Should FinTech be Regulated or Not? - Paper Example

Introduction

FinTech should be regulated because they form part of the financial system that must be controlled for various purposes. There are two primary categories of financial regulation: compliance and safety-and-soundness. Regulation depends on the financial structure for it to be effective. Even though FinTech is just the use of technology to provide financial services, it shifts the structure of the financial system from the traditional ways to new ways, guided by innovation. Nakaso indicates that FinTech is restructuring and unbundling financial services through its changes. There are three categories of the latter. The first consists of distributed ledger technology (DLT) and blockchain which can transform the fundamental infrastructure of financial activities because of their effect on the ledgers and money. They were invented from the concept of bitcoin. The second consists of big data analytics and artificial intelligence. Lastly, there is the use of smartphones and cell phones to access financial services. All these changes present some risks to the consumer and the financial institutions that need to be addressed by revised regulation.

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Restructuring and Unbundling of Financial Services

Financial institutions have various functions. There are depository institutions such as savings and loans, banks, and credit unions that convert liquid liabilities into illiquid assets. The same institutions also manage the payment system that shifts the bank balance of an account through wire transfers, checks, and card transactions. Most commercial banks take deposits When giving loans and processing payments. The purpose of this is to ensure the bank's fractional reserve and consequent maturity transformation, make it stable to avoid insolvency. Sometimes these cause bank-runs if not well managed. Therefore, central banks "serve as the lender of last resort" to prevent economic catastrophes.

On the other hand, FinTech companies have further differentiated financial services. There are those that focus on payment services only and do not take deposits. Others do not even use their balance sheets to provide services, for example, the fund intermediation service companies. FinTech companies also combine e-commerce related activities with financial services to realize their economies of scope. These changes affect the fractional reserve rule and can contribute to a financial crisis.

Additionally, the digital financial services and new payment systems are changing the relationship between the financial service provider and the consumer. There are new financial service providers such as the crowdfunding platforms, and peer-to-peer lending that finance SMEs. This is a diversion from the traditional lending system. Although it is a useful innovation, now targeting underserved markets and improving the financial services market, it poses a threat to the stability of the system, which is one of the reasons for regulation.

The FSB also reports that digitalization of financial services has also resulted in changes in the intermediation process. Electronic payments can now be made without passing through the banking system. Financial payment systems are now using cryptocurrencies. