Is that a Fish Behind the Wheel? Remarks before the University of Central Florida’s Inaugural FinTech Summit

Thank you, Barry [Miller]. Thank you also to Professor Ajai Singh. It is a pleasure to be part of the University of Central Florida’s inaugural FinTech Summit. This morning, I would like to discuss the ways in which financial regulators ought to engage with innovation. Before I begin, I will give my standard disclaimer: the views I express are my own and not necessarily those of the Securities and Exchange Commission (“SEC”) or my fellow Commissioners.

I do not think like, or have the skills of, a technologist. A recent scientific article that got picked up by the mainstream press brought that home to me. The article reported on an experiment in which the authors had created a terrestrial vehicle on wheels that could be navigated by goldfish in a tank sitting on the vehicle’s chassis.[1] The “Fish Operated Vehicle” moved in response to the fish’s movements in the tank, and the fish got a food pellet reward for reaching a target. The bottom line is that, as the researchers reported, “a fish was able to transfer its space representation and navigation skills to a wholly different terrestrial environment, thus supporting the hypothesis that the former possess a universal quality that is species-independent.”[2] In other words, fish can drive. And they can drive well enough to put to shame my sixteen year-old self, having piloted the family van into a ditch by the side of the road.

In addition to being a lousy teenage driver, I also never would have thought to create a Fish Operated Vehicle, and, even if I had thought to create one, I could not have done so. I admire people who ask unusual and difficult questions, devise ways to get answers, and then translate those answers into something that improves society—that piece of the fish experiment may be yet to come, but I am sure that it is coming.

Sometimes the process of conceiving an idea and translating it into something useful takes a long time and involves many people, not necessarily working together or even aware of each other. At any point along the way, an outside observer looking into the technologist’s fish bowl might be asking, “Why are you doing this?” The wonderful thing about human society is that we all bring something different to the table, and the combined ingenuity of a diverse set of people enables us to achieve things none of us would on our own. Bringing together multiple disciplines, your inaugural event today embodies that spirit, which is why I am so pleased to be part of it.

FinTech too is the product of interdisciplinary efforts. Technologies developed far outside of the financial sphere turn out to be useful to investors and the people who serve them. Fish Operated Vehicle technology may not transfer into the capital markets anytime soon, but mobile technology, supercomputing, artificial intelligence, virtual reality, and cryptography, among many other technologies, already have made the leap.

Regulation influences whether, how, and when technology finds its way into the financial markets. I would like to talk today about three ways regulators should engage with innovation. First, regulators need to approach technology with a mix of skepticism and wonder. Second, regulators need to embrace the idea that new technology can make it easier to achieve worthy regulatory objectives. Third, regulators need to leave space for experimentation, tinkering, and even failure. These ideas about how regulation and technology should interact are not intended to be a complete framework for that interaction, but only themes that should inform that interaction. Let me discuss each of these ideas in turn.

1. Embrace both skepticism and wonder.

People are skeptical of new things, including innovations that end up transforming their lives. The oft-replayed Bill Gates-David Letterman colloquy in 1995 about the computer and the internet is an example of how people approach innovation.[3] Letterman—likely giving the voice to the skepticism of most of the American public—asks “What about this internet thing?”[4] Gates explains that people are using the internet to publish information and send electronic mail and enthusiastically explains: “It’s wild what’s going on. It is the big new thing.” An unimpressed Letterman, conceding that “it’s easy to criticize something that you don’t fully understand,” pushes back on the then uses of the internet as not innovative at all:

I can remember a couple of months ago there was . . . a big breakthrough announcement that on the internet or on some computer deal they were going to broadcast a baseball game . . . and I just thought to myself, “Does radio ring a bell?”[5]

Gates gives Letterman several other examples of how the internet might be used, but Letterman dismisses these too, although he does admit “I think one day I’ll get one of these deals,” by which he meant a computer. Yes, he would, and it would be hooked up to the internet too.

