In a recent speech, Commissioner Hester Peirce from the U.S. Securities and Exchange Commission (SEC) admonished financial regulators against behaving like “helicopter parents,” treating innovators like children constantly in need of adult supervision. “If we do not become more comfortable with risk,” Peirce warned, “our helicoptering may so burden fintech innovations that they begin to lumber along at a regulatory pace.”

Commissioner Peirce’s skepticism of regulatory proliferation is unusual among U.S. financial watchdogs. Her dissent from the SEC’s July decision not to authorize a bitcoin exchange-traded fund (ETF) earned her the nickname “Crypto Mom” and the Twitter fandom of 19,000 cryptocurrency enthusiasts. At a time when regulators’ attitude to financial innovation is suspicious tolerance at best and Luddite hostility at worst, Peirce’s openness to new ways of doing things, and her call for humility from officials, is refreshing.

Her colleagues are slow to catch up. Cryptocurrency markets in the United States remain shrouded by regulatory uncertainty as we celebrate the tenth anniversary of the invention of Bitcoin. The pressure on policymakers has subsided as market valuations declined and consumer appetite for new cryptocurrency issues became less voracious. But it will resume if the technology proves to have staying power.

The costs of regulatory fragmentation

Regulators have shown greater willingness to revise their rulebooks for other financial innovations. At the end of July, the Treasury released a much anticipated report with its recommendations for nonbank and fintech firms. This segment of the market has grown rapidly since the financial crisis, as risk management software improved, and as regulation made certain forms of lending costly and bureaucratic for deposit-taking institutions. A study published by the U.S. National Bureau of Economic Research last year found that 60 percent of the growth in nonbank market share was explained by increased bank regulation after the financial crisis. Another 30 percent was explained by better technology. At the end of 2017, online lender Quicken Loans surpassed Wells Fargo as America’s largest mortgage originator.

Yet, for a long time, the U.S. regulatory structure has not kept up with developments in the private sector. States have historically been the primary regulators for nonbank lenders such as Quicken and Lending Club. This may have made sense in a previous era when most marketplace lenders were local in scope. Yet, even then, states often used their prerogative to protect local incumbents from competition by non-state lenders and new firms. The National Banking Act of 1864 partly helped overcome state protectionism by creating an alternative federal charter for banks. But nonbank lenders could not use this charter.

As financial regulation at both the federal and state levels has expanded, and as technology has created economies of scale in marketplace lending, state-by-state licensing has become an onerous burden. A recent report by the U.S. Government Accountability Office reported annual licensing costs for nonbank lenders at between $1 million and $30 million. Costs of recordkeeping and complying with regular examinations come in addition to that. Plainly, state-level regulation is no longer competitive.

That is why the Office of the Comptroller of the Currency (OCC)’s announcement – shortly after the release of the Treasury report – that it would begin to accept national bank charter applications from fintech lenders was a momentous development. This charter will allow lenders that do not take deposits to eschew the fragmented state-by-state licensing regime and apply instead for a single, nationwide license.

The OCC charter will not usher in a free-market nirvana. Chartered institutions will be subject to significant disclosures of their business plan, capitalization, liquidity position, and community lending activities at the time of application, as well as in ongoing periodic examinations. But a federal charter will give nonbank lenders an outside option from the redundant state-based framework which presently makes scaling up needlessly costly. As venture capitalist Jay Reinemann from Propel Venture Partners put it to me at a conference in September, “a plethora of options is good … different firms are going to want different things.”

Can data make all of us richer?

Licensing is not the only area where regulation is slowly evolving to accommodate promising financial innovation. The Treasury report devoted much attention to the use of data to make financial services provision cheaper, more personalized, and more competitive. The U.K. has led the way among developed countries in seeking to facilitate third-party access to banks’ consumer data in a bid to make it easier for customers to find out about new products from a wider range of providers. So-called “open banking” would, in the minds of its proponents, make possible in the financial services industry the diversity and choice we currently enjoy on

Internet marketplaces.

A crucial way in which consumer data can be productively deployed is the calibration of loan interest rates. Risk-based pricing is the cornerstone of credit markets, allowing financial institutions to efficiently allocate scarce capital, and fomenting competition between lenders.

