Financial Regulation in Cyberspace

Ekaterina Svetlova

Rebuilding Macroeconomics’ Finance Hub held its second workshop to discuss the interdisciplinary approaches to financial resilience and stability. We focused on digital currencies and their impact on regulation and central banking.

In the first session, we considered whether the new shadow payment systems creates new risks and, if so, how they should be handled. This is important because peer-to-peer payment systems such as PayPal, mobile money platforms such as M-Pesa, and crypto-currency exchanges such as Mt. Gox are not part of the established banking system and not subject to the same regulation. In many senses, ‘digital currencies’ is a misnomer because they are not, strictly speaking, currencies (more later-on).

Risks range from simple operating risk (technology failure) to systemic effects of possible mass liquidity withdrawal from markets. As more individuals and institutions hold funds and make payments outside the conventional banking system, systemic risk may develop. This raises several important questions for financial policy.

If money on mass is created within, or moves into the shadow banking system, how should financial and monetary policy adapt? Will conventional tools such as capital regulation or interest rates and open market operations continue to be efficient? If not, what alternatives should we use?

The discussion united lawyers and economic geographers on issues that arise from boundaries. The shadow payment systems, lending platforms and digital currencies challenge traditional domains of regulation being nations, territorial jurisdictions and material locations. They operate in cyberspace that can be understood as “the communications within a network of digital computers conceptualised as a space” (Allen and Lastra, 2018).

So how are we supposed to govern risks that emerge in those new cyber-territories? How do we define these territories in the first place? Should regulation be primarily national, or transcend states and cyber-boundaries.

We also considered the importance of geographical differences among shadow banking institutions and platforms. The emerging regional models of Fintech vary over the world (such as Silicon Valley vs. China) and they increasingly shape financial architecture, but in different ways. A comparative study that highlights the issues is surely required.

In the second session, we asked how new technologies could promote financial stability through big data and providing real-time monitoring. The focus was on the so-called “RegTech” and its potential in regulation. Whilst algorithms based on machine-learning can be used for real-time observations of the financial system, the limitations of these technologies need to be better understood.

Current AI is limited in some important ways, such as being unable to identify new events (think of the Swedish self-driving car that failed to recognise a Kangaroo). In some cases, it is even possible to solve for how to ‘trick’ AI into misidentifying images and events where a human would clearly not be misled (adversarial examples). The implication this may have for creative accounting and regulatory arbitrage poses important questions for how this technology is used. Furthermore, the profound question of how to approach regulation of the financial system that becomes more complex with integration of AI and other technological innovations was raised.

Do we want to chase complexity or rather improve upon simplicity? Can complexity science help to search for a solution here? Are there new ways of modelling that enforce simplicity?

The third session was concerned with the changing nature of money. First, interesting alternatives such as central bank digital currencies and private central banks were discussed. There was also a strong call for a collaborative project between economists and lawyers on the origination of money in the modern economy. Macroeconomics typically conceptualizes money creation as the solution to an optimization problem and omits the consequences that money is a creature of law decided by governments.

There are numerous aspects related to these issues worth investigating. First, the idea of what money is changes rapidly as new forms of money such as cryptocurrencies, Facebook money etc. emerge. Perhaps institutions other than the state will define what money is in the future. Research into comparing the economic and legal notions of money is also required.

Second, macroeconomists that include banking sectors in their models do not take into account that banking systems create money (rather they are assumed to play an intermediation role). This is an issue that legal scholars, however, understand and brought to the table during the workshop. Third, traditional banks differ from the shadow banks. An important question is to understand how these two groups of financial institutions differ in the money creation process and whether the differences really matter.

Finally, the idea of organizing a workshop for the early career researchers to involve them into the interdisciplinary research in macroeconomics was raised and, in my opinion, is worth pursuing.