The Promises, Perils and Challenges of FinTech
Moran Ofir - Interdisciplinary Center (IDC) Herzliyah;
Ido Sadeh - Interdisciplinary Center (IDC) Herzliyah
-- FinTech innovations have transformed a variety of financial activities and reshaped the structure of the financial market. In our new article, “The Rise of FinTech: Promises, Perils, and Challenges”, forthcoming in Leading Legal Disruption, D’Agostino, Piovesan and Gaon eds (Thomson Reuters, 2021), we provide a high-level overview of these simultaneous changes and explain why and how they create new opportunities, risks, and regulatory challenges.
How is FinTech different?
To capture the effects of FinTech innovations on the financial market, we begin with identifying the key features that differentiate today’s FinTech from early applications of technology to finance. Those include (i) massive processes of digitization and digitalization (e.g., financial firms are closing branches at a rapidly growing pace and moving to communicate with their clients through online channels); (ii) increasing use of algorithms with decision-making capacity to displace humans in the provision of financial services (e.g., robo-advisors); (iii) increasing use of data, including new data types, to deliver financial services (e.g., credit scoring); and (iv) disintermediation, i.e., the creation of new business models that allow startups to provide financial services directly to consumers, without the involvement of traditional middlemen (e.g., marketplace lending).
Combined, those features underlie much of the promises, perils, and challenges brought by FinTech and thus form an effective framework for analyzing its potential.
By way of illustration, consider the case of marketplace lending platforms. Marketplace lending platforms, such as Prosper and Lending Club, match lenders with borrowers, without the involvement of traditional credit intermediaries. By cutting out a level of intermediation, they can reduce operational costs, and consequently, offer attractive interest rates for both borrowers who look for an external source of credit and lenders who seek to diversify their investment portfolio with a new asset class (P2P loans).
Those platforms also showcase the potential benefits associated with the increasing use of AI and big data techniques. By utilizing sophisticated algorithms and a wide variety of data sources—such as social media activity and property ownership—to credit scoring, they can produce more predictive credit assessments and promote financial inclusion by providing access to credit for potential borrowers with limited credit history.
Against those benefits, however, FinTech applications also introduce new concerns in terms of consumer protection, market integrity, and financial stability.
Big data credit scoring, for instance, creates new concerns in terms of fairness and market integrity. The lack of representativeness in the data collection process may result in a biased sample, which, in turn, may lead to the unfair denial of credit from certain groups. Relatedly, the consideration of new data types, such as race and gender, may give rise to discriminatory effects, as observed in the marketplace lending market.
Less visibly, new concerns also arise due to the massive disintermediation processes of financial services. The financial market is gradually transforming from a concentrated market dominated by a few “too-big-to-fail” institutes into a more dispersed market that includes a variety of small firms (in terms of human capital). And as William Magnuson argues, those small startups (e.g., Betterment and Prosper)—which tend to be narrowly focused on one type of services, poorly capitalized, and thus vulnerable to adverse shocks—are gradually capturing sizeable market share and therefore creating new concerns in terms of financial stability.
From another perspective, FinTech innovations also create new types of regulatory challenges. To begin with, financial transactions increasingly rely on emerging technologies that introduce informational uncertainties to regulators. A prominent example is distributed ledger technology—a rapidly evolving technology with potential vulnerabilities and risks that are not yet fully understood—which creates the challenge of drafting rules to govern unknown vulnerabilities.
Another challenge arises because FinTech applications often rely on automated decision-making systems, and hence do not fit into the existing regulations, which are designed to govern human decision-making. An illustrative example is the case of robo-advisors, whose their lack of human perception makes it uncertain whether and how they can be accommodated under the investment advisers' regulation and fulfill fiduciary duties.
Finally, FinTech also creates new regulatory challenges from a structural perspective. Today's financial market includes increasingly diverse types of market participants—ranging from FinTech startups to TechFin companies (e.g., Google and Amazon) to large financial institutions—with different levels of maturity, and who rely on different types of business models. Financial regulators are facing the challenge of maintaining fair competition between those different types of participants and draft consistent rules to govern their operations.