Battling the Regulatory Hegemon
Buy the rumor, sell the news
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About 15 years ago I was hired by Citigroup to manage a $120 million capital budget, which budget was part of a larger Continuity of Business (CoB) initiative. The very high level summary is this: in the immediate aftermath of 9/11, financial regulators in the United States informed Citigroup that its data centers, then clustered around the New York City metro area, had to be more geographically dispersed across the United States. When presented like that, this makes some sense: if another terrorist attack were to strike New York City (or Washington, DC, which was also judged to be a likely target for future terror attacks) then having data centers far from these potential target cities was a good idea.
If you’re wondering why it took the combined forces of a terrorist attack and regulatory attention to force Citigroup to do something about its data center locations, then you probably haven’t had much experience with regulators and their effect on businesses. In the immediate aftermath of the Global Financial Crisis, a common refrain that you heard was that banking and finance were unregulated. Nothing could be further from the truth: the financial industry is one of the most heavily regulated. (Whether the regulations are effective is another question entirely.) But, consider this: one aspect of the regulations under which Citigroup operated at the time that I managed this $120 million capital budget required that Citigroup store its various financial data in a mainframe. Re-read that sentence: a particular regulation, buried deep in the bowels of the federal government, specified that Citigroup (and presumably other banks similarly regulated) had to store certain financial data on a fifty-year old technology.
I am relating all of this because of two things that I have noticed over the past few years: a lot of entrepreneurs hate regulation. And I don’t blame them: they want to build products and services for people and companies. They don’t want to deal with lawyers, regulators, or accountants. But consider two prominent examples of regulatory constraints from the past five years:
A vaccine for Covid was apparently created in two days in January, 2020, but regulatory requirements mandated extensive (and slow) clinical trials.
Hundreds of crypto-entrepreneurs created initial coin offerings (ICOs) to fund the development of their projects, which ICOs violated various securities laws.
In both cases, entrepreneurial types balked at the regulatory constructs which constrained these activities. Both vaccine development and novel funding mechanisms for blockchain-related projects have something in common: Moore’s Law has made crunching large amounts of data very inexpensive. This has led to an explosion in new technologies, entrepreneurial activity, vaccine development, and efforts to remake the global financial system.
And, in both cases, the silicon-powered data crunching spits out products that bump up against the regulatory state. The vaccine was developed in two days only because scientists have very powerful computers that allow them to rapidly sequence the genome of a virus. Blockchain technology and its ancillary developments arose only because cheap and powerful silicon chips made distributed computing feasible.
On the one hand, silicon-enabled technologies promise rapid innovation. On the other hand, rigid regulatory frameworks militate against rapid innovation. Medical ethicists will tell you that requiring extensive (and slow) clinical trials is an important friction, lest the vaccine be worse than the disease. Entrepreneurial types will tell you that in silico simulations of new medicines is inevitable, and will be more effective and efficient than in vivo testing. On the question of effectiveness and efficiency, I will defer to the experts, but it is clear that simulation of biological structures in silico will only become more prominent in the future.
Likewise, the diffusion of powerful computers across the world, combined with broadband internet connections, has made distributed computing possible. But just because something is possible doesn’t mean that the results of that thing won’t violate some arcane regulation. And that is exactly what we saw with ICOs.
More prosaically, I recently worked for a startup whose goal was to launch a cloud-based securities exchange. In order for that company to be able to operate and acquire customers, it needed a financial regulator to grant it a securities exchange license. Securities exchange licenses are relatively rare and require significant upfront legal paper work. If the financial regulator wouldn’t grant the license in a timely manner, the company would run out of money without having generated any revenues, and that’s precisely what happened to this company.
The point that I am trying to make here is that certain industries, among them being healthcare and financial services, are very heavily regulated, and entrepreneurs who enter either of these two spaces have to be ready to contend with complex regulations and slow regulators. Regulators don’t move at the speed that technology does, and have no incentive to change their ways. To a very large extent, the companies that best contend with regulators are not nascent startups, but rather technology companies that are no longer really startups, but are still entrepreneurial enough to fund engagement with regulators.
Consider this example from Square’s Cash App:
When you land on a problem and a market that’s remained stagnant, you’re giving yourself a massive head start out of the gate—but it doesn’t come easy. “When you’re working within domains that are regulatorily complex, generally, once you establish a beachhead, there are higher barriers to entry. That complexity is a reason that people don’t tend to try it,” says Omojola. “For years, the core advantage Cash App had was that for a long time in the U.S., if you wanted to move money from Bank A to Bank B instantly, Cash App was literally the only way you could do it. The other options were either paying to use wires or using ACH, which was free but would move money slowly,” he says.
“That insight came from quite a bit of imagination and a team of people that spent years at Square banging their heads against the wall, working with card networks, and realizing that there was an unexploited mechanism for instant money movement. It happens to be the case that nobody’s using it this way because it’s a slog to pull it all together,” he says.
Let’s unpack this a bit. Cash App is a money transfer service developed by Jack Dorsey’s company Square. Square is a large company, whose balance sheet has about $4.5 billion in assets. As I’ve said before, business constraints are always and everywhere a balance sheet phenomenon. Square could finance the development of a product whose specifications conformed to complex regulations. A lot of startups don’t have that luxury because they don’t have the balance sheet to sustain such development.
It’s at this point, if you’ve read this far, that you want to know the solution to regulatory complexity. Unfortunately, there isn’t one, really. The best an entrepreneur can do is to pick a small piece of a regulated market, establish product-market fit, generate revenues, raise capital, and expand from there. Hopefully the revenues (and venture capital dollars) can finance the legal work required to contend with opaque regulations. If it were easy, it would not be entrepreneurship.