The Call for AI Championing Regulatory Compliance

Regulatory law, in the context of banking and insurance regulation, is naturally complex. Much is at stake since banks and insurance companies are centerpieces of our modern economies. At the same time, however, various stakeholder interests’ clash. On one hand, regulators work towards crucially important goals, such as overall financial stability and robustness, or policyholder protection (for a European perspective see here). On the other hand, the financial industry (i.e., banks and insurance companies) generally strive for profits and growth while having to comply with rigid regulations. This is complemented by the particular interests of customers and consumers.

In the aftermath of the Global Financial Crisis (GFC), the overall regulatory environment tightened. For instance, in the US, the Dodd-Frank Act vastly introduced new rules affecting both banks and insurance companies. The EU banking legislation likewise moved into that direction. With respect to the insurance sector, a new EU directive came into force in 2009 and established extensively novel rules regarding solvency and capital (pillar 1), governance (pillar 2), and reporting and disclosure (pillar 3) requirements. However, they were not a reaction to the crisis and the legislative process that already started years before the GFC. Eventually, it was amended in 2014 in response to the crisis. Since then, the overall trend was more sophisticated and detailed regulation that has not stopped, and it is unlikely to do so amidst pressing changes and developments (e.g., pandemic recovery and resilience, digitalization and sustainability).

Generally speaking, banks and insurance companies must carefully monitor and follow not only regulatory law de lege lata but also have to anticipate regulatory changes de lege ferenda. Otherwise, they face the risk of fines and reputational losses (E.g., in 2020 global banks paid billions of fines because of regulatory non-compliance). Additionally, the board of a bank or an insurance company may bear professional and liability risks for non-compliance with regulatory rules and standards. Both are particularly delicate since it can take time to actually implement and enforce the law internally, depending on the complexity and the dimension of the change of the legal environment. Regulatory compliance is of utmost importance and requires adequate and effective steps. Given the tightening regulatory landscape, compliance efforts, and costs increase, this trend will presumably not stop.

Insofar, voices championing the use of modern technologies promising more effective and efficient regulatory compliance grow louder in the broader frame of RegTech. One argument is that AI-based software, (e.g., legal document management systems), achieves “preparedness, adaptability, and resilience,” and ultimately, supports the overall capability to adapt and comply with challenging legal requirements. Additionally, AI-based applications conceptually may favor customers and consumers in the course of more tailor-made financial and insurance products. This may lead to the conclusion that a bank or insurance companies’ board is not only allowed, but also legally compelled to actually apply AI-based applications. This is a discussion which already takes place in the corporate law context and may well be transferred into the regulatory context.

This all sounds like an easy and quick fix to the dilemma of increasingly complex and costly regulatory compliance efforts; in fact, under certain circumstances and from a more abstract point of view, one cannot deny that AI-based or supported solutions — leaving aside what AI precisely means outside and inside the regulatory context — may have positive impacts. This appears to be especially the case for AI-based legal document management systems. However, in trying to fit this into the broader regulatory context, the picture is more complex. Apart from the quite narrow example of document management systems, there are a lot of complicated applications such as credit scoring, credit and rate making, or anti money laundering. In other words, AI in the field of regulatory compliance touches various areas with likewise unsolved problems. These problems include transparency, explain-ability, data protection, liability, board responsibility, fit and proper requirements, the role of third-party AI vendors, anti-discrimination, and so on and so forth.

There is an urgent need for further AI research in potential fields of applications, and its complications with regulatory goals and stakeholder interests. AI can bring relief to the regulatory compliance dilemma and can probably already do so in narrowly defined fields such as document management systems. However, this should not automatically lead to a general legal rule for the board of a bank or insurance company to apply AI-based systems. Notwithstanding, where the benefits and risks of certain applications are sufficiently identified, it seems reasonable to think about it and fathom the details. In the meantime, there remains much to discuss from a rather restrained setup.

Keeping Retirement Fund Management Standards Up to Date: Reforming ESG-Considerations in ERISA Investments

We have seen a steady change in the business world over the last few years, away from the shareholder-focused approach of the last decades. Many investors now consider more than just a company’s bottom line and take into account environmental, social, and governance (ESG) issues.  In 2020 alone, over $51 billion was invested in funds focusing on ESG, and some think that such assets could account for over a third of all assets under management by 2025.

Now it seems like the Labor Department is joining in. A new proposal forwards changes to the laws governing retirement funds, especially the Employee Retirement Income Security Act (ERISA). The proposed changes would make it easier for their managers to consider ESG issues in their investment decisions. But these changes, while undoubtedly a step in the right direction, are not as revolutionary as they might seem.

For starters, the Labor Department’s position is clear: the proposed changes are nothing new. Rather, they merely undo changes made by the previous administration and clarify preexisting standards for fund managers’ fiduciary duties. These managers had, have, and, under the new rule, will continue to have a duty to maximize long-term returns for the programs’ beneficiaries. They have never been and will not be permitted to sacrifice monetary returns for non-financial goals. While some, especially in the wake of the current pandemic, advocate for a stronger focus on other stakeholders, the Labor Department’s reaffirmation of this fundamental principle drives home the fact that fund managers are agents, investing money entrusted to them for the beneficiaries’ retirement.