Matt Ridley, providing many wonderful examples of similar attitudes in his recent book on innovation, suggests that this skepticism is a perennial feature of human social and cultural life. He gives the example of the introduction of the potato to Europe five hundred years ago—a time when the calorie content of potatoes would have been a very welcome addition to people’s diets.[6] According to Ridley, people’s tuber trepidation was rooted in part in a popular theory of the day that because potatoes look like leprous fingers, they cause leprosy. Although their reasons for dismissing today’s new things may sound more sophisticated, people’s reluctance to embrace new things is the same as it was back then.

Regulators share this fundamental human trait. Just as other people, regulators like dealing with known quantities: a rulebook they have mastered; familiar regulated entities that know and love the rulebook almost as well as the regulators do; and time-tested technologies and business processes that fit neatly into that rulebook. But this affection for the familiar is typically even more pronounced among regulators. For one thing, regulatory agencies draw very smart and talented, but risk-averse, employees, many of whom are lawyers, a profession not known to be entrepreneurial; I can say so in this crowd of engineers and business people.[7] For another, regulators generally operate under incentives that make them look skeptically at the unknown and the new: They are rarely rewarded for innovation, and any performance metrics generally measure their productivity in numbers of rules, exams, or enforcement actions. Doing things the way they have always been done—which is probably also the way that saw the regulator’s predecessors off to a happy, fulfilling retirement—seldom carries significant risk. Departure from tried-and-true methods, on the other hand, creates all sorts of risks.

These features of bureaucratic life create an environment that often is indifferent, or even hostile, to innovation. Innovations almost always disrupt existing ways of doing things. They can render currently successful products and services obsolete or passé; even worse, from a regulator’s perspective, they bring unfamiliar participants to the agency’s doors, unwanted guests bearing undesirable gifts in the form of knotty problems that do not fit neatly into a regime that works just fine, thank you very much.

Moreover, the significance—or even the point—of the innovation may not be immediately clear to the regulator, or to anybody besides the innovator; in some cases, she may not even understand the full significance of her own innovation. Consider the automobile. Although H.G. Wells and others predicted soon after the introduction of this novel method of locomotion many of the ways that this new technology would change our lives, nobody was able to foresee that the automobile would become a near-universal mode of transport, even for working men and women, in industrial societies.[8] As Matt Ridley notes, this inability to understand the significance of innovations, even among experts in the field, is a constant theme in the history of technological breakthroughs.[9] Why would a rational regulator choose to approve the introduction of a technology or product the benefits of which may seem clear only in retrospect, especially at the risk of disrupting a market that is operating to the general satisfaction of incumbent players, many of their customers, and of course the regulator herself?

If this instinctive skepticism toward innovation is so universal, how can regulators, also human but facing incentives to exercise even more skepticism than typical and acting out of a genuine concern for investors, learn to take a more positive attitude toward the possibilities of innovation? This question is a perennial one for those concerned about the relationship between regulation and innovation[10] and has no easy answers. But I do think that we financial regulators might benefit from recovering a sense of wonder at the history of innovation that built the financial markets that have made possible the modern American economy. Further reflecting on the opposition that those innovators faced—and on what might have been lost had those opponents prevailed—should lead us to greater humility as we consider innovations in the markets we regulate today.

Because these markets are highly regulated—including even the trading venues themselves, whose nearly every rule we must approve—it is easy to fall into thinking that they are our creation, that the U.S. has the world’s largest, most liquid markets because we crafted just the right rule set. But this just is not so.

