Despite its many promises, RegTech, and especially AI, is too expensive to justify the use case on the buy side today. But as it becomes more commoditized, and develops deeper intelligence capabilities, it stands to revolutionize the way firms do business. Mary Kopczynski, CEO and Founder of regulatory solutions company 8of9 explores. (Listen to related podcast)
So far, interest on the buy side for RegTech solutions has been relatively low. The majority of the regulations that impact buy-side firms tend to be one-and-done regulations, where they need to register as something for the first time. The buy-side firm calls a Big Four accountancy client, or a law firm, has them fill out the paperwork and that is it. As a business, the buy side doesn’t have the requirements of repeatable and automatable tasks in the same way that the larger broker dealers do.
As a result, it is not really worth it for buy sides to invest heavily in RegTech at this stage. Tier-one banks can save hundreds of millions of dollars by moving to an artificial intelligence (AI) or robotics solution because of the scale of the challenges they can solve with it. But smaller dealers, regional and community banks and hedge funds tend to have much smaller IT budgets and want to focus it on things like trading platforms and speed of execution rather than compliance automation.
Price point is also an issue. RegTech service providers are naturally more inclined to do a $10 million sale rather than a $50,000 sale. They are able to build RegTech systems for the large institutions because they are willing to pay the true development costs. Once those big players invest in it, and the technology becomes more commoditized, it will provide more flexibility for the service providers to charge less and bring solutions out on a mass scale.
AI will ultimately save firms a lot of money
Sell-side firms have more incentive to invest in newer technologies because of the scale of their operations. As an example, one dealer recently partnered with a data firm, plugging in all their trading platforms, email, fax machines, printers and building access codes to a monitoring system. Within four days, they were able to predict all five of the rogue traders the bank had had to deal with over the previous ten years. This technology could have saved the bank billions in lawsuits and regulatory fines. Global institutions especially can face sanctions from multiple regulators at the same time, once one regulator finds a digression.
“One dealer recently partnered with a data firm, plugging in all their trading platforms, email, fax machines, printers and building access codes to a monitoring system. Within four days, they were able to predict all five of the rogue traders the bank had had to deal with over the previous ten years. This technology could have saved the bank billions in lawsuits and regulatory fines.”
The buy-side is very different in that their business is very specific. They tend to cater to a smaller subset of the population, specializing in certain jurisdictions, regions and products. The number and type of regulations don’t apply as heavily to them. But there is still a huge opportunity for the buy side with AI, because it can reduce a lot of data issues that will cause them problems down the road, for example around their legal contracts.
For example, the U.S. Securities and Exchange Commission (SEC) now insists buy-side firms estimate their capital requirements and ensure they have enough liquidity, which is new for this side of the industry. The legal contracts with their broker dealers and other partners set the value of certain types of collateral. By utilizing AI and natural language processing to read across their portfolio of contracts, firms can save a lot of time and money developing a collateral optimization strategy to find and send the cheapest-to-deliver collateral. Firms need to prove to regulators that they are holding sufficient amounts of money aside. Rather than doing this blindly with Microsoft Excel, and with their ledgers and books, firms can enhance what they are doing on a mass scale by using new technologies.
The legal industry costs all firms significant amounts of money. In the financial world, everyone is really just negotiating contracts of money for money. These contracts tend to be text-based agreements written in Microsoft Word. Lawyers are not generally known for embracing new technologies. But these legal contracts are the heart of what everyone is doing. So as computers become better at extracting and understanding human thought, language and rule sets, eventually everyone will gain cost-savings by automating a lot of their legal and compliance-related functions.
Firms need to invest more in data
Data science is one area firms should be investing in, and have not always paid enough attention to. After the financial crisis, global regulators issued new rules and worked together to protect the industry from future crises. BCBS 239 was just adopted in the US under what some call the CFO Attestation Rule, which requires CFOs of large financial institutions to attest that the data in their organization is of high quality. In any industry, not just financial services, mergers and acquisitions can lead to poorly thought out systems integrations. This has led to the rise of the Chief Data Officer, a new role in the industry.”