However, what is new is the explicit language regarding the importance of ESG factors. The Trump administration changed the rules to require that the evaluation of any investment be based on “pecuniary factors.” This language made it unclear to what degree, if any, fund managers could consider ESG factors and had, in the words of the Labor Department, a “chilling effect” on integrating those factors into risk assessments. In contrast, last week’s proposal includes a section explicitly stating that evaluating the risks and returns of an investment often requires considering the potential economic effects of climate change and other ESG factors. The underlying idea is that ESG effects can be material risks, especially for the kind of long-term investment that characterizes retirement funds. Take, for example, the issue of climate change: part of maximizing investors’ value for payout in 30 years is making sure that the planet and a functioning society are around in 30 years, so the retirees can actually benefit from their investment. Higher short-term returns from environmentally damaging investments mean nothing if there’s nowhere to spend the money. The Labor Department has adopted the view that considering ESG factors is part of prudent risk assessment, management, and mitigation, and that considering those factors is in the long-term interest of the funds’ investors. In other words, the labor department wants fund managers to make informed investment decisions to guarantee lasting profitability, not to engage into ESG goals for their own sake.

While this might be a significant change for ERISA, in recent years this approach has already been gaining popularity within the academic world, but also with investors and corporations. In contrast to traditional, shareholder-focused, Milton-Friedman-inspired theories that encourage companies to ignore “externalities” like worker welfare and environmental issues, voices from all sides now demand that companies not ignore the needs of the world around them. In 2018, Larry Fink, CEO of Blackrock, the world’s largest asset manager, wrote in his annual letter to CEOs that companies should make “a positive contribution to society.” Similarly, in 2019, the Business Roundtable, an association of the CEOs of leading US-companies, published a statement saying that the purpose of a corporation is to benefit all stakeholders. While some argue that much of this is merely greenwashing, a PR effort to make the same investments look environmentally friendly and socially responsible, the broader trend towards the incorporation of ESG issues into business decisions is undeniable. Meanwhile, large investor initiatives like Climate Action 100+ and regulators around the globe keep increasing the pressure on companies, especially regarding environmental issues. Finally, consumers and employees are also increasingly interested in whether the companies they interact with or work for care about more than their bottom-line.

What the Labor Department is doing is, therefore, not bravely leading the way, but rather implementing something that is becoming common knowledge: that companies cannot ignore the world they are operating in any longer. Caring about ESG issues is good business practice, but, maybe even more importantly, ignoring them would be clearly shortsighted. However, while allowing fund managers to take those factors into account might not be revolutionary, it is nevertheless important, as it keeps the governing rules up to date with the emerging market standard. Only when fund managers can factor ESG issues in are they truly in a position to comprehensively assess potential investments and generate long-term profits for the coming decades.

Playing with Power: Implications of the Increased Presence of Corporations in the Social Sphere

Among many actors influencing social, economic, and political life, corporations are increasingly gaining power. Society is divided into two categories: those demanding more social activism from corporations, and those fearing corporations may grow too powerful. In their pioneering work, The Modern Corporation and Private Property, written in 1932, Adolf Berle and Gardiner Means predicted that corporations will eventually grow so powerful that they will be competing with the government for the dominant form of social organization. Has that day come?

Recent examples of corporate social advocacy on LGBT rights and Gun Control Movement by companies like Salesforce and DELTA exemplify how corporations use their economic leverage to push their political agendas– demonstrating both the potential of corporate activism and the vulnerability of the policymakers. Even more vociferous are the evolutions on voter suppression issues, where it becomes harder and harder to draw the line between pure social activism and partisan political championing.

The 2020 presidential elections exposed a longstanding problem: the fragile balance of voting rights. After his defeat, former President Trump incited an overly zealous movement which resulted in hundreds of bills and policy proposals all over the country, most of them limiting voting rights in one way or another. Opponents of these laws, including voting rights activists and community leaders, urged businesses to stand up for democracy. And many stood.

An impressive business alliance soon emerged opposing the former President’s movement, led initially by black leaders, such as Kenneth Chenault (a former American Express CEO) and Kenneth Frazier (CEO of Merck). It grew steadily, coopting notable brands, such as JP Morgan, Apple, PayPal, Amazon, Airbnb, Google, Pepsi, and many more. Some of them went even further than simple statements. For example, Major League Baseball decided to move its All-Star Game from Atlanta after Georgia legislators passed a highly controversial voting rights bill. Other big names, like Coca-Cola, announced their decision to pause political donations.

But what repercussions can corporate activism have on political processes? Will it be the balancing element between people’s needs and interests of politicians or a trojan horse driven by pure profit?