Take the stock exchange: In the late 17^th and early 18^th century, this institution was just getting started in London in a big way. It was not created by an Act of Parliament or a royal edict. In fact, as interest in trading government debt and company shares in the secondary market developed at the Royal Exchange, which had long been a venue for reputable merchants to meet and trade, the dealers in these securities—or stockjobbers, as they were called—soon found themselves unwelcome. They were rowdy, a bit déclassé, and the quality merchants apparently did not want them making a scene where proper business was done.[11] The government also saw them as a threat and a nuisance and, in 1697, passed an “An Act to restraine [sic] the Number and ill Practice of Brokers and Stock-Jobbers.”[12] The Act described stock-jobbing as “a very great abuse of the [] ancient Trade and Employment and [] extremely prejudicial to the public Credit of this Kingdom and to the Trade and Commerce thereof.”[13] Indeed, the Act thundered, if this activity is not “timely prevented,” it “may ruin the Credit of the Nation and endanger the Government itself.”[14]

The stockjobbers did not disappear, of course; they simply decamped to a friendlier neighborhood, just a couple blocks away where a number of coffeehouses—another recent innovation, also disfavored and briefly banned by the authorities—had set up shop.[15] Jonathan’s Coffee House and another shop called Garraway’s, in Exchange Alley, conveniently located between the Royal Exchange and the Post Office, would soon become the hub of trading in stocks and government debt.[16]

Barriers to entry were not terribly high. Thomas Mortimer, writing in the 1760s, explained what it took to set oneself up as a broker in Jonathan’s Coffee House:

Every person who enters Jonathan’s to do any business there, pays 6 [pence] at the bar, for which he is entitled to firing, pen, ink, and paper, and a small cup of chocolate; and if he understands the business, is as good a Broker for that day (at least for his own affairs) as the best.[17]

The brokers and stockjobbers continued to irritate the government and the more respectable sort of merchants. The government repeatedly sought to make many types of transactions illegal, but not only did these trades continue to occur, the brokers themselves routinely performed, and enforced performance, on these contracts that could not be enforced in a court of law.[18] Over time, they formalized these practices into private rules and regulations to govern their conduct.[19]

Of course, although the accusations leveled at the stockjobbers were not the whole story, they did have some basis in fact. The innovation of a largely self-regulated market for securities led to innovations in various forms of misconduct as well. Information, then as now, was a prized commodity, and schemes to disseminate false information, or to use deception to obtain confidential information, were common. This conduct led observers like Daniel Defoe to rail against the trade:

’tis a complete System of Knavery; [] ’tis a Trade founded in Fraud, born of Deceit, and nourished by Trick, Cheat, Wheedle, Forgeries, Falsehoods, and all sorts of Delusions; Coining false news, this way good that way bad; whispering imaginary Terrors, Frights, Hopes, Expectations, and then prevailing upon the Weakness of those whose Imaginations they have wrought upon.”[20]

Messy beginnings, yes. But the fruit of these early stockjobbers’ insistence on carrying on despite official prohibition and establishment disapprobation is the modern stock exchange, an institution that is capable of executing hundreds of millions of shares and handling billions of messages each day. Regulation over the past eight decades has certainly played a role in shaping these markets, but it is not at all clear that the regulatory mind could have created them from scratch, or that the stockjobbers would have succeeded in making the exchange so central to the modern economy had the state levied its full force against them.

Reflecting on this history can help restore our appreciation for, and wonder at, the creative power of human innovation. We need to keep before us this evidence of the capability of men and women working together to find creative, novel solutions to real-world problems, including problems that we do not even know we have because they are so embedded in our day-to-day lives. Of course, the wonder also needs to be leavened with an appropriate dose of skepticism, since, human nature being what it is, human ingenuity can come up with innovative ways to help or hurt people. But that skepticism needs in turn to be leavened with a good dose of humility; changes that make us uncomfortable because they seem chaotic and destabilizing and unpredictable are the kind of change that has the power to transform our world for the better.

2. Welcome the role technology can play in meeting important regulatory objectives.

If regulators approach technology with a sense of wonder, not fear, they might also spot ways in which it makes it easier to accomplish regulatory objectives such as investor protection and market integrity. Let us look at a couple examples.