The European Union’s General Data Protection Regulation (GDPR) data privacy regulation is another hot topic. Firms the world over will now have to get the permission of EU citizens to collect their data, as well as give them the right to be forgotten. Many people have not yet fully understood how impactful GDPR is going to be, but it all comes down to data. It will be prudent for buy-side management and boards to start looking at RegTech solutions to tackle these challenges.
In addition to the data challenge, there is also a need for a better compliance culture in the industry. Culturally, business and compliance have very different viewpoints, with the business side wanting to make as much money as fast and cheaply as possible, and the compliance side wanting to protect the firm from lawsuits and make sure no rules are being broken, which takes time to asses, especially if the business is trying to do something new. Regulators have pushed for chief compliance officers to sit at the executive board table, but the relationship between the business and compliance needs to change, so that both sides understand each other’s perspective and can work well together.
Political uncertainty impacts compliance strategy
Global political change is making it difficult for firms to develop and implement long-term regulatory strategies. From Brexit to Donald Trump and possible Dodd-Frank repeal, uncertainty in the markets as to the future of regulation is impacting compliance budgets and stalling initiatives at many firms. There is a lot of tentativeness on Wall street as people are unsure, especially in the US, what will happen over the next two years.
The regulation causing US firms the most pain right now is the Volcker Rule, which came out a couple of years after the financial crisis and everyone complied with, stopping any business that was not Volcker compliant. The Trump administration and various regulators are trying to simplify and shrink the Volcker Rule, which in many respects is good for the industry, but firms are concerned they may have wasted a lot of money to comply, and now they will have to waste a lot more to make sure they are not overdoing it.
In contrast, in Europe there is the Markets in Financial Instruments Directive (MiFID II) and GDPR as well as other regulations coming down the pipe. European firms are investing much more on the RegTech side because they have no choice. European regulators tend to be more prescriptive and mechanical, whereas US regulators can issue regulation that is more conceptual. And when it comes to Brexit, the whole world is waiting to see where the dust settles. Similarly, to the US, there is some hesitation that this might not be permanent – that the tide of populism might run its course and then everything will go back to the way things were. Nobody knows, so there is a lot of hesitation. Firms are making Brexit plans, and some are moving headquarters and staff to be safe, but not with any certainty or fervor. Everyone is making a mediocre plan B, because they know there is no definite plan A and they can’t rely on it.
AI and blockchain promise is still a long way in the future
Looking ahead, I think that AI and blockchain will change the world the same way the iPhone did, but probably not for another 10-20 years. AI still has a long way to go until it can be autonomous. In our homes, Siri and Alexa can barely tell us the weather or give accurate directions. It will be a while before we can rely on them for more than third or fourth-grade level intelligence. And all of these AI systems need data to consume and understand. Until there is enough data for these programs to consume in order to start making intelligent business decisions, they are not very good for one-off situations and things that require human judgment.
Blockchain will change everything we do to the core, but I think it will be more like 15-20 years rather than the three years some are predicting. If you think of IBM’s Watson as a fourth-grade child, he still needs to go to biology class before he can go to medical school, and before he can cure cancer.
In the same way when it comes to regulation, you have to go to law school, to understand business theory and judgment, and to have enough information to make a good prediction. And a lot of times in business, you are dealing with uncertainty like Trump and Brexit, where there is a lack of data. That is something that AI can’t handle, so humans are always going to be a part of the game.
The RegTech industry has a lot of growing up to do before it delivers the impact that a lot of people are anticipating. It will be far more impactful on the large dealer side before it makes its way to community and retail banks, to broker dealers, asset managers, hedge funds. There may be some great RegTech companies that come in and make things a lot easier quickly, for example products that help firms monitor fraud. But the vision of computers replacing humans is a long way off. Roles will change as professionals such as lawyers have more access to better intelligence than they had before, but their jobs are not going to be taken by machines.