When we were living through the COVID-19 pandemic of 2020-2021, society came together to hunker down and follow a set of rules that would have been judged bizarre at any other time. A Quebec couple tried to circumvent one local curfew law, one of the exceptions to which was dog owners walking their dogs after dark within a kilometer of their homes. A woman put a leash on her partner during a walk, stating to police that he was, in fact, her dog. Sadly, the strategy failed and the couple were fined for their transgression.
A story as old as time
This is how state-driven regulation often looks to free marketeers - a big, scary obstacle one has to pass to get their destination. But there have always been ways to get around this obstacle.
The COVID-19 example is a case of attempted regulatory arbitrage. I would call it a classic, except that term is usually reserved for projects of greater scale and impact. Attempts to bend laws and rules to one’s advantage have been made ever since there have been laws and rules. All regulatory systems are vulnerable to and available for manipulation. Regulatory arbitage can technically be described as “exploiting the gap between the economic substance of a transaction and its legal or regulatory treatment.”1 A more poetic description is that arbitrage is a mental model that respects “both similarities and differences, all at once.”2
Exploitative arbitrage is the best understood framework. Where a desired commercial outcome or interest conflicts with the associated governance regime, there is your space for arbitrage. Finance has been the pioneering field here, reaching impressive outcomes with tax, jurisdictional and other kinds of arbitrage. A relatively recent beneficiary has been the technology industry. The media lionisation of the players and products and their outsized impact on modern life have spawned some ambitious manipulation.
The lore of Uber and Airbnb is well known and well worn now. They embody the idea of doing and asking for permission or forgiveness later. Crypto is perhaps the purest avatar of the desire for permissionlessness - no overarching regulator or encumbrances at all. All the spaces these players have created and operate in - cryptocurrencies, the gig economy - came from true disruption.
This is traditionally what venture capitalists have sought out. Brazen seafarers exploring the unknown and taking on huge risk, which surely must pay off. The greater the risk, the greater the return, as one motivational ditty goes. But we know that the reality is that the bet pays off rarely. Backing ideas and companies that have the greatest chance of ‘making it’ and increasing their chances of doing so is the real value add.
Lassoing the dragon and bleeding it dry
The big game, however, is in regulatory capture, not arbitrage. The latter will deliver results, even some great ones, but for durability and size, the aim is often regulatory capture. In several industries, the incumbents maintain their market leading status by, among other things, working over long time horizons to bend the law to their advantage (hence to the disadvantage of other players). They survive for so long partly due to their expertise in ‘regulatory entrepreneurship.’
“Regulation is a friend of the incumbent” - Bill Gurley
Bill Gurley’s now legendary 2023 talk at the All-In Conference states the case for tech’s success as a result of limited regulatory capture. Silicon Valley, according to him, has benefited from avoiding excessive regulation, so far. He cites several examples of regulators being corrupted by the largest of the players they are charged with regulating, leading to net losses for society. Regulatory capture is one of the criticisms of capitalism - it enables a system where incumbents or monopolists can build a wall of regulations to suppress competition ‘lawfully.’
Here’s the modern classic: Boeing and the FAA. Boeing recently pleaded guilty for the 737 Max crashes of 2018 and 2019, which killed a total of 346 people. No surprise that they’re paying a fraction of the amount demanded by victims’ families as fines. An investigations by the Seattle Times in 2019 found instances of gross corruption within the Federal Aviation Administration (FAA), where regulatory design reviews would often be delegated to Boeing itself.
For some industries, the way out has been in regulatory competition, where different jurisdictions compete to attracts more innovative (often smaller and newer) companies. An example is the 2010s vintage ‘regulatory sandbox’ provided by the UK’s financial regulator, the Financial Control Authority (FCA). Startups could get a ‘holiday’ from regulations that would allow them to try out innovative business models. The most popular graduates include the UK’s branchless banks like Monzo.
But for the vast majority of sectors, regulation and its gaming often casts a long shadow over competitiveness. Innovation-friendly regulatory regimes are necessary for more level playing fields and a sharper focus on problem solving for customers. The discord between entrenched lawmakers and the swashbucklers of the tech industry renders this a difficult project.
A new paradigm
Hence, a tribe of ‘Techno Legal Optimist’ (h/t to
) regulatory entrepreneurs is required. This group would include not just entrepreneurs and technology industry executives with a benign disposition towards the law and regulators, but also creative and forward thinking players from the legal, lawmaking and regulatory community. Any player or institution with sufficient autonomy - organised industries, large companies, sovereign nations - can encourage a thriving internal economy through a mix of capital, long term investments into future looking research, the rule of law and a pioneering spirit. A coming together of thinkers and doers with similar aims and ideologies would catalyse these kinds of incremental changes. The American project in the 20th century is a prime example of success.Victor Fleischer, Regulatory Arbitrage, 89 Tex. L. Rev. 227, 229 (2010).
Riles A (2014) Managing regulatory arbitrage: a conflict of laws approach. Cornell Intl Law Journal 47: 63-119