Fintech: A New Frontier in Finance

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The many sides of financial technology, and the risks involved.

In the world of finance, there is a consensus that technology-driven change is inevitable, and that it brings with it massive potential for disruption.[1] Central banks and supervisory authorities meet internet challenges to their financial systems by communicating their intentions to the public on their websites.

Most of them have set up dedicated units for monitoring developments. [2] Among the leading ones in Asia are the Peoples’ Bank of China (PBC), the Hong Kong Monetary Authority (HKMA), the Monetary Authority of Singapore (MAS) and Bank Negara Malaysia (BNM).

Compared to advanced economies, those in the Asia Pacific region have a tremendous untapped potential in finance. The region is a very significant unserved market, particularly South-East Asia, China and India. There is also a new generation of tech-savvy individuals in Asia.[3] Malaysia is planning to mobilise this generation in 2017, designated by Prime Minister Najib Razak as “The Year of the Internet Economy 2017.”

Central banks acknowledge that financial technology, or fintech, offers vast opportunities for those who have been neglected by traditional finance – such as SMEs, those without access to finance who are the target group of financial inclusion, and also those who feel that traditional banking does not offer most efficient services in the payments system or wealth management.[4] At the same time, however, they run the risk of utilising financial services provided by unsupervised or inadequately supervised entities.

How Does Fintech Function?

Fintech may be defined as technology-based businesses that compete against, enable and/ or collaborate with financial institutions. More than 12,000 start-ups in the fintech space are utilising tech tools and innovative financial services for the banked and unbanked population.[5]
Fintech products run counter to mainstream economic thinking. They mark a shift away from centralised trading and reduce the need for liquidity by increasing net settlement.[6] How this holds up during market turbulence remains to be seen.

The main areas where fintech has made rapid advances are digital currencies, payments (including automation of receivables), crowd sourcing, lending in the form of peer-to-peer (P2P), wealth management and credit insurance.[7] The usual risks of financial products apply, and importantly, so does cybersecurity – with various sources reporting that cybersecurity in Asia is weaker than in advanced countries.

Taking the methodology of the Financial Stability Board (FSB) to classify shadow banking activities according to their economic functions,[8] the same approach will be used here to classify fintech products.

While it is difficult to put precise magnitudes to reflect the economic importance of each fintech product,[9]
the ranking reflects their potential relative importance.

Supervisory Responsibilities for Fintech Products

Central banks believe that this time, the challenge posed by fintech is here to stay. Ravi Menon from MAS gives a number of reasons for this. These are mobility of technology, mobility of ideas, mobility of payments as well as new trends in technology affecting finance – including mobile and digital payments, authentication and biometrics, block chains and distributed ledgers, cloud computing, big data, and thinking computers or learning machines.[10]

Fintech: A New Frontier in Finance

According to the Payment Aspects of Financial Inclusion report by the Committee on Payments and Market Infrastructures (CPMI) and the World Bank Group, fintech products offer opportunities for 40% of the adult population worldwide who still do not have a formal account for payments. As most of these people have access to mobile phones, fintech offers a real chance to provide basic financial services and payment needs, and to safely store some value and as gateway to other financial services.[11]

The report also stresses the need for a legal and regulatory framework which underpins financial inclusion by effectively addressing all relevant risks and protecting consumers, while fostering innovation and competition.

China is a booming economy with an underdeveloped financial sector and a vibrant internet population. The PBC, which faces these very challenges in the domestic financial system, has gone a long way in assigning the supervisory responsibilities for various products to particular supervisory agencies.

Various fintech products are provided by different entities which might eventually need to be subjected to regulation and supervision. Existing entities, such as banks, payment providers, various funds, insurances and broker-dealers are less of a problem as they are already regulated and supervised to a great extent. One detects encouragement by central banks and other supervisory authorities for these entities to engage in fintech products, particularly in advanced countries.

The challenge, however, are entities that only exist in the virtual world, without links to “brick and mortar” institutions; the experience of e-money in the 1990s shows that these were short-lived and did not pose a real challenge to established institutions. This time might be different, as Ravi suggests – they need to be taken seriously for regulation and supervision.

Regulation and Supervision

Digital currencies

Regulatory issues for digital currencies based on distributed ledgers cover three main fields: consumer protection, prudential and organisational rules for different stakeholders, and specific operating rules as payment mechanisms.[12] As they are presently not widely used, their impact on the mainstream financial system is negligible.

The International Monetary Fund (IMF) sums up similarly: some are asking whether bitcoin or other block chain applications could eventually undermine monetary policy and financial stability, but the consensus is that there is no immediate risk.[13]

Fintech: A New Frontier in Finance Physical representations of bitcoin.