Innovation that ushers in more accurate loan pricing can expand loan volumes and lower interest rates, making consumers better off and increasing economic activity. A recent Federal Reserve paper found that Lending Club’s proprietary credit-pricing model predicts borrower default better than the long-standing Fair Isaac (FICO) score. Lending Club can thereby extend more and better-priced loans than some of its older competitors.

However, government regulation can chill innovation in credit pricing because providers are wary of falling foul of anti-discrimination laws. The fight against differences in the price of credit based solely on the race, age or gender of the borrower has informed U.S. public policy since the 1970s. But regulators and courts have sometimes given these statutes a broad interpretation, judging lenders not on the intent or design of their policies but on the impact of their lending on different communities.

Customized lending vs. discrimination

It may be that certain practices that are not overtly discriminatory end up allocating credit on different terms to people of different races. On the other hand, what superficially might look like discrimination can be driven by legitimate business factors.

For example, if a lender offers two prospective borrowers of different races a similar loan on different terms, one might conclude that the lender was discriminating, in violation of the law. However, if the two borrowers also have different incomes, then differential pricing is not gratuitous discrimination but rather an adjustment of interest rates on the basis of default probability, since borrower income is a predictor of loan default. Asian Americans, for example, have higher median household income than other ethnic groups. If they get better loan terms than whites on average, that may have little to do with discrimination and instead be the product of third factors that also correlate with race.

The promise of financial technology is to customize risk-based pricing in a way that not only makes credit markets more efficient, but also mitigates the injustice of generalization – whereby diligent borrowers face higher prices because some of their group traits (income, occupation, housing status) correlate with a higher default probability. By using data-rich aggregation techniques, fintech lenders can better account for individual characteristics and rely less on group characteristics.

When regulators push the envelope

Yet, this beneficial innovation can only happen in an environment where lenders have the assurance that new practices will not put them on the wrong side of regulators. The Bureau of Consumer Financial Protection, one of the most activist post-crisis watchdogs, set a dangerous precedent by assessing fair lending compliance by auto dealers on the basis of aggregate statistical analysis that used borrower last names and ZIP codes as the primary variables. Both economists and industry participants regarded such “enforcement by proxy” as flawed, because it failed to account for relevant factors like borrower income and lender market power.

Recently, there have been signs of a more constructive stance. The Bureau has changed direction under the Trump administration, vowing no longer “to push the envelope” in a bid to expand its regulatory remit. In September, the agency proposed a trial disclosure program to encourage innovation. Modeled after so-called “sandbox” programs implemented, among others, in Arizona and Britain, this initiative will exempt qualifying firms from specific registration and disclosure requirements as they try out new products and business models.

Sandboxes are an attempt to increase certainty among innovators and reduce the fixed costs of regulatory compliance. Coupled with broad safe harbor provisions, sandboxes could perceptibly increase the scope for innovation in U.S. consumer financial services.

Implications for finance in America – and beyond

Time will tell if this modest trend toward regulatory forbearance can effectively promote new ideas by financial incumbents and startups. With U.S. financial services among the most heavily regulated industries in the world, whose rulebook grew by 27,000 new mandates after the 2008 crash, the road to make finance dynamic and competitive will doubtless be a long one. But U.S. credit and capital markets represent tens of trillions of dollars in value, so the consumer gains – and associated profits – from effective cost-cutting innovation are huge.

For offshore jurisdictions, the changing regulatory winds in the United States present an opportunity, as well as a challenge. Offshore financial centers have historically functioned as small-scale laboratories of innovation, where favorable tax and regulatory policies encouraged the location of multinational affiliates and investment funds. America’s newly-found tolerance for experimentation, if it does materialize, would place competitive pressure on smaller jurisdictions such as the Cayman Islands.

Yet it is unlikely, much as one would like it, that U.S. financial regulators will soon adopt an across-the-board presumption in favor of permissionless innovation. Particularly for more headline-grabbing technologies like cryptocurrencies, policy uncertainty will probably remain a feature of the business landscape for some time, with a statistically significant impact on cryptocurrency prices. This is where smaller markets like Cayman can offer a more welcoming environment, as the recent EOS initial coin offering – at $4.2 billion, the world’s largest so far – illustrates.

Commissioner Peirce beseeched her colleagues at the SEC and elsewhere to relent from “helicoptering” and embrace “free-range parenting.”

It is as yet unclear whether U.S. regulators will heed Peirce’s call, but it applies just as forcefully to any other jurisdiction eager to harness the benefits of financial innovation.