Some community leaders say corporations gain their power directly from communities and people, thus it is natural that companies should use their leverage to speak up and stand for those communities. The idea that companies should increasingly utilize this leverage is seemingly reinforced by local leaders who have come to expect this kind of advocacy on their behalf from influential companies. For example, in Georgia, Governor Brian Kemp signed a bill restricting voting rights by limiting volunteers from serving water or food to voters in line, along with imposing voter ID requirements and limiting drop boxes. As a result, Black communities publicly demanded action from big companies based in Georgia. And when that action didn’t come, some religious and community leaders, such as Bishop Reginald T. Jackson of the Sixth Episcopal District of the African Methodist Episcopal (AME) Church—representing over 500 churches in Georgia—announced an economic boycott of Coca-Cola, Delta, and Home Depot on April 1, 2021. Notably, Bishop Jackson asserted, “We cannot and will not support companies that do not support us in our struggle to cast our ballots and exercise our freedom.”

Opponents of corporate social advocacy warn about the perils of such ventures. The Senate minority leader Mitch McConnell claims that businesses ought to “stay out of politics.” Mr. McConnell blamed corporate leaders for “dabbling in behaving like a woke parallel government.” He went further, threatening that companies’ actions “will invite serious consequences if they become a vehicle for far-left mobs to hijack our country from outside the constitutional order.”

As an old saying says, the truth must be somewhere in the middle. Mr. McConnell’s allegations do bear some rationale and there are troublingly powerful corporations indeed. But it can hardly be argued that any of them have done too much social activism if too much social activism is even possible at all. Business leaders standing for religious, racial, or sexual minorities or corporate engagement on climate crisis is barely a sign of “hijacking the country.” If there is something to be apprehensive about, it is the other side of corporate advocacy: suspicious funding of political agenda and all shades of influence peddling. And this, unlike corporate social activism, is not new at all.

But there is another angle to look at this problem. The growing need for corporate interference on social issues is proportional to the increasing inefficiency of policymakers. Politicians are so absorbed by political battles and games, struggling to keep their power and undermine their opponents, that in the process they become simply ineffective. Good laws are repealed, laws of compromise are passed, and those policies that people need the most are subjected to infinite debate with no foreseeable outcome.

In absence of efficient political power, people and communities are turning to the next able actor in line. As it happens, it is corporations.

COVID-19’s Silver Lining in Latin America: Startups

The massive migrant caravan making its way to the United States from Latin America is another symptom of the economic ills that currently plague the region. Prior to the COVID-19 pandemic, the region’s gross domestic product was expected to grow at a rate of 1.8%. However, the pandemic caused Latin America’s GDP to contract by 7%, even as global GDP contracted by 3%. While the U.S. and Western Europe are witnessing a significant economic recovery, the picture in Latin America seems bleaker, as the region continues to struggle with job recovery and economic revitalization.

There appears to be a ray of hope breaking through the austere economic panorama that COVID-19 brought to Latin America: startups. The internet boom that was beginning to take shape in the region was accelerated by pandemic lockdowns as Latin Americans, like most of the world, became more reliant on technology for basic needs. This increased reliance is creating an ideal ecosystem for Latin American unicorns to flourish and catch the eye of some of the most renowned names in private equity and venture capital. According to preliminary data from the Association for Private Capital Investment in Latin America, the region saw a grand total of $6.2 billion in incoming venture capital in the first half of 2021. This figure dwarves the $2.6 billion invested in the same period last year and easily surpasses the $4.1 billion invested across all of 2020.

Kavak, a Mexican startup that runs a pre-owned car marketplace in Latin America, exemplifies the burgeoning startup ecosystem that COVID-19 has helped nourish. With the pandemic making it more challenging to use public transportation, Latin Americans turned to pre-owned cars for their needs. The increased demand seems to be paying off. Last month, the company announced that it had raised a staggering $700 million in a Series E round, doubling its valuation to $8.7 billion. Kavak is just one example of Latin American startups benefiting from the startup boom rocking the region.

While it would be naïve to assume that startups alone will address Latin America’s many economic challenges, they have the potential to be a channel for economic development in the region. Kavak, for example, recently announced that it plans to create over 16,000 jobs in Brazil. Currently, the startup employs about 5,000 people, up from 300 employees a year ago.

While data on startup-led job creation is hard to measure in Latin America, startups in the United States have proven to be powerful economic engines. According to a recently released analysis by the Congressional Research Service (CRS), startups account for 5-6% of all businesses with employees, but account for “almost all [net] job creation in the economy.”

Although these numbers are impressive, it is important to note that many of the startups generating these jobs are what the CRS’s study calls “high impact” startups. These are companies that have doubled their sales over the most recent four-year period and have substantially increased their number of employees. Typically, these startups have been around for over five years and have surpassed the 20-employee mark.

Of course, few startups end up becoming “high impact” startups. In Latin America, where the lack of access to substantial capital and political instability can hinder startups’ success, the likelihood of a startup becoming “high impact” is even slimmer. It is also no secret that the vast majority of startups will die in their infancy and that their job creation will be negligible. However, as Latin America continues to reel from the economic devastation brought by the COVID-19 pandemic, any glimmer of hope, as minute and remote as it may seem, is a welcomed sight.

Holding Multinational Corporations Accountable: A U.S.-U.K. Comparison Case

Multinational corporations (MNCs) have great power but little responsibility. MNCs are 69 of the 100 largest economic entities in the world, which makes them more economically powerful than some countries. These powerful corporations work in poorly regulated zones to get the cheapest prices for labor, breeding potential for massive violations of human rights. Often, the US or UK parent company will incorporate a foreign subsidiary in the country of operations. This creates a legal shield between the subsidiary’s actions and the parent company’s liability. However, if the subsidiary violates human rights, this corporate structure makes it very difficult for victims to sue the parent company in the US or UK.

