How Should the Law Tackle Rapidly Evolving Financial Technologies?

The use of technology to provide financial services (FinTech) represents one of the most fascinating interplays in economic history in the last 150 years. Beginning with the introduction of the telegraph in 1838 and the first transatlantic cable in 1866, technological innovation defined the development of global financial markets throughout the 19th century. Similarly, Barclay’s introduction of the automatic teller machine in 1967 represents one of the most important financial innovations in the banking sector in the last century and initiated financial players’ shift toward digital infrastructure. Over the last half-century, the global financial industry has become one of the top purchasers of IT products. Regulation has struggled to keep apace.

Exponential growth in the digital economy has particularly impacted the financial industry over the last decade, not to mention other industries such as advertising, media, and retail and wholesale business. The adoption of Application programming interfaces (APIs)—which enable interoperability, smooth data sharing, cloud computing, and new patterns of consumer behavior based on smartphone usage—have significantly changed interactions between banking providers and users.

On the demand side, the digitalization of retail commerce has influenced customers’ experiences and expectations with reference to the speed, convenience, and user-friendliness of banking services. Moreover, demographic factors such as the increasing digital literacy of millennials has contributed to the strengthening demand for FinTech services.

FinTech innovation is set to allow new players and business models to enter a heretofore stodgy market. Technological developments will allow traditional financial services to be unbundled, weaking customer dependency on a single traditional bank or financial conglomerate. Empirical research has found that FinTech services are becoming widespread among retail customers in specific market niches all around the world (eg crowdfunding, cross-border payments, peer-to-peer (P2P) lending, financial services targeting unbanked individuals who lack a credit history). Digital platforms and electronic aggregators are acting as distribution channels of financial services, and robo-advisors are harnessing customer information and digital footprints to provide tailored services. 

Moreover, firms can make use of FinTech to provide domestic and cross-border payment services (by means of pre-funded e-money or digital wallets), retail and commercial banking (by establishing innovative lending and borrowing platforms), customer relationship services (by providing price comparisons, credit risk ratings, and enabling the switching of services), wholesale banking and markets, wholesale payments, and clearing and settlement infrastructure. 

Last but not least, big data analytics and new platform-based business methods like P2P are set to radically disrupt the lending sector by using machine learning algorithms and alternative data sources to identify and fulfil unmet demand for loans to individuals and small and mid-size enterprises.

FinTech also includes efforts by well-established technology firms with extensive customer networks, such as Google, Amazon, Meta, and Apple, to take advantage of their platforms to provide financial services to their users. Unlike the many new firms that have emerged to provide FinTech services, these BigTech companies can scale up very quickly by leveraging network effects, brand recognition, state-of-the-art technology, and large proprietary customer data sets. In some jurisdictions such as China and other emerging markets and developing economies in Southeast Asia, East Africa and Latin America, the BigTech expansion has been rapid. BigTech’s previous disruption of industries, such as news media and retail, suggests the banking sector will face serious competition if BigTech’s expansion goes unregulated.

Yet, concurrent with this financial innovation has been a steady evolution of financial regulation since the 2008 financial crisis, particularly in the US and EU. However, the increased regulatory burden for financial providers has mostly targeted traditional banks. Policymakers have increased the compliance obligations of banks and have altered their commercial incentives and business structures. The paradigm of the universal banking model has been tackled with ring-fencing obligations and increased regulatory capital requirements. New rules have been enacted to curb systemic risk generated by financial institutions’ intense use of collateralized debt obligations, one of the main triggers of financial contagion due to the detachment of credit risk from the underlying loan originator.

On top of all this, the US and EU have put in place new resolution regimes to ensure the orderly failure of banks: traditional financial institutions are now under the obligation to set forth recovery and resolution plans and conduct stress tests to evaluate their financial and environmental viability.

As a result of regulation for traditional financial institutions and technological advances, new FinTech players have had the chance to enter financial markets by providing specific services that might compete with legacy players while avoiding stricter regulation on capital and liquidity requirements (ie Basel III framework).

In fact, the increasing pace of FinTech development has triggered a worldwide race among policymakers to overhaul their own regulatory landscape to be as friendly to innovation as possible. Consequently, a vast array of new tools and regulatory practices have emerged over recent years, threatening to disrupt traditional approaches to regulation. This raises the need to figure out the true potential of each allegedly new practice so as to avoid any confusion between original, far-reaching avenues of market regulation and the rebranding of old ideas prompted by legal marketing considerations.

Innovation hubs and regulatory ‘sandboxes’ provide for a trusted interaction channel and experimentation environment allowing new market participants to test their services in the real market with reduced regulatory burden but under the scrutiny of the supervisor. At the same time, we have been witnessing the development of ‘Open Banking,’ whereby banks are required to allow consumer data sharing in favor of third parties willing to provide data-enabled services.

Lastly, crypto transactions have grown to the point that they now form part of the mainstream economy. The involvement of central banks and the possibility of government-backed financial products also raise the question of competition and coexistence between fiat money, CBDCs, crypto assets, and other stablecoins.

Regulatory reform is still coming to terms with the tasks FinTech has set before it. On the one hand, regulation must remain flexible enough to permit innovation, but on the other, prudent enough to prevent financial crises and market subversion. As new FinTech continues to develop and be adopted, academic and policy oriented research is needed to make economic regulation equally innovative and effective.

Oscar Borgogno is a Researcher at the Bank of Italy and a Fellow at the University of Turin.

Giuseppe Colangelo is the Jean Monnet Chair in European Innovation Policy and Associate Professor of Law and Economics (University of Basilicata).

Cristina Poncibò is a Professor of Comparative Private Law at the University of Turin.

This post was originally published on ProMarket, the blog of the Stigler Center at the University of Chicago Booth School of Business.