Historically, the financial services industry has been protected from significant market disruption based on new technological innovation. ((Miklos Dietz et al., Cutting Through the Noise Around Financial Technology, McKinsey & Company (Nov. 26, 2017, 7:51 PM), https://www.mckinsey.com/industries/financial-services/our-insights/cutting-through-the-noise-around-financial-technology.)) Incumbent companies in the industry have a number of economic moats to rely on: “ubiquitous distribution through branches”; “unique expertise such as credit underwriting”; and “the special status of being regulated institutions that supply credit . . . [and have] sovereign insurance for their liabilities (deposits).” ((Id.)) Consumers have also generally been loyal to “established . . . brands” in the industry. ((Id.))
Despite these economic protections, however, in recent years, an influx of new financial technology (“fintech”) companies appears to be dramatically changing the industry and creating significant regulatory problems as a result. In this blog post, I will first describe some general features of fintech companies and their recent successes. I will then describe some of the unique regulatory problems that they have introduced.
In the past, “fintech” was a term used to describe “technology applied to the back-end of established consumer and trade financial institutions.” ((Fintech, Investopedia (Nov. 26, 2017, 7:53 PM), https://www.investopedia.com/terms/f/fintech.asp.)) Recently, however, the term is more often used to describe new independent financial technology companies and an “emerging financial services sector.” ((Id.))
Through the innovative use of mobile and online platforms, these fintech companies have been able to distinguish themselves from incumbents. ((William J. Magnuson, Regulating Fintech, Texas A&M U. School of Law Legal Studies, Research Paper No. 17-55 (Aug. 26, 2017), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3027525.)) By using these platforms to develop new distribution channels, “[u]nlike earlier generations of finance-related technology, which typically focused on providing services to already established financial firms, today’s fintech companies are increasingly providing services directly to consumers.” ((Id.))
Fintech companies now offer products and services in a wide range of areas: account management, lending and financing, payments, and financial assets and capital markets. ((Dietz, supra note 1.)) These companies also serve a number of customer segments: retail enterprises, small and medium-size commercial enterprises, and large corporate entities. ((Id.))
The list of examples of fintech companies and their innovations seems endless. Crowdfunding companies like Indiegogo and Kickstarter provide broader access to capital by allowing individuals to seek public funding for projects. ((Shoshanna Delventhal, 2016’s FinTech Disruptors: How Can You Benefit?, Investopedia (Nov. 26, 2017, 7:57 PM), https://www.investopedia.com/articles/investing/022616/2016s-fintech-disruptors-how-can-you-benefit.asp.)) Peer-to-Peer online lending platforms like LendingClub and Prosper provide alternative sources for loans outside of traditional financial institutions. ((Id.)) Robo-advisors like Wealthfront and Betterment increase access to investment advice that had been only “accessible to wealthier individuals who could afford their own financial advisor.” ((Id.)) Companies like Square and Venmo have increased access to new kinds of payment processing and transaction services. ((Id.))
To explain the success of fintech companies, McKinsey & Company notes two recent, significant changes in the financial services market. ((Dietz, supra note 1.)) The first is that “the financial crisis had a negative impact on trust in the banking system” and consumer loyalty to traditional companies. ((Id.)) A combination of widespread negative economic effects and extensive media and government attention appears to have created a new distrust of traditional companies in the financial services sector. ((Manjo Singh, The 2007-09 Financial Crisis In Review, Investopedia (Nov. 26, 2017, 7:59 PM), https://www.investopedia.com/articles/economics/09/financial-crisis-review.asp.))
In addition, McKinsey notes that “the ubiquity of mobile devices has begun to undercut the advantages of physical distribution that banks previously enjoyed.” ((Dietz, supra note 1.)) Consumer preferences have changed to align with fintech companies’ use of new mobile and online distribution channels. ((Id.))
McKinsey notes that new fintech companies have already distinguished themselves from similar companies offering innovative financial technology during the dot-com boom. ((Id.)) Of the 450 dot-com companies that challenged incumbents “[f]ewer than 5 of these challengers survive as stand-alone entities today.” ((Id.))
By contrast, the emerging fintech sector already offers a very different picture of challengers and their success. In the U.S., fintech companies have increased from 800 in April 2015 to more than 2,000 in February 2016. ((Id.)) According to a recent report by Accenture, global investment in fintech companies increased “from $930 million in 2008 to more than $12 billion by early 2015.” ((Bernard Marr, The Complete Beginner’s Guide to Fintech in 2017, Forbes (Nov. 26, 2017, 8:01 PM), https://www.forbes.com/sites/bernardmarr/2017/02/10/a-complete-beginners-guide-to-fintech-in-2017/#22b0da113340.))
There are now “27 fintech ‘unicorns,’ or private companies worth more than $1 billion.” ((Magnuson, supra note 6, at 6.)) In addition, “[i]n 2016, Nasdaq . . . launched a financial technology index to track the performance of companies specializing in financial technology.” ((Id.))