Recent decisions in the US and UK Supreme Courts highlight a developing split in approaches. The UK is beginning to hold UK parent companies accountable for human rights violations committed by their foreign subsidiaries, whereas the US is still maintaining a strong shield against US parent company liability.

Why do victims want to sue in the United States or United Kingdom rather than their home country? The three main reasons are speed, money, and access to justice. First, although claims can take many years in US or UK courts, a claim in foreign courts can take decades. Second, normally, the parent company will have more financial resources than a subsidiary to pay damages to the victims. Finally, it can be impossible to get a judgement against a powerful multinational company in domestic courts. As King Emere Okpabi (tribal king of the Ogale community in the Niger Delta, claimants in Okpabi v. Royal Dutch Shell) stated, “[y]ou can never, never defeat Shell in a Nigerian Court … Shell is Nigeria and Nigeria is Shell.”

The first hurdle that plaintiffs must overcome when bringing a parent liability case is forum non conveniens. Under this doctrine, courts can dismiss a case if there is another court that is better suited to hear the case. This is difficult for foreign plaintiffs to overcome because they have to show that the UK or US courts are better suited to hear the case than their home country where the violations took place. If plaintiffs cannot overcome this hurdle, they lose their US or UK case.

Foreign plaintiffs can bring litigation in the United States for extraterritorial human rights violations under the Alien Torts Statute (ATS). The statute gives federal district courts jurisdiction to hear civil claims brought by “an alien for a tort only, committed in violation of the law of nations.” The Second Circuit Court of Appeals in Filártiga v. Peña-Iralainterpreted the “law of nations” to include human rights, thereby giving the U.S. extraterritorial jurisdiction over all human rights claims. This case, and subsequent jurisprudence, led to viable ATS litigation against corporations. However, the US Supreme Court in Kiobel v. Royal Dutch Petroleum Co. narrowed the scope and held that plaintiffs could only use the ATS in cases where there was a “sufficient[ly] force[ful]” nexus to the United States.

This July’s US Supreme Court decision in Nestlé USA, Inc. v. Doe makes it clear that it is very difficult for plaintiffs to prove this nexus and sue under the ATS. In that case, the plaintiffs were West African children enslaved by cocoa plantations. They sued US corporations Nestlé and Cargill, which were large buyers of the cocoa beans. The plaintiffs alleged that Nestlé was liable under the ATS because it controlled the supply chain and provided financial incentives and training programs to the plantation owners. Eight justices found that general corporate oversight was not a tight enough nexus to the US and so did not meet Kiobel’s high bar. Additionally, in a split 5-4 decision, the Supreme Court found that the ATS does not create a cause of action to sue corporations. Therefore, the case was dismissed.

In the United Kingdom, Vedanta Resources PLC and another v. Lungowe and others holds that plaintiffs can bring a case if the U.K. parent company had “control, direction, [and] intervention” over the foreign subsidiary’s actions. Examples of sufficient control includes evidence of management control, group wide policies, group wide compliance, and parental supervision and control over the subsidiary’s actions.

This February’s UK Supreme Court decision in Okpabi and others v. Royal Dutch Shell Plc and another shows that this is a lower bar than the US standard. There, the claimants were 42,500 residents of Ogoniland in the Niger Delta. They sought to hold the English parent company, Royal Dutch Shell, responsible for its Nigerian subsidiary’s oil spills. According to a UN Environment Program report, these oil spills have polluted the Niger Delta so the water is contaminated with the carcinogen benzene over 900 times above the WHO guidelines. Moreover, an Amnesty reportfound that, because there has been no meaningful clean-up, the water and land is unusable. Applying Vedanta, the Supreme Court found the case could not be summarily dismissed because the English company exercised a high degree of control and direction over the subsidiary’s activities. In particular, U.K. executive trips to Nigeria, global health, safety and environmental policies and standards, monitoring of those policies, and monthly reporting from the subsidiary to the parent all showed the UK company controlled the Nigerian subsidiary. Therefore, this case is now proceeding to the substantive question.

Parent-subsidiary human rights cases require a fact-specific analysis to show that the parent company exercised enough control over the subsidiary. In Okpabi, the UK Court found that general corporate policies were sufficient to overcome the forum non conveniens question. In contrast, Nestlé held that general corporate policies show an insufficient nexus to the US. As human rights cases continue to be brought, it will be interesting to see how parent company liability jurisprudence in the US and the UK develops.

 

Corporate Values and Profits: Which ESG Initiatives Will Survive in the South?

As the fight against the Coronavirus continues, infection and death rates are still rising at alarming rates. These rates are particularly high in states like Texas and Florida, where governments are not only doing little to fight the coronavirus, but are actively making it more difficult for private businesses to do so.

Texas Governor Greg Abbot recently announced a new executive order on private businesses prohibiting vaccine mandates. This order is only the newest in a series of orders dedicated to curtail the communities’ tools to fight the pandemic. The Governor has also banned mask mandates in public schools as well as vaccine mandates in public entities. Private businesses; however, are resisting.

