Regulating Innovation

Increasingly international R&D efforts of technology companies - established ones, such as Google and Amazon, or start-ups - positions them as central actors in national, regional and city innovation agendas. As a consequence, competition between national and regional governments for the leading tech companies has substantially increased in the past few years while regulators are more and more required to rapidly create, modify, and enforce regulations in emerging technologies. The eminent issue is how to attract the most innovative companies and let business prosper while protecting citizens and guarantee fair markets.

R&D-intensive FDI has become a highly potent option to initiate international technology transfers, allowing cities and regions to develop highly specialized technology ecosystems. Understanding how international technology companies select locations for their R&D units abroad is key to the design of new regulations or the adjustment of existing ones. Site selection processes are generally data driven and depend on the nature of R&D activities as well as on the investment options, e.g. partnership with local universities, expansion of an existing entity, greenfield investment, etc. and of course on the regulatory framework. Typically, R&D-intensive FDI doesn’t happen through greenfield investment but through the expansion of existing entities in a certain jurisdiction or through partnerships with R&D institutions. In the site selection process, regulations can be seen as an attraction but also as a discouragement. One of the key roles of regulations should be to encourage R&D-intensive FDI by anticipating developments that drive the location decision. Referring to Birkinshaw (2003), the OECD lists three factors that mainly drive the site selection process for R&D-intensive FDI: parent company strategies, subsidiary potential and host country characteristics. Firstly, even though parent company strategies are largely outside the scope of influence of national policies, governments need to monitor and understand how the country/region may fit into those strategies. Secondly, subsidiary potential is referring to the capabilities of governments to enable the managers of a subsidiary company to upward influence and “sell issues” to their headquarters, particularly when it comes to the identification of new R&D opportunities. And thirdly, host country characteristics for R&D functions are mostly defined as the availability of world-class research infrastructure, the availability of highly-qualified talents as well as the dynamism of the national innovation ecosystem. Regulations might be an attraction factor in themselves, but they can also reinforce other site selection factors.

Challenges to traditional regulation

Since the existence of modern-day business, regulations have posed significant opportunities but also challenges. For example, in the early days of the automobile industry, restrictive regulations on motorized vehicles slowed innovation for a quarter of a century or more. Radical technological developments lead to a veritable upheaval in the regulatory environment and confront regulators with fundamental challenges. While regulatory processes and changes can be daunting and tedious, regulatory flexibility has become a key site selection factor for emerging technology companies. However, until the present day, regulations are typically drafted to remain in place for a long time. Today’s advancements in tech, such as the tokenization of securities or facial recognition, changed the character of regulations profoundly. Government agencies are required to constantly create or modify regulations while communicating and enforcing them.

A number of technological innovations have raised questions about the current regulatory framework around the world. According to the World Economic Forum those innovations include Artificial Intelligence (AI), drones, Internet of Things (IoT), blockchain and distributed ledger technology, fintech, regtech and big data. For those technologies, the existing regulatory framework is typically too slow in adjusting to the disruptive innovations as regulators tend to be risk averse. One of the most common issues is the so called “black box” problem. The “black box” problem is the inability to see what is inside an algorithm. Algorithms are coded by private companies and oftentimes are of such complexity that even the company behind a certain algorithm is unable to fully control and access it. In an unprecedented move, the European Union responded to the “black box” problem and introduced General Data Protection Regulation (GDPR) in May 2018. GDPR requires companies to give E.U. citizens “meaningful information about the logic” of automated decision-making processes.