Research by Goldman Sachs provides some predictions about how these new companies will interact with incumbents, indicating that “startups in the area are poised to siphon $4.7 trillion in annual revenue from more conventional banks.” ((Milton Ezrati, Opinion: Fintech Will Require Regulation, Investopedia (Nov. 26, 2017, 8:04 PM), https://www.investopedia.com/news/opinion-fintech-will-require-regulation/.)) It also indicates that “traditional financial services firms will ultimately lose 20 percent of their business to fintech. . . .” ((Id.))
This dramatic influx of fintech companies creates new regulatory problems for agencies overseeing the industry. The most pressing set of problems are those introduced by the possibility that fintech companies may create new kinds of systemic risk.
The financial services industry—the mediator “between suppliers of capital and users of capital”—is uniquely positioned to produce shocks that “ripple out to the broader economy.” ((Magnuson, supra note 6, at 19-20.)) Regulation of the industry is “distinguished by its particular focus on [this] systemic risk.” ((Id. at 19))
There may be, however, significant differences between the types of systemic risk associated with fintech companies and those associated with traditional financial services companies, according to William Magnuson, an associate professor at Texas A&M University School of Law. ((Id. at 29.)) As a result, regulatory schemes tailored to these traditional companies may not be appropriate or sufficient.
Magnuson notes that systemic risk associated with traditional companies is seen “as primarily a problem of institutional size.” ((Id.)) When shocks occur within these companies, the large size of the companies creates higher costs and affects more parties. ((Id.))
By contrast, fintech companies operate as a large group of “small, disaggregated actors.” ((Id.)) Magnuson argues that these companies still introduce their own unique systemic risk because the “individual actors are fragile” and lack the diversification and size to withstand shocks; “shocks are easily propagated” based on features like “susceptibility to hacking” and “automated decisionmaking”; “information asymmetries are widespread” based on the lack of disclosure requirements and information about firm structures and operations; and the “overall market is large” and growing based on the introduction of new firms and investment. ((Id. at 31-35.))
Another significant problem created by new fintech companies is a lack of regulatory coordination. At the federal and state levels, the financial services industry is already heavily regulated. ((Michael Schmidt, Financial Regulators: Who They Are and What They Do, Investopedia (Nov. 26, 2017, 8:08 PM), https://www.investopedia.com/articles/economics/09/financial-regulatory-body.asp.)) Examples of regulatory bodies governing the industry include the Federal Reserve Board, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, etc.. ((Id.)) There is a similarly high number of agencies at the state level. ((Id.))
Currently, fintech companies have to comply primarily with state regulatory schemes: “[s]tate regulators continue to license and supervise these companies, as well as enforce compliance with laws, regulations, and supervision programs.” ((The Evolving Fintech Regulatory Environment, Deloitte (Nov. 26, 2017, 8:10 PM), https://www2.deloitte.com/us/en/pages/regulatory/articles/fintech-risk-management.html.))
Some federal regulators, however, have attempted to establish national regulatory programs. The most prominent recent example is the Office of the Comptroller of the Currency’s (“OCC”) proposal in 2016 to institute a national charter program for fintech companies. ((Nik Milanovic, An Obscure Regulatory Debate Has Put the Entire U.S. Fintech Community On Edge, TechCrunch (Nov. 26, 2017, 8:10 PM), https://techcrunch.com/2017/04/24/an-obscure-regulatory-debate-has-put-the-entire-u-s-fintech-community-on-edge/.)) As the OCC described in its proposal, if a fintech company applies for a national charter, “the institution would be held to the same rigorous standards of safety and soundness, fair access, and fair treatment of customers that apply to all national banks and federal savings associations.” ((Office of the Comptroller of the Currency, Exploring the Special Purpose National Bank Charter for Fintech Companies 2 (2016), https://www.occ.treas.gov/topics/responsible-innovation/comments/special-purpose-national-bank-charters-for-fintech.pdf.))
Another example is the Consumer Financial Protection Bureau’s (“CFPB”) move to begin issuing no-action letters to fintech companies. As the CFPB describes, the no-action letter program “advises a recipient that [Bureau] staff has no present intention to recommend initiation of an enforcement or supervisory action with respect to the specific matter.” ((CFPB Announces First No-Action Letter to Upstart Network, Consumer Fin. Protection Bureau (Nov. 26, 2017, 8:17 PM), https://www.consumerfinance.gov/about-us/newsroom/cfpb-announces-first-no-action-letter-upstart-network/.)) In this way, the letter is meant to indicate a certain degree of approval of a particular company and thereby facilitate “consumer-friendly innovations where regulatory uncertainty may exist for certain emerging products or services.” ((Id.))
Despite these moves by federal agencies, however, the lack of regulatory coordination remains an ongoing problem for fintech companies. As one commentator notes, even the no-action letters and a national charter will not “shield fintechs from other regulators who may have different rules.” ((Milanovic, supra note 38.)) For the time being, fintech companies continue to operate without a clear sense of the regulatory environment, often in multiple jurisdictions under the authority of different regulatory regimes.