In response, Southwest Airlines has released a statement that they will instead continue to comply with federal regulations mandating vaccines for employment. According to one spokesperson, it is their position that federal law supersedes any state order.

However, the coronavirus is not the only way in which private entities are resisting the state, with varying degrees of success. Financial institutions who hoped to do business in Texas are finding it increasingly difficult to advance their own Environmental, Social, and Corporate Governance (ESG) initiatives.

On the environmental front, the state has passed laws prohibiting state agencies from contracting with any institution that boycotts oil and gas industries. As these financial institutions have aimed to advance the fight for clean and renewable energy, the state has pushed back in its goal of saving the interests of oil and gas.

In terms of social policy, Texas has passed a similar law prohibiting state agencies from contracting with banks that cut ties with the firearms industry. In addition, these banks are required to submit written declarations proving they are in compliance with the law.

This is worrisome for financial institutions and businesses who are reluctant to continue supporting for the firearms industry, but this is also worrisome for business concerned with the presence of firearms within their premises. Texas law now permits constitutional open carry in public places for individuals without a license.

These new political developments have driven socially conscious financial investors out of the south. Even as some remain, this reduced availability limits competition for debt sales and harms lending relationship, not to mention the flight of capital outside of the state.

While it is true that financial institutions are still moving toward the state, and the state’s financial power is growing, the government is doing itself no favors. As Jen Stark of the Tara Health Foundation argues, a state’s financial incentives can be complicated when personnel do not want to be there. What most observers overlook is that financial decision makers have their own beliefs about what society and policy ought to be, and that often affects their decisions. This does not necessarily mean that financial decision makers tend to become publicly political without reservations, nor does this mean that politics are often a greater factor than profits. It does mean that financial institutions are late to recognize that effecting political in change in Texas is different than on the national stage and on Wall Street.

Whereas New York is used to political decisions following the money, Texas has a very different system. The political structure of Texas distributes power among 254 counties, each of them difficult to influence through sheer money alone. Corporations will ultimately need to make a choice. Will they attempt to push through ESG initiatives and risk losing access to resistant markets? Or will they allow the bottom line to outweigh their conscience?  Corporate America has been loud about “corporate purpose” and “mission” in recent years; it remains to be seen how they handle these difficult choices.

Will Competition Concerns Impede Science? Grail Promises an Early Detection Test for Cancer

In late September, the Federal Trade Commission (FTC) finished an administrative trial in which it sought to force genomics-sequencing company, Illumina, to reverse its recent $8 billion acquisition of Grail. An initial decision from the trial is not expected until 2022.

Grail, a startup that makes blood tests to detect early-stage cancers, was founded by Illumina in 2016. Grail develops a test that analyzes fragments of DNA in the bloodstream to identify cancerous cells at early stages. llumina spun off Grail to raise more money for studies and ultimately raised $1.9 billion in capital from investors while Illumina maintained a 12% stake. In September 2020, Grail was exploring an initial public offering when Illumina swooped in with a $8 billion offer.

Grail’s mission to innovate cancer screening is revolutionary because it delivers a single blood test capable of detecting the presence of multiple cancers early, including cancers with no recommended screening tests. Currently, recommended screenings exist for only five cancers (breast, colon, prostate, cervical, and lung in high-risk smokers), and they often produce false positives. For example, cancer is absent in 70% of patients with elevated prostate-specific antigen and 7% to 12% of those with suspicious mammograms. In contrast, Grail’s test can detect 12 deadly cancers, including esophageal, gastric, liver, ovarian, and pancreatic cancers, with a less than 1% false-positive rate. Grail estimated that adding its blood test to existing screenings could reduce late-stage cancer diagnoses by more than half among patients aged 50 to 79, which would translate into a 26% overall reduction in five-year cancer mortality.

The proposed merger would accelerate patient access to the test by speeding up commercialization and making the test more affordable. Undoubtedly, this has the potential to save many lives. In the United States, many Americans currently face financial obstacles to accessing Grail’s test because it is not covered by insurance. Instead, it costs a whopping $950 out of pocket. This situation exacerbates the disparities in healthcare accessibility, specifically for African Americans and other minority racial and ethnic groups. Because cancer patients from these groups are more likely to be uninsured than others, they are less likely to seek care (including screenings) until their symptoms have progressed, and therefore more likely to be diagnosed with cancer at a later stage, when survival rates are lower. Illumina could address this problem with its experience in negotiating reimbursements with governments and insurers for DNA tests.

Illumina’s dominance in the DNA testing space, however, attracted regulatory scrutiny. In March 2021, the FTC suedIllumina and Grail in federal court to block the acquisition, arguing that the merger would “lessen competition in the U.S. multi-cancer early detection test market by diminishing innovation and potentially increasing prices.” The FTC allegedthat Illumina might thwart Grail’s potential future competitors by charging them more or denying them technical assistance.”

