The DTCC released a new white paper exploring Fintech and Financial Stability. I found the article very compelling, and frankly in line with research I’ve been conducting myself. Among the top risks, as spelled out in the press release:
- The provision of core banking functions by fintech firms
Fintech companies that provide core banking functions could enhance financial stability through diversification of credit and liquidity risk. However, given the short track record of these companies, they could also create systemic vulnerabilities.
- The level of fintech-related fragmentation
The unbundling of financial services associated with the rise of fintech has the potential to fragment the creation and delivery of financial services across additional providers and platforms.
- The impact of fintech on concentration risk
The rise of fintech could reduce concentration risk by allowing non-traditional service providers to compete with existing players. Conversely, it could also create new pockets of risk if a small cluster of fintech companies were to become dominant in any given area.
- The substitutability of fintech services
Substitutability is a key concept in assessing systemic risk – financial services that are highly substitutable create less systemic risk than those that are not.
- The effect of fintech on financial interconnectedness
The interconnectedness of financial service providers could have a significant impact on financial stability. It is important to analyze how fintech developments affect financial networks.
- The degree of competition vs. cooperation between fintech firms and incumbents
Competitive pressures on banks could erode their profitability, and may encourage them to pursue riskier strategies. Outright competition between fintech companies and incumbents is less likely to promote financial stability than an environment where parties engage in cooperative arrangements.
7. The degree of reliance on automated decision-making processes
Overreliance on purely data-driven algorithms could lead to errors that may not have occurred in an environment that requires additional human judgement. In addition to the potential for errors, due to the inherent complexity of decision-making algorithms, their opaque nature could also hide biases that may be hard to identify.
- The sustained growth and adoption of fintech services
The impact of fintech depends on the extent to which it becomes a mainstream part of the financial ecosystem and how it will ultimately be used for delivering critical financial services.
- The evolution of the regulatory environment
Policy decisions and regulatory actions will determine to what extent fintech will penetrate and ultimately impact financial stability for years to come.
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I’ve only a couple of thoughts to add, generated largely from some of the insights gained from listening to the many excellent panelists during Fintech Week. First, part of the fragmentation that is arising is moving not just at an institutional level, but also along transaction value chains. Traditionally, practioners and scholars have tended to think of financial services as provided by institutions—say broker dealers, banks, exchanges and so on. But what we’re seeing now, at least for the moment, is the decomposition of services, of which many had been vertically integrated by incumbents dominating the market.
As this has happened, “transactions” are themselves increasingly being decomposed into discrete functions: “data gathering” “data analysis” “advising,” “trade execution,” “capital compliance,” “clearing and settlement/recording,” “transaction reporting” and so on. And this is not infrequently being done by little known start-ups, with the help of artificial intelligence and big data.
Theoretically—and assuming the technology actually works as intended (and this is a big if)—this should increase competition. But one of the truly difficult but essential tasks of regulators will be to create rules that do not permit today’s insurgents to ultimately become tomorrow’s monopolists, something that, perhaps counterintuitively, is especially likely in data-driven digital economies.