However, central banks have set up dedicated units to monitor developments, as it is they who are responsible for monetary and financial stability. All central bank laws assign the power to issue sovereign currency to the central bank. Trust in digital currencies rests ultimately in sovereign currencies. It is unlikely that digital currencies would be accepted if they cannot be freely exchanged into any sovereign currency.

Confidence in a decentralised system can sideline cash and the sovereign currency for the time being, but never displace it. Central banks have to be on standby if the trust in digital currencies waxes and wanes, even before a possible collapse. However, recent cybersecurity breaches in digital currencies – with the latest being in August 2016 –have led to significant losses, but have not resulted in panics requiring central banks to step in.

Central banks, through their dedicated units monitoring fintech developments, would be well advised to prepare a Plan B: what to do with outstanding holdings of digital currencies by nationals in case confidence evaporates and flight into sovereign currencies occurs.

The payments system

This is clearly the responsibility of a central bank. Very often the mandates put the promotion of a safe and efficient payments system as a key task. Acting as a lender of last resort is the core of a financial system linking monetary policy with financial stability. How far a central bank is responsible for the smooth running of the payments system if it is largely run by an internet company with distributed ledgers is uncharted territory. Banks are already deprived of big data on clients, as online payments operators cut lenders’ access to crucial transaction details.[14]

Total reliance on smooth internet functioning can lead to a false security that payment risks have been eliminated. Central banks remain responsible for flagging, monitoring and managing risks in the payments system, such as counter-party risk, liquidity risk, and legal and operational risk. For internet payment systems, providing cybersecurity is of paramount importance. A central bank’s role in case a payment system is hacked has not yet been defined.

Crowdsourcing

As a collective investment vehicle is part of the asset management industry and, as such, belongs in the domain of the securities supervisor, most funds have a whole set of regulations to comply with, including their funding, investment strategy and transparency requirements. While in the regulated and supervised world, open-ended funds make up the majority of funds for retail investors, [15] internet platforms acting as such have so far been unregulated and have escaped supervision.

Online platforms have a clear competitive advantage as their fees are much lower than established funds, and they allow online monitoring of their investment strategies. It is questionable if retail investors are able to exercise this function in view of the complexity of the investment universe. Most likely they will sacrifice governance for higher returns.

Lending as P2P

This is clearly a credit provision activity and falls within the authority of the banking regulator. As such, funding, liquidity and risk management needs to be reported regularly. Whether online P2P lending can be excluded from banking regulation and monetary policy regulation is an ongoing discussion.

Allowing P2P lending to be excluded from banking regulation is rightly seen by traditional banks as unfair competition, which feeds the disruption of traditional banks that still support the main part of the economy – not only in Japan, China and India, but also in financial centres such as Hong Kong and Singapore. Excluding P2P lending from monetary regulation would seriously undermine the effectiveness of monetary policy and the transmission mechanism.

Wealth management

It is yet to be decided whether internet wealth management belongs to the first category of lightly or non-supervised entities, or broker-dealers that are subject to tighter regulation and supervision. The national securities commission and the International Organisation of Securities Commissions (Iosco) as the international body are working on recommendations for fintech securities regulation.[16]

Insurance

Insuring the risks of financial products has provided rich experience, ranging from rather successful derivatives markets to specific products such as insuring collateralised debt obligations (CDOs), which has been more problematic. While derivatives markets – both market risk as well as credit risk derivatives – have survived the global financial crisis rather unscathed, individual players such as AIG had to be bailed out because of systemic concerns.[17]

If the risks of providing credit can be insured and sold in the derivatives market, the players are well-known, well-regulated and supervised. However, even established players such as AIG got themselves into trouble with new products, such as CDOs. Moreover, if new insurance players emerge on the internet, their ability to assess risks and manage these might not be up to the task.

At present, protecting insurance customers has priority over financial stability concerns relevant for real-world insurance business. This should also be the prime concern of national insurance supervisors as well the International Association of Insurance Supervisors when they come up with recommendations regarding online insurance.

BNM’s Approach

BNM has been among the leaders in facing challenges from fintech. BNM Governor Muhammad Ibrahim announced that Malaysia issued a discussion paper, introducing a sandbox approach which allows fintech solutions to be tested in a controlled environment with appropriate risk mitigation in place. Regulation should be harmonised to focus on activities (the economic functions in Table 1) rather than the institutions conducting such activities.[18]

In October 2016 BNM introduced the Financial Technology Regulatory Sandbox Framework. Innovations eligible under this scheme should have the clear potential to improve accessibility, efficiency, security and quality of financial services, enhance the efficiency and effectiveness of institutions’ risk management, and address gaps in or open up new opportunities for financing or investments. The framework took effect on October 18, and BNM invited applications.[19]

Conclusion

As fintech innovations are here to stay, regulatory and supervisory authorities should adopt a two-pronged approach. First, working with established, well-regulated and supervised entities to come on board and develop their own internet solutions. Any internet solutions to enhance the performance of established financial intermediaries, such as of banks and funds, also fall into this category.