The FTC’s arguments are uncompelling. First, vertical mergers, combinations of noncompeting businesses operating within the same supply chain (in this case, Grail using Illumina’s device), tend to unlock significant pro-consumer efficiencies. There has only been one litigated challenge to a vertical merger in the past four decades: the Justice Department’s 2017 case against AT&T’s acquisition of Time Warner, which the government lost. Second, while traditional merger challenges focused primarily on harm to price competition, the FTC’s allegation here focuses on how the transaction will harm innovation competition. Trying to address this concern, Illumina extended its long-term supply agreements to current and future clinical oncology customers to allow full access to its DNA sequencing platform. Third, the FTC is concerned that the transaction could harm competition in the emerging cancer testing market, even though there is no guarantee that Grail will actually obtain FDA approval to launch a test commercially and generate revenues. The FTC’s concern is unjustified because Grail’s test is highly differentiated, thus any other screening tests being developed are more likely to be complements rather than substitutes. Lastly, it is interesting how the FTC is treating this proposed acquisition without regard to the history that Illumina founded Grail.

To make the situation more complicated, in April 2021, the European Commission (EC) announced that it would reviewthe transaction. Traditionally, a foreign country should only review a merger if the deal materially impacts consumers in its domestic market. Despite Grail’s lack of business activity in Europe, the EC decided to utilize Article 22 to exercise jurisdiction over the transaction. The FTC then moved ahead with its lengthy administrative proceeding to challenge the deal.

The Illumina-Grail deal must be complete by December 20, 2021 under the agreed terms, yet the FTC and EU actions threaten to run out the clock. Worried the transaction would not get approved before that deadline, the companies made a bold move of closing the transaction ahead of any regulatory decision. Illumina announced it would hold Grail as a separate company during the EC’s ongoing review and plans to appeal an adverse FTC ruling in federal court. It likely will prevail considering the U.S. government has not successfully challenged a vertical merger in court since 1972. Even so, Illumina and Grail face risk that the deal could be blocked for years.

Scientists have long been on a quest for a blood test that can diagnose cancer early and the aptly named Grail might offer a solution. Today, it promises a diagnostic test to catch cancer early, but the regulatory rabbit hole is slowing it down.

The Rules of Crypto: A Comparison of U.S. and Chinese Regulatory Policies

On both sides of the Pacific, regulators are keeping a close eye on cryptocurrency developments. Earlier this month, a White House National Security Council spokeswoman said that “the White House is considering a wide ranging oversight of the cryptocurrency market to combat the growing threat of ransomware and other cybercrime.”  In China, the People’s Bank of China (PBOC) announced that all crypto-related transactions were illegal which greatly influenced cryptocurrency’s price. While both countries are scrutinizing cryptocurrencies to suit their policy goals, they adopt different approaches for balancing financial innovation and risk prevention within their existing financial regulatory regimes.

Blockchain-based crypto assets are technology-driven financial innovations that include digital currencies and digital tokens in the payment and financing areas. Financial regulators face the problem of how to supervise risks involved in the issuance and trading of crypto assets.  Although financial regulation goals are quite similar worldwide, (i.e. market efficiency and integrity, consumer and investor protections, capital formation or access to credit, taxpayer protection, illicit activity prevention, and financial stability) regulators take divergent approaches to counter the various financial risks.

Both United States and China have a fragmented financial regulatory system. In each country, multiple regulators supervise the cryptocurrency market based on their jurisdictions to target specific risks. For instance, in U.S., the Commodity Futures Trading Commission regulates cryptocurrencies as commodities, including cryptocurrencies derivatives markets. The Securities and Exchange Commission treats some cryptocurrencies as securities if they satisfy the Investment Contract Test and aims to protect investors. The Internal Revenue Service treats cryptocurrencies as property to fight against taxation evasion through cryptocurrencies transactions. Finally, the Financial Crimes Enforcement Network (FinCEN) treats cryptocurrencies as “currencies” and imposes anti-money laundering obligations to virtual currency exchanges.

Similarly, China also has multiple authorities in charge of different aspects of the financial markets, institutions, and related risks. For instance, PBOC, China Securities Regulatory Commission (CSRC), China Banking and Insurance Regulatory Commission (CBIRC) are responsible for supervising macroprudential risks, micro-prudential risks in banking, securities and the insurance industry, respectively. In addition, private virtual currency is a subsection of Fintech where its technological characteristics subject it to the domain of the Chinese Ministry of Industry and Information Technology (CMIIT), Central Cyberspace Administration (CCA). Private virtual currencytransactions fall within the scope of the State Administration for Market Regulation (SAMR) and, if crimes are involved, the Ministry of Public Security (MPS). Therefore, it is not abnormal to see several authorities jointly release regulations on private virtual currency.

Since 2013, the regulations jointly released by the former mentioned regulators include:

Date Tittle of Regulations Authorities
Dec 3, 2013. Notice on preventing Bitcoin risks PBOC; CMIIT; CSRC; CBIRC
Sep 4, 2017 Announcement on Preventing Token Issuance Financing Risks PBOC;CCA;CMIIT; SAMR;CSRC; CBIRC
Aug 24, 2018 Risk Warnings about Preventing Illegal Fund-raising in the name of “Virtual Currency” and “Blockchain” CBIRC; CCA; MPS; PBOC; SAMR;

These regulations stem from China’s view that Initial Coin Offerings are considered illegal activity, and the government is seeking to “annihilate and destroy” blockchain-based pyramid schemes. As a result, financial institutions and third-party payment providers are banned from accepting, using, or selling virtual currencies. The recent PBOC’s announcement that all crypto-related transactions were illegal is consistent with the Chinese long-lasting policies upon cryptocurrencies.

