create particular kinds of regulatory problems that demand particular kinds of regulatory solutions. For example, ex ante licensing regimes and effective information-forcing mechanisms—such as the right to play in a “fintech sandbox” in exchange for providing a regulator with extensive information about one’s operations—could be reasonable ways to try to slow down innovation while the regulator addresses the data scarcity problem. A brave regulator should be willing to consider them.
By contrast, most innovation proceeds in a more incremental way, through what I call “sedimentary” layers of innovation. This is exactly the kind of innovation that regulatory scholarship, from Justice Louis Brandeis’s laboratories of democracy onward, seeks to celebrate. In this version, each new layer of practice or product, like each individual drop of water, seems fairly unremarkable. It does not trigger the alarm bells. Cumulatively, however, the layers can add up to very significant change. Think of the recent growth of social media as a force in society and politics.
The regulatory challenge in such cases of sedimentary innovation is that, like the apocryphal story of the frog in boiling water, we may fail to notice the change until society is a long way from safety. Because humans are poor at recognizing and responding to slow-moving, accretive change in real time, a capacity for monitoring and detecting sedimentary change must be built into the regulatory framework itself. Rather than developing ex ante licensing regimes, for example, regulators might be better off focusing on developing better systems for tracking and responding to change, in real time and over time.
Innovation is a complex, multifactorial phenomenon, and developing regulatory responses to it is challenging. In my book, I propose a framework of questions and strategies, drawn from case studies, for addressing the technical challenge of regulating in the face of innovation. Yet I also believe that these are not only technical questions. Regulation is at the leading edge of politics and policy in ways that we do not always fully grasp.
Seemingly innocuous regulatory design choices have clear and profound practical ramifications for many of our most cherished social commitments. Groups of people win and lose when innovation changes the ground rules. Financial regulation in particular is a crucial site for addressing inequality in some of its most embedded and pernicious forms. Society needs a regulatory structure that facilitates governmental and private-sector use of best practices, while also staying attuned to the broader equality, justice, and fairness concerns that animate and ought to inform regulatory priorities.
Source: Regulatory News