Secondly, giving a fair chance to internet startups to create and try out their internet solutions, such as through “sandboxes.” It is only when they start to become critically important to the financial system should they be subjected to regulation and supervision.

During the trial period, unregulated entities might enjoy competitive advantages compared with traditional players. Clients should be made aware that they might be taking on additional risks, including cybersecurity, in return for their monetary advantage. Remembering the development of e-money in the 1990s, the experience shows that only entities linked with well-established players and solid internet entities have some staying power.

  • [1]Jaime Caruana, “Financial Inclusion and the Fintech Revolution: Implications for Supervision and Oversight” (address, Third GPFI-FSI Conference on Standard Setting Bodies and Innovative Financial Inclusion, Basel, October 26, 2016).
  • [2]MAS has set up the Fintech Affiliation Office and published guidelines on the “sandbox exercise” together with application forms.
  • [3]Tharman Shanmugaratnam, “Promoting Innovation in Finance in Singapore” (address, Singapore FinTech Festival, New York, April 12, 2016).
  • [4]Muhammad Ibrahim, “Governor's Opening Remarks,” (address, Global Symposium on Innovative Financial Inclusion, Kuala Lumpur, September 21, 2016).
  • [5]KPMG and Nascomm, FinTech in India - A Global Growth Story, June 2016, http://www.nasscom.in/fintech-india-global-growth-story-june-2016.
  • [6]François Velde, “Money and Payments in the Digital Age: Innovations and Challenges,” Financial Stability Review, no. 20 (2016): 103-11.
  • [7]People’s Bank of China, “Guidance on Promoting the Healthy Development of Internet Finance,” July 18, 2015, http://www.pbc.gov.cn/goutongjiaoliu/113456/113469/2813898/index.html.
  • [8]Financial Stability Board, Global Shadow Banking Monitoring Report 2015, November 12, 2015, http://www.fsb.org/wp content/uploads/globalshadow-banking-monitoring-report-2015.pdf/; and International Monetary Fund, “Shadow Banking Around the Globe: How Large, and How Risky?” in Global Financial Stability Report 2016, https://www.imf.org/external/pubs/ft/gfsr/2014/02/pdf/c2.pdf.
  • [9]The Red Book of the Committee on Payments and Market Infrastructures covers only bank linked e-money.
  • [10]Ravi Menon, “A Smart Financial Centre” (address, Global Technology Law Conference 2015, Singapore, 29 June, 2015).
  • [11]Committee on the Payments and Market Infrastructures and World Bank Group, Payment Aspects of Financial Inclusion, April 5, 2016, http://www.bis.org/cpmi/publ/d144.pdf.
  • [12]Committee on the Payments and Market Infrastructures, Digital Currencies, November 23, 2016, http://www.bis.org/cpmi/publ/d137.pdf.
  • [13]Andreas Adriano and Monroe Hunter “The Internet of Trust,” Finance and Development 53, no. 2 (2016): 44-7.
  • [14]Yuval Noah Harari, “Yuval Noah Harari on Big Data, Google and the End of Free Will,” Financial Times, August 29, 2016.
  • [15]International Monetary Fund, “The Asset Management Industry and Financial Stability,” in Global Financial Stability Report 2015, April, 2015, http://www.imf.org/External/Pubs/FT/GFSR/2015/01/pdf/c3.pdf.
  • [16]International Organisation of Securities Commissions, Cyber Security in Securities Markets – An International Perspective, April 2016, https://www.iosco.org/library/pubdocs/pdf/IOSCOPD528.pdf.
  • [17]International Monetary Fund, “The Insurance Sector – Trends and Systemic Risk Implications,” in Global Financial Stability Report 2016, October 5, 2016, https://www.imf.org/External/Pubs/FT/GFSR/ 2016/01/pdf/c3.pdf.
  • [18]Muhammad Ibrahim, “Governor's Opening Remarks.”
  • [19]Bank Negara Malaysia. “Financial Technology Regulatory Sandbox Framework,” October 18, 2016, http://www.bnm.gov.my/index.php?ch=en_press&pg=en_press&ac=4273&lang=en.
Herbert Poenisch is a retired senior economist at the Bank for International Settlements.



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