Leveraging regulatory opportunities

Countries with open-minded regulators and governments such as Switzerland or Singapore, willing to understand emerging technologies and work directly with tech companies, were able to develop some of the fastest growing tech hubs. The city of Zug for instance, home to the Swiss Crypto Valley, has been named the fastest growing technology community in Europe by London-based global investment firm Atomico. One of the key enablers of Crypto Valley has been the Swiss Federal Government recognizing the potential of blockchain and distributed ledger technology. It frequently publishes reports and provides an overview of the relevant regulatory framework and the need for action. According to a blog post by EY Switzerland from December 2018, the Swiss Federal Council aims to create the best possible framework conditions to further and effectively leverage the opportunities of digitalization. Switzerland as a leading location for fintech and blockchain companies shall ensure a sustainable environment for innovative companies and technologies especially in the financial sector. At the same time the integrity and good reputation of Switzerland as a financial centre and business location shall be preserved. In March 2019, the Swiss Federal Council initiated the consultation on the adaptation of federal law to developments in distributed ledger technology. It thereby wants to increase legal certainty, remove hurdles for DLT-based applications and limit risks of misuse. The draft serves to further improve the regulatory framework for blockchain in Switzerland, in particular in the financial sector. The regulatory adjustments focus on the following areas: the Swiss Code of Obligations, the Federal Law on Debt Collection and Bankruptcy, the financial market infrastructure law and the licencing to operate an organised trading facility. Those measures will further improve the requirements for an effective use of the opportunities of emerging technologies and ensure the competitiveness of the Swiss economy in the long-term.

In Singapore, the Monetary Authority of Singapore (MAS) has not only acknowledged the rapidly changing payment services landscape but also the fact that new business models present emerging risks which are not addressed under the current regulatory regime. In November 2017 the MAS released its proposed Payment Services Bill and consultation paper. The aim of the proposal is to simplify the legislation and broaden the scope of regulated activities in order to integrate certain new business models. The bill provides for two parallel regulatory frameworks for retail payment services (payment services to consumers or merchants) and interbank payment services. According to PwC the new bill will act as a catalyst for the development and sophistication of Singapore’s payments industry and enhance its competitive edge.

Another example comes from the drone industry. Over the last five years, Switzerland has positioned itself at the forefront of drone innovation. The country is home to more than 100 drone startups of which many have their roots at the Swiss Federal Institutes of Technology in Zurich (ETH Zurich) and Lausanne (EPFL Lausanne). Switzerland has also attracted the leading companies in the space such as Matternet, GoPro or Yuneec. The Swiss Transport Minister Doris Leuthard mentioned at the World Economic Forum Drone Innovator’s Network in June 2018: “Innovative companies and universities driving the success, along with pragmatic government regulation that takes the needs of research and development into account: This unique mix has created an environment that is equally attractive for start-ups, companies and research.” The Swiss Federal Office of Civil Aviation (FOCA) fully acknowledges that the importance of unmanned aviation will continue to grow strongly, both militarily and civilly and that this will increasingly lead to a substitution of manned aviation activities by drones. Anticipating the rapid changes in drone regulation, FOCA in collaboration with Skyguide, the Swiss air navigation service provider, and AirMap, the leading global airspace management platform for drones, has developed and approved the Swiss U-space reference architecture, which is a set of new services relying on a high level of digitalisation and automation of functions and specific procedures designed to support safe, efficient and secure access to airspace for large numbers of drones. With supportive regulators, world leading research and an innovation friendly government, Switzerland is well positioned to continue to grow. In the words of Raffaello D'Andrea, Professor at ETH Zurich’s Institute for Dynamic Systems and Control: “You have world class facilities for research, you attract the best people in the world to come and do research here, we have an environment where the universities support start-ups and there’s good angel support. Really all the ingredients are there, I think it’s a promising place to be.”

Going forward

The examples show that regulation becomes crucial for innovation to remain sustainable. Close collaborations between tech companies and regulators are not only an opportunity for governments but also for the companies themselves. Newly developed regulations allow them to revisit their business models and reinforce regulations, e.g. by creating tools to bring internet users back in control of their personal information. As most countries and governments have little wiggle room to increase R&D spending or lower tax rates, it is likely that more governments will start focussing on their regulatory framework as a potential innovation driver. As a result, policies to improve the regulatory framework conditions relevant for innovation are becoming more important.

Lukas Sieber