The institutional structure of crypto regulation is not the only difference between the United States and China—the underlying regulatory perspective on cryptocurrencies is different too. The United States treats all kinds of cryptocurrencies, whether they are used as payment instruments or belong to financing products, as financial innovations with potential risks, and utilizes the existing regulatory mechanisms to deal with risks based on financial regulators’ jurisdictions. In other words, when cryptocurrencies are utilized by people as payment instruments, banking regulators would be involved, and when cryptocurrencies are treated as investment tools, securities regulatory authorities would have authority. By contrast, Chinese cryptocurrency regulation policies are dichotomous. Regulations on cryptocurrencies in the financing area (also called “private virtual currency”) are very strict —nearly a complete prohibition, as former mentioned. Nonetheless, policies for the public digital currency are quite lenient and supportive. For instance, PBOC launched central bank digital currency (CBDC) in 2020. China’s approach reflects Beijing’s desire to encourage Blockchain innovation and revolutionize the existing payment system within government’s control and supervision. This in turn will improve transaction efficiency, transparency and save costs, and could also prevent potential financial risks. However, due to the current Chinese securities regulation regime’s limitations, Beijing is unwilling to allow cryptocurrency investment without a proficient risk prevention mechanism.

In summary, the United States and China have multiple financial regulators to supervise cryptocurrencies based on the financial risks within their jurisdictions. In the United States, the determinants for who regulates which potential cryptocurrency risks are closely related to their usages and functions. By contrast, China’s financial regulation policies for cryptocurrencies are split between private and public cryptocurrency. The former is totally prohibited, while the latter is encouraged and even supported by the government. The different approaches between two countries mirror their own perspectives on how to balance financial innovation protection and risk prevention effectively.

China’s Debt Problem: Is Evergrande a Black Swan Event?

Mark Twain famously claimed that “history doesn’t repeat itself, but it often rhymes”. Whether or not Evergrande—the second largest property developer in China— emerges as a ‘Lehman moment’ is yet to be determined. The world in the wake of a global pandemic and after decades of expansionary monetary policy, awash with debt. News headlines in the United States are questioning if Secretary of the Treasury Janet Yellen should mint a $1 trillion coin to prevent a debt default; the debt to GDP ratio in the EU sits at 92.5%; finally, Evergrande is highlighting a potential debt crisis in China. Time will tell which of these three major economies will give birth to what would be difficult to call a black swan event, as the signs of a debt epidemic have been there for some time. China’s economy is currently facing the potential repercussions of using leverage to build the strongest economy in the world, but the adverse effects could be troubling for many.

China is perhaps on the fastest trajectory to industrialize in history. Deng Xiaoping designated a small fishing village called Shenzhen as China’s first special economic zone in the 1980s; now, Shenzhen is home to 18 million people, the world’s 4th busiest container port and a direct competitor to Silicon Valley. Shenzhen, the site of the second most skyscrapers in the world, is also connected with other cities in China, such as Shanghai which holds the fifth most skyscrapers in the world, by high-speed rail or a quick visit to the airport. As such, it’s clear that China’s economic growth is both realized and personified by infrastructure.

Without companies like Evergrande, which offer both home ownership and housing to millions this miracle industrialization may not have been possible. However, this growth was predicated on cheap borrowing and massive spending. The timeline of borrowing to construction was so fast that many housing units in China are unoccupied, up to 20% according to Bloomberg. This is problematic to the cash flow and books of property developers, such as Evergrande. Moreover, a major caveat is that growth in the Chinese context is complicated as the state is heavily interwoven with the private sector to the extent that both could be argued to be synonymous. This has led growth to be coordinated but uneven, and potentially painful for both the public and private sector going forward.

Some  financial pundits have argued that Evergrande is not a Lehman moment but a localized problem confined within the borders of China. However, this is a rather naïve approach. The world economy is more interconnected than ever, even in the wake of protectionist policies. Moreover, China’s response will serve as a signal to the rest of the world as to whether to follow a similar path to solve financial issues – this could have a profound effect on global spheres of influence.

How will the Chinese government act? Evergrande can be both a catalyst of impending crisis and indicative of a slowing overleveraged economy. China’s manufacturing indexes are all down on the year. Further, as previously mentioned, the supply of housing has outpaced demand. The Chinese government is fully aware and trying to ‘deleverage’ the economy to equalize supply, demand, and growth. However, historical rapid expansion has created a monster that may be impossible to contain without incurring collateral damage. The New York Times claimed that “China’s growth is slowing, and the government may have to work harder to rekindle it.”

