The business and personal finance media has for some time been awash with talk of fintech disruptors muscling in on the financial services market. A particular focus has been their apparent ability to take advantage of the malaise endemic across the banking market since the global financial crisis and the sector’s antediluvian technology.
It now seems that the threat to traditional banking has become official, after Bank of England governor Mark Carney warned in late January that, in time, fintech could “signal the end of universal banking as we know it”.
In fact, the potential impact of fintech was confirmed as long ago as January 2015 when the Royal Bank of Scotland announced its intention to partner with a number of leading crowdfunding platforms, such as Funding Circle, referring on loan applicants that it had rejected.
Traditional financial institutions have been buying up fintech operations
Traditional financial institutions have also been buying up fintech operations, either to learn from them or to use their innovative skills to generate alternatives to their existing software and operating systems. Banks are also looking to reinforce their economies of scale and broaden the scope of their business models.
The real magic of fintech is its ability to ‘unbundle’ banking, separating it out from existing providers into its core competencies: settling payments, handling maturity transformation, sharing risk and allocating capital. These functions can now all be handled by fintech entrants – payment service providers, aggregators and robo-advisers, peer-to-peer lenders and a whole range of tech-enabled trading platforms.
This revolution has been driven, of course, by the ubiquity of the internet, the availability of ultra-high-speed computing, the emergence of mobile communications, advances in cryptography and, most important in terms of human impact, machine learning leading to potential artificial intelligence (AI) solutions. (Click here for our latest feature on that fertile topic .)
The impact on the banking system itself is one cause for concern. Customer loyalty has the potential to disintegrate as alternative financial service providers proliferate, much as it has in the insurance sector. One outcome could be a reduction in bank-funding capacity for commercial customers.
New underwriting models, such as those under close scrutiny at the moment in the crowdfunding space, could reduce credit quality and pricing, thus lowering profitability for traditional funders and, therefore, capacity.
Another worry is the functioning of some credit markets in the face of new investing and risk management paradigms. A useful parallel is what has happened in the retail sector as technology has revolutionised the interaction with consumers – dramatically raised investment costs and generally reduced profit margins.
An illustration of how power is shifting even in these early stages of the fintech revolution is in payment services. Traditionally, these have relied on cash, credit and debit cards, and wire transfers. Fintech providers are now offering domestic and international services on a significant scale, using ‘digital wallets’ and pre-funder ‘e-money’.
Part of the process is the gathering of all-encompassing customer transaction data, giving them control over this vital knowledge base, which can then be exploited for other purposes.
The whole area of credit availability and default rates is also being suborned by fintech providers. Carney cites the example of China, where advanced e-commerce platforms are using algorithms to analyse transaction and search data to improve credit scoring.
The outcome has been increased credit and reduced bad debt rates. In the UK, peer-to-peer advances now represent 14% of new lending to SMEs. There are estimates that more than 50% of these credits would not have been offered by traditional banks.
Fintech solutions are also honing in on one of the most intractable areas of financial services: the whole payment, clearing and settlement infrastructure. This has long been bedevilled by inaccuracies, inefficiencies and security issues, and is a favourite hunting ground for fraudsters. Securities settlement processes with their high costs and risk profile are another clear target for the disruptors.
The whole area of credit availability and default rates is also being suborned by fintech providers
As with all rapid change in financial markets, the key issue for users of these new technologies is the effectiveness of regulation and the minimisation of systemic risk. History offers many lessons on the downside of financial innovation; booms and eventual busts stretching back to the Dutch tulip scandal in the 17th century and on into antiquity.
Fintech is facilitating the growing use of digital identities, supported by biometric and cryptography as consistent and reliable validation tools. The extent to which this can be achieved can be seen from the extraordinary success in India, where the government has created more than 800 million digital identities for its citizens.
However, the risk of exploitation of this technology by the unscrupulous is obvious.
Data privacy and data protection is another troubling area. Traditional financial institutions have long sought to keep such data to themselves and are closely monitored through well-established regulatory regimes. This is, of course, far from foolproof as so many recent examples of customer data loss or theft demonstrate.
Nevertheless, the instincts of fintech companies on these issues are more likely to be aligned to those of the social media giants. Customer data, whether they are on consumers or commercial entities, is seen as a resource to share and exploit. In theory, this should always be with the customer’s consent, but, in practice, such permission is often granted unknowingly as part of routine internet access.
Consideration also has to be given to the effect of fintech on general global financial stability and the world’s systemic regulatory frameworks. Fintech firms tend to be regulation averse, on the grounds of cost and the freedom to innovate. The UK’s Financial Conduct Authority recently announced a review of the regulation of the crowdfunding market, and the action by the Securities and Exchange Board of India to rein in the activities of some crowdfunding platforms.
This shows that the authorities recognise that the fintech revolution must not escape their scrutiny. The big questions are whether they can regulate effectively what many fear they may never fully understand, or if they can be sufficiently flexible to at least stay up to speed with such a rapidly evolving market.
At present, conduct regulation of fintech is progressing reasonably well in developed markets, but in due course, financial stability monitoring will have to catch up as more players broaden their services from payment processing and advisory services into what can be identified as banking.
Also, no individual fintech companies are big enough at present to be systemic risks on their own, unlike Bear Stearns or Lehman Brothers in the global financial crisis. However, many observers believe that a period of consolidation in this market is inevitable, leading to the creation of far bigger operators with more significant issues on topics such as maturity transformation, leverage and liquidity mismatches. Increasing use of robo-advice and algorithms may also increase market volatility.
Last, but no means least, the fintech revolution plays into the narrative of cybersecurity and the apparent inability of even the most sophisticated operators to fend off the nefarious actions of hackers, whether they may be rogue lone operators or those with state-sponsored political motivation.
There is no doubt that banking and other financial services have already been changed by the advent of fintech disruptors. It is possible that within just a few years this sector will be unrecognisable to those who use it and those who work in it.
It will be vital for treasurers to stay as informed and up to date as possible as this process unfolds, or else risk spending time stumbling into one financial elephant trap after another.
Nick Hood is a business risk analyst at Opus Business Services Group.
This article was taken from the March 2017 issue of The Treasurer magazine. For more great insights, log in to view the full issue or sign up for eAffiliate membership