March 10, 2017

Tech and Innovation in Financial Services: Opportunities and Challenges for Regulators and Policymakers

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"Oh, wonder

How many goodly creatures are there here

How beauteous mankind is!

Oh brave new world."

With these lines from The Tempest, Christine Lagarde opened a session at the 5th World Government Summit on financial technology and government. It’s not often that Shakespeare and fintech are mentioned in the same breath. But Lagarde’s point was well made: new financial technologies hold enormous potential to transform financial services for the better. However, because these technologies are still nascent, we don’t yet fully understand all of their implications and risks.

Fintech as a force for good

The benefits of technology and innovation in financial services are well known. One of the most obvious is easier, cheaper access to financial services in both emerging and mature economies. For example, mobile payments services are flourishing. They are especially popular in China (paywall), and M-PESA boasts more than 25 million users in sub-Saharan Africa and India. Services like TransferWise and World Remit enable cross-border transfers at a fraction of the cost charged by main street banks. Peer-to-peer lending platforms such as Lending Club and Funding Circle enable faster, cheaper access to credit for individuals and small businesses.

Enter “RegTech”

But it’s not only customers who stand to benefit. Regulators are increasingly exploring new ways to leverage technology, and the term “RegTech” is gaining currency. Jo Ann Barefoot, CEO of Barefoot Innovation Group and former Deputy Comptroller of the Currency, points out that in the United States, financial regulatory practices were “designed for the analog era…when data and computing power were scarce.” With both commodities now in abundance, and combined with advanced data analysis techniques, regulators can potentially supervise the financial sector more efficiently and effectively. They can better achieve the policy outcomes they want, for instance, by better analysing consumer complaints and more quickly identifying unfair lending practices. Eventually, perhaps regulator can leverage big data and machine learning to spot impending threats to financial stability and take early action to prevent financial crises.

Opportunities for policymakers

Emerging financial technologies offer opportunities for policymakers, too. A report by the UK Government’s Chief Scientific Adviser, Mark Walport, explored government use cases for distributed ledger technology. One example is more efficient and effective welfare payments. Using this technology, governments could more cheaply and accurately transfer money to welfare recipients, and it would be easier to bring these citizens into the formal financial system, with all the benefits of financial inclusion. Importantly, it could also reduce the sum that is overpaid through fraud and error (£3.5 billion in the UK’s case, according to the report). The government could even experiment with monitoring or setting parameters on how particular benefits are spent. This could enable better measurement and policy outcomes.

Challenges remain

Nevertheless, as Peter Sands, former Group Chief Executive of Standard Chartered Bank warned at a recent event at Harvard Kennedy School, “don’t underestimate the paradigm shift facing the regulator.” New technologies pose new — sometimes unknown — risks. Blockchain is one example. Patrick Murck, a fellow at Harvard’s Berkman Klein Center for Internet & Society, points out that where financial transactions are concerned, blockchain offers transparency in all the wrong places. It provides full transparency into a user’s transaction history — which is traditionally considered confidential information. And it fails to provide transparency into who owns what, and the verified identity of who is making the transaction. This damages trust, and hampers important anti-money laundering and anti-terrorist financing checks.

The way forward

Jo Ann Barefoot estimates that in around 20 countries, financial regulators are working on innovation hubs and sandboxes — including in the UK and Singapore, where they are working both with established financial institutions and challenger start-ups. The idea is to better facilitate innovation and experimentation, and to observe the effects, in a controlled environment. The sandboxes also have the benefit of allowing regulators to learn more about newer technologies — like blockchain — and better understand different fintech business models.

These efforts are important at the national level and should be encouraged. However, more coordination is needed at a global level, for two reasons. First, there is a need to address regulation for cross-border fintech: such as in trade finance and in cryptocurrencies, for which regulation varies considerably among different markets. Second, and most important, regulators need to work together to better understand the implications for the stability of the global financial system. In this “brave new world,” regulators should not go it alone.

The views expressed in the Government Innovators Network blog are those of the individual author(s) and do not necessarily reflect those of the Ash Center for Democratic Governance and Innovation, the John F. Kennedy School of Government, or of Harvard University.

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