We will start with an unglamorous example—broker-dealer recordkeeping. Broker-dealers need to keep accurate and complete records to run their businesses and to meet their regulatory obligations. The Commission adopted a recordkeeping rule 25 years ago that requires broker-dealers to maintain records in a static “Write Once, Read Many” format or, more affectionately, “WORM.” Over time, dynamic recordkeeping systems became the norm in the industry, so many broker-dealers have parallel systems—one for their own use in running their business and one for the regulators.[21] Although firms have been raising concerns about the requirement for the past couple of decades, we have been reluctant to abandon the WORM approach out of concern that more dynamic recordkeeping might not be as reliable. Recently, however, we proposed to free firms from technology that was state-of-the art in 1997, so that they could use today’s technology, which enables much better monitoring of activity.[22] We have more work to do on the rule,[23] but the goal is to empower firms to use the latest technology.[24] It turns out that this technology is better at providing firms and us a complete picture of the firm’s activities, which in turn will help both firms and us better protect investors and market integrity.

Now let us shift from staid recordkeeping to the more exciting world of crypto.[25] While we do not have time to talk in depth about crypto today, it too offers opportunities to better achieve certain regulatory objectives. Decentralized finance (“DeFi”) can serve investor protection goals and market resilience goals by cutting out middlemen from financial transactions and breaking down concentration within the financial services industry. Moreover, in a recent article, Professor Chris Brummer imagines using “crypto-native solutions,” such as smart contracts, non-fungible tokens, decentralized autonomous organizations, and Decentralized Identifiers to build a retail-oriented disclosure system that would be superior to existing traditional disclosure systems in that it would provide disclosures in a form and manner that people would actually use.[26] The objective, as he puts it, is to allow “disclosure systems [to] grow with technology instead of being superseded by it.”[27] Yes, crypto raises some real challenges and risks for society, but it also may help society to achieve some of the things the SEC cares about—protecting investors, facilitating capital formation, and fostering market integrity.

3. Allow, and indeed encourage, trial-and-error, rather than insist on check-the-box compliance.

If innovation is to thrive in a regulated space, regulation needs to leave room for experimentation, tinkering, and, yes, failure. History shows that innovation is an iterative process, one that involves constant “incremental tinkering” and slight modifications, “trial and error,” and sometimes spectacular failures.[28] Innovation does not happen on an orderly schedule, and it cannot be planned, and certainly not by rule writers and rule enforcers. If the innovator encounters a regulatory hurdle each time she tinkers with her innovation, she is almost certainly going to tinker a lot less than she would have without that regulatory oversight. The result is almost certain to be less innovation overall[29] and perhaps eventual technological stagnation at an immature state of innovation.[30]

SEC Chair Gary Gensler has said, “I am technology-neutral. I think that [crypto] technology has been and can continue to be a catalyst for change, but technologies don’t last long if they stay outside of the regulatory framework.”[31] Describing this approach as technology-neutral, of course, works only if new technology can in fact comply with a prescriptive rule set designed for old technology, which is not at all clear.[32] Even if it can work, though, technologies forced into an inflexible, stultifying regulatory framework may not last long either because they cannot go through the trial-and-error process that allows them to mature and thrive. In other words, it is not enough to say that we welcome innovation; we also have to welcome the conditions under which innovation is possible.

Professor Ed Stringham describes the innovations in product development and private regulation that characterized the early stock exchanges. As mentioned above, stockjobbers routinely performed on contracts that were not enforceable at law. Adam Smith explained that, even though most contracts made on the exchange were illegal under English law, those who failed to perform on their contracts were “turned out [of the exchange], and in the language of Change Alley [were] called lame duck.”[33] The rule continued to evolve throughout the 18^th and 19^th centuries and covered categories from exchange membership to bankruptcy to quotation of prices and settlement.[34] Violators could be subject to sanctions, including permanent expulsion from the exchange.[35] The New York Stock Exchange developed in a similar manner.[36]

Matters are quite different today. If a stock exchange registered with the Securities and Exchange Commission wants to change any but the most trivial of its rules, it has to file those rules with the Commission for review and approval. Most substantive rule changes—those permitting the trading of new products and changes to listing standards, among others—are subject to a process that can, and often does, take up to 240 days from the date the rule change is filed with the SEC. Many exchanges will consult with our staff before filing to test the waters, meaning that the effective time from conception of a new idea to implementation is typically a year or more. Is it any surprise that many critics of the exchanges complain that much of the “innovation” by exchanges has occurred in the form of new fees for connectivity and data? Many of these filings, coincidentally, are classified under the Exchange Act as immediately effective, meaning that the regulatory process has generally been far less burdensome.

