According to a speech dated June 17, 2024, entitled “Innovation in the Financial System,” and reportedly delivered at the Salzburg Global Seminar on Financial Technology Innovation, Social Impact, and Regulation, the Federal Reserve’s Michelle W. Bowman suggested that US regulators should foster innovations in the banking system and the broader financial system, including distributed ledger technology and Ai.  To achieve this, she encouraged regulators to focus on “developing an understanding of the technology, having an open approach to innovation, and making innovation a priority in the development of regulatory frameworks.”

Understanding new technology and innovators

Concerning new technology, Bowman said:

Take for example, distributed ledger technology (DLT), including blockchain, which is the backbone of some innovations that are being explored in the financial system.

DLT provides a way for parties to record transfers of digital assets without the need for any centralized authority and relies on multiple participants who coordinate to maintain a synchronized version of the "ledger."

Notwithstanding the DLT’s benefits, she said, "regulators also need to be confident in the players who operate in a particular innovative space.”

For example, in the financial services space, Bowman acknowledged banks and their “long history of innovation.”  Generally speaking, entities conducting banking activities are also regulated.

In contrast, some of today’s #blockchain and #AI innovators are not banks and may be unregulated parties.

Bowman appeared to indicate that this is an issue when she said, “The broad range of participants involved in this space presents another layer of complication.”

One such “complication” seems to be that some non-bank innovators “describe themselves as financial system "disruptors," which indicates their “ambitions” to change the existing financial system.  According to Bowman, this “proves the need for a deliberate and cautious approach to regulation.”

Bowman added: “It is especially important for regulators to be able to distill the reality from the prototype hype to achieve a comprehensive understanding necessary to inform a policy viewpoint and ultimately an effective regulatory framework.”

She continued:

In the long run, the goal of financial innovation is to integrate the new technology into the fabric of the financial system. To do so in a responsible way, we need to understand the effects the technology will have, including the risks and consequences of introducing it, and the risks and consequences of its wide adoption in the financial system.

It is not my intent to downplay the difficulty of understanding new developments that could change key activities, technology, products, or processes within the financial system. We are in an era of rapid change, and there are a wide range of innovations that may play an important role in the future of the financial system. But within the regulatory perimeter of the banking system, we need to be cautious about the risks of new technology, not only to the safety and soundness of individual financial institutions, but also to financial stability concerns.”

While Bowman noted that regulators should be cautious when adopting new technology, she said they should not “pre-judge financial innovation and take a harsh view.”

Taking a harsh view and “eliminating innovation,” in her words, “could result in significant harm to the stability of the financial system and in terms of limiting the role of banking in the economy.”

She continued:

Hostility to innovation within the banking system often results in activity migrating outside of the banking system.

This is not an elimination of the underlying risk of these activities.

They remain in the financial system but are often subject to less transparency and less regulation than the same activities conducted by banks.

There have been a number of examples in which regulatory approach has driven activity outside the banking industry, thereby creating different and less transparent risks.

Put another way, Bowman appears to be saying that while innovations like AI and DLT should not be stifled, they should be subject to regulatory oversight, especially where they have the potential to impact the existing financial system or compliance with regulations.

She implied that such oversight or regulation would ensure that “important compliance safeguards” remain in place “that deter criminal activity.”

According to Bowman, an appropriate way forward is to encourage innovators and regulators to interact and share feedback “throughout the innovation life cycle and incorporate regulatory feedback on innovation.”

She added: “The more that regulators understand innovation, the more comfortable they will be in accepting and promoting its adoption in the financial system.”

She concluded: “As we continue to enhance our understanding, my hope is that we can strike a more receptive tone to financial innovation, in a way that enables a more innovative, efficient, and effective financial system for the future.”

Bowman noted that the views expressed were her own and not necessarily those of her colleagues on the Federal Open Market Committee or the Board of Governors of the #FederalReserve System.