In July 2017, the Bank of Canada released a discussion paper outlining a framework for the assessment of risks and opportunities for central banks in connection with Fintech. This paper also more generally explores potential implications of Fintech for central banks, given their mandate over monetary policy, the design and distribution of currency and/or financial stability.
Impact of Fintech on Monetary Policy
One of the reasons that Fintech is being keenly watched by central banks is in connection with its potential implications on monetary policy and the design and distribution of currency. Cryptocurrencies and distributed ledger technology more generally have revived interest in the idea of electronic currency, potentially leveraging such distributed ledger technology. Such concept could have significant implications on a central bank’s ability to manage monetary supply.
The Bank of Canada has begun experimenting with distributed ledger technology in the payments system (although not in respect of currency directly) by running a pilot called Project Jasper (please see our blog post on the subject). The conclusion of the first stage of the pilot project was that such technology was not yet ready for live use in wholesale large value settlement systems, and the pilot is continuing and has progressed to a later stage. This seems to suggest that electronic currency may still be some time away for central banks.
Entity-Based vs. Functional Regulation
The paper also discusses entity-based regulation vs. functional regulation, and their applicability in the regulation of Fintech. Entity-based regulation is based on type of entity (banks, credit unions, securities dealer, etc.). Functional regulation is based on type of activity (payments, lending, etc.). The reality is that financial regulation will always involve aspects of both entity-based regulation and functional regulation. However this blend is constantly evolving and it is important for regulators to strike the right balance.
Overemphasizing entity-based regulation can be risky because it presumes that there are well-defined institutions to regulate. Fintech is shifting the traditional definitions of what is a bank, a wealth manager, a broker dealer, etc. Entity-based regulation could consequently result in entities in key parts of the financial sector falling outside the scope of the regulatory scheme. This could expose the entire system to additional risk.
Fintech is also resulting in changes to existing players and an increased shifting and blurring of organizational boundaries. If the size of large banks becomes a hindrance to their ability to keep pace with innovation, these institutions may begin to spin off business units in a process known as “unbundling”. Banks and other established players may also choose to partner with and acquire Fintechs. The major consequence will be that the line between bank and non-bank entities will become less defined, making entity-based regulation more challenging.
There are also challenges with functional regulation. If regulators do not clearly define the specific function they are targeting, there is a risk of market confusion which acts as a deterrent to innovation. Functional regulation can also be too prescriptive. Overly prescriptive regulation risks being outpaced by technological developments and thus becoming ineffective. This is a particular challenge given the rapid pace of advances in Fintech.
Impact of Fintech on the Financial Services Competitive Landscape
The paper applies the Porter five forces competitive analysis framework to the Fintech industry and presents the following conjectures with respect to the financial services industry:
"Our analysis at the industry and firm level leads us to two conjectures: (i) banks will have the incentives to “integrate forward,” and (ii) fintech firms will have incentives to “integrate backwards.” Forward integration will be the trend of banks and other financial intermediaries to acquire or adopt the technology that fintech firms are developing. In many cases this is possible because neither the technology nor the business models are proprietary. The direct banking model is an old example of this. Since the advent of the Internet, banks have tried to attract deposits via a simple banking model without branches. Many of the established banks have direct banking as one of their business models. Backwards integration, on the other hand, will be the attempt by some fintech firms to exploit the traditional economies of scope of banks. For that, some start-ups or big technology firms might seek traditional banking licenses. Some P2P lenders, and traditional technology companies, have gone this way."
In particular, the paper includes a more specific Porter analysis of the P2P consumer lending industry and concludes that, to succeed, a P2P consumer lender will need to harness four key factors: “(i) a strong customer experience, (ii) low-cost funds, (iii) low customer-acquisition costs and (iv) accurate identity authentication and risk estimation.” While P2P lenders generally have an advantage in the first category, the paper states that the remaining three can be more of a challenge and in particular, access to low-cost funds is particularly challenging for Fintechs, especially when compared to banks who have access to demand deposits. This is one of the reasons that the paper suggests that Fintech entrants will have incentives to become regulated, in order to have access to lower cost funds.
Central Bank Framework for Analysis of Fintech Innovations
The paper also sets out certain key questions a central bank should consider when determining whether a Fintech innovation should be of concern to a central bank: “(i) Does the fintech solution solve an economic friction? (ii) Is the fintech solution better than currently available technology? (iii) Does the fintech firm offering the solution hold a competitive advantage? (iv) Does the solution affect the central bank’s mandate?”
If any of these questions are answered are in the negative, the central bank should not, at such point in time, concern itself with the particular innovation, as it either falls outside the mandate of the central bank (and falls instead within the responsibility of either regulators or parts of government) and/or has not yet achieved the scale of to be of concern. This analysis may warrant revisiting at a later point in time should the innovation continue to progress.
Fintech creates challenges for central banks because it has the potential to disrupt monetary supply and management, as well as the organization of the financial system, both at the macro and micro levels. Central banks and other regulators have a very delicate balancing act to play to strike the right balance. The Bank of Canada discussion paper provides helpful analysis with respect to certain issues to consider in connection with the regulation of the ever-evolving Fintech industry.