Rather than checking in with regulators about every tweak and adjustment in consultations that may require many months, the innovator may just determine to do everything she can to stay out of the regulator’s sights, where serendipity may still be possible. As the rule filing process for exchanges illustrates, needing to subject even minor innovations to the regulator for approval likely has slowed the rate of progress in heavily regulated industries like finance.

Consider, for example, the fate of spot Bitcoin Exchange Traded Product filings, which the Commission has repeatedly disapproved over the past four years, or the continued inability to solve the problem of how broker-dealers can custody digital assets.[37] In response to this inflexibility, many entrepreneurs have decided to avoid the SEC entirely, some by exiting the US to work in places like Singapore, others by keeping fingers crossed and proceeding as if the SEC does not exist. These outcomes are unfortunate.

The SEC, however, has some great tools—exemptive orders and no-action letters, for example—that we can use to make experimentation a bit easier in this highly regulated corner of the world. How we use those tools matters. Without sacrificing our regulatory objectives or displacing the market’s ultimate decision about whether a particular approach has merit, we can use exemptions and no-action positions to accommodate trial-and-error.

This will take some courage on our part, for reasons I have already explained: We regulators shy away from giving the green light to projects that involve experimentation and the possibility of failure. We want to take the “error” out of trial-and-error. The first step is to understand, deep in our bones, that, if we want to be more than vaguely supportive of innovation on a theoretical level, we are going to have to take risks as well. It is only proper, though, for us to have skin in the game if we are going to try—as we always do—to take credit for the quality and future growth of our markets.

We might also remind ourselves that maintaining this openness to tinkering and to failure is simply to give due respect to fundamental American values: The can-do attitude that built much of this country without seeking approval from some government official, and the love of liberty that nurtured this attitude. Adam Thierer describes the proper role of the regulatory in a country like ours in his book, Permissionless Innovation, where he writes:

The burden of proof should be on those who favor preemptive, precautionary controls to explain why ongoing trial-and-error experimentation with new technologies or business models must be disallowed. There may indeed be times when a dose of precautionary policy is necessary, but rigorous benefit-cost analysis must be conducted in each case to illustrate why the freedom to experiment and innovate should be curtailed.[38]

The trial-by-error approach worked to make traditional exchanges as important as they are today. Decentralized crypto exchanges are the coffeehouse exchanges of the present era. They allow people to come together to trade crypto-assets through automated open-source protocols that are outside the control of any person. The Daniel Defoes of today are sputtering eloquently about the activity taking place there, and some of that activity is bad. But there is also the experimentation and self-discipline that we saw at work in those early exchanges. We ought to allow this trial-and-error process to play out, rather than trying to shut decentralized exchanges down out of fear. Any effort to do so would be as effective as historical attempts to shut down the coffeehouse exchanges of the past.

4. Conclusion

I have spent much of my time today talking about how fear of the unknown can stand in the way of regulators engaging with technology, but fear of the unknown also can prevent technologists from engaging with regulators. I hope my remarks have emboldened you. Studying engineering and business sets you up to be at the heart of these debates about innovation and how to regulate it. Your voices are vital, if we are to get the regulatory structure right. The government, which exists to serve the people, needs to hear from people who are designing the technology and building the companies to turn that technology into products and services.

Thank you, especially to those of you who were able to queue the fish-driving videos[39] to watch after my talk was done.