Due to the strong relationship between big business and the state, Evergrande could be “too big to fail.” If the Chinese government lets Evergrande fail, it could cause ripple effects felt within both Chinese and foreign markets. If Evergrande defaults, and goes bankrupt, then other companies in a similar position are likely to do the same, and insurance companies, other financial firms, and eventually the whole Chinese economy could come crashing down as well.

If Evergrande is bailed out, it will be hypocritical to China’s goals of deleveraging. However, most importantly, China’s response will reveal their political economy model. The Chinese government has already restricted their tech industry to align more with the values of the communist party, rather than free capitalist markets. The Chinese government will need to make a choice whether to avert economic disaster through socializing the failure of Evergrande or will the government take the ultimate capitalist approach and let it fail.

China’s approach will set the tone for the coming decades. Evergrande has the potential to grind China’s economic miracle to a halt and stop growth going forward. China has too many overleveraged companies in key industries, and the fact that the government recognizes this highlights the potential scale of the problem. As western governments argue how much more debt to take on, with no contradictory argument hitting the headlines or policy debates, China is aware of a deep problem that can unravel their markets. The jury is out on whether Evergrande will be China’s black swan event. For now, it is most certainly an ugly duckling.

 

 

Stablecoins in a Volatile Market: How Regulators Can Unleash Technological Innovation

Remember Laszlo Hanyecz? The guy who bought two Papa John’s pizzas for 10,000 Bitcoins (BTC), which at the time was only worth $30? Today, those same Bitcoins are worth around $550 million. You can probably see the problem with this. A currency should act as a medium of monetary exchange and a mode of storing monetary value, which ideally, should remain relatively stable. But because of instability in their value, cryptocurrencies such as BTC and Ethereum (ETH) for instance, suffer serious price fluctuations that make them hard to adopt. Would you adopt a cryptocurrency if you knew that tomorrow you could end up like the pizza guy? Certainly not, which is why there is another type of ‘cryptocurrency’ called stablecoins.

Stablecoins are digital coins that promise to maintain their worth by attaching their value to the U.S. Dollar or any other asset. Basically, they mimic the U.S. Dollar digitally through blockchain technology, and hence serves as a safe and stable coin. The largest stablecoins: Tether, USDC, and Binance USD all try toback against fiat currency (USD). However, other types of stablecoins are backed by gold, oil, cryptocurrencies, or through algorithms (by controlling the supply and demand). These stablecoins do hold advantages to consumers, such as instant transactions as opposed to banks. Since it maintains its value against the U.S. Dollar, people can use it to transact with each other 24/7 without a bank acting as an intermediary.

The current market cap of stablecoins is exponentially increasing, it currently rests around $130 billion, where they are backed by assets such as the U.S. Dollar, US Treasuries certificates of deposit, short-term debt, corporate bonds, and more. Given such size and potential impact to the financial system, stablecoins continue to come under scrutiny by regulators. Regulators fear that Stablecoins are vulnerable to a ‘bank run’, where large number of investors rush to redeem them, forcing sponsors to sell the assets at fire sale prices and consequentially stressing the financial system, similar to what happened to money market mutual funds during the 2008 financial crises. Therefore, regulators are rushing to put into place robust legal and economic frameworks to protect the financial market as well as consumers.

Stablecoin regulation should include essential components to protect the financial system such as creating types of reserve assets, ensuring issuers honor direct redemption claims, and establishing limits on risk maturity transformation activities. In addition, reserve segregation and coin holder claims in bankruptcy or insolvency should be honored. But questions remain on how we should regulate Stablecoins, and indeed, who should even regulate them– questions that have proven especially challenging in consideration of the need to balance the interests of different stakeholders and the financial system itself.

For Stablecoins to be regulated, they need to be classified into a certain category. However, creating a new category for crypto assets altogether may be more ideal. Because Stablecoins are not treated as deposits, the Federal Reserve (Fed) and the Office of the Comptroller of Currency have limited oversight. The Securities and Exchange Commission (SEC) also has limited authority unless the Stablecoins are classified as securities. If they are, they will be subject to bigger disclosure requirements. But paradoxically, such classification might not be of importance due to the Fed’s willingness in issuing a Central Bank Digital Currency (CBDC) or more simply a digital dollar, which might be introduced to a separate category of regulation. The CBDC would make money directly available to the public, hence, increasing outreach to people with no access to the financial system. The CBDC’s innovations however, can coexist with the current Stablecoin market, as the Fed can issue coins, while the private sector can build rails and applications. But the magnitude of dealing with millions and maybe billions of users is increasingly over the Feds power and capabilities. Therefore, this might also indicate a radical change to commercial banking soon if they do not adjust accordingly.

The US needs to catch up as China has already cleared over $5.3 billion in transactions through its digital renminbi. While it may be tempting to preserve the status quo, blockchain technology can reshape market structure and improve competition if regulated properly. Adopting digital currencies, such as Stablecoins, provides ease in transactions, convenience for unrepresented minorities in the financial system, and acts as a direct bridge between central banks and people. Maintaining the status quo within the era of rapid technological innovation, hampers competition and innovation, forcing individuals to shift to the new unregulated financial system. The question for central banks and regulators is which approach can improve competition, lower cost, and increase access to the financial system. Afterall, regulatory frameworks will define if and when the technology can deliver on its potential.