According to Merchant Savvy, global losses from payment fraud and financial scams more than tripled from $9.84 billion in 2011 to $32.39 billion in 2020. By 2027, these losses are expected to exceed 40 billion. With eye-watering figures such as these, both consumers and companies must put fraud prevention measures in place to mitigate risk and keep their finances safe.
What are financial regulations?
In short, financial regulations are a collection of fixed rules that supervise financial markets and institutions. Fundamentally speaking, these rules are designed to protect the consumer against fraud, unethical lending, and exploitation. However, in capitalistic societies, financial regulations mustn’t be too strict so that they do not impede the economy by allowing it to function effectively.
Why are they important?
One of the primary functions of regulations is to uphold the financial system’s integrity. By prosecuting cases of misconduct, investigating complaints, and protecting clients, regulations allow consumers to maintain confidence in the financial system. After all, if people do not feel their funds are safe due to exposure to high levels of risk, they will be far less likely to use these systems. This lack of trust causes the system to fail, which is why it is in everyone’s best interest to have at least some form of regulation within the various financial subsectors.
Traditional financial regulations
There are three key elements to regulations in traditional financial systems. These are banking, financial markets, and consumer. Here is a brief overview of how each one functions and helps to prevent scams/fraud.
Bank regulators are some of the most important (and stringent) regulators that operate within the financial system. They help strengthen and maintain trust in the banking system (which is what most economies rely on). These regulators achieve using several methods, including:
- Examining the safety and soundness of banks
- Ensuring banks have access to sufficient capital
- Insuring deposits
- Evaluating threats to the entire banking system
In the USA, the Federal Deposit Insurance Corp (FDIC) supervises and provides deposit insurance to more than 5,000 banks.
Financial market regulations
The Securities and Exchange Commission (SEC) is the main regulatory body that oversees the securities market and protects investors. The SEC is broken up into five major divisions, these are:
- Corporate finance
- Investment management
- Economic and risk analysis
- Trading and markets
In general, the SEC’s responsibility is to govern the stock markets, review corporate filing requirements, and bring civil actions against lawbreakers by working with the Justice Department on criminal cases.
The final aspect of traditional financial regulations is attributed to consumer protection. In the USA, the Consumer Financial Protection Bureau (CFPB) ensures that banks don’t overcharge for credit facilities (such as loans, credit cards, overdraft facilities, and mortgages). The primary role of the CFPB is to make sure that all financial companies are treating consumers fairly, regardless of their credit history. They also implement and enforce consumer financial law to ensure that markets for consumer financial products are fair, transparent, and competitive,
Regulation in decentralized industries
Regulation in decentralized industries is somewhat of a contentious topic. In many ways, regulation goes against the very essence of what industries such as DeFi and cryptocurrency stand to achieve.
However, as pointed out in a recent post on DeFi scams, “One of the most significant barriers to DeFi’s widespread adoption is a lack of regulation in the industry. On the one hand, decentralization provides numerous advantages that assist businesses in overcoming many of the issues associated with the traditional financial market, such as unnecessary bureaucracy. However, since there are no legally recognized, centralized entities that can be held liable for smart contract issues, such as a coding error that may result in the loss and investors losing funds, it only increases the likelihood of scams.”
On top of this, there are many cases of fraud within the DeFi industry. In 2021 alone, there were a reported $2.8 billion in losses from DeFi rug pulls (exit scams), according to Chainalysis. This accounted for 37% of all scam revenue in the cryptocurrency industry for that year. With the introduction of more financial regulations, this number would likely reduce significantly. Moreover, more regulation could boost transparency, increasing financial inclusion and the utilization of the products in this new and exciting industry.
The downsides of financial regulation
To finish, let’s address some downsides of financial regulation. Firstly, excessive regulation inhibits the free market and can even dampen economic growth. This is because financial companies are obligated to use their capital to comply with the various rules and regulations, rather than investing in their internal operations.
Secondly, regulators are quite slow to adjust to new products. This means that even if they were to move into the DeFi space, it is unlikely that they would have much of an impact until the space matures.
Lastly, many people argue that the free market is the best and most efficient way to set prices. Even if it is done with the best interest at heart, any interference will only serve to reduce the efficiency of the market, which may result in increased prices for the end consumer.
With that said, financial regulation is still a vitally important aspect of a well-functioning economy, since it helps maintain confidence in the system. Whether they have a place in the DeFi world is still up for debate. Although, most people are in agreement that some level of regulation needs to be introduced if these decentralized products are to be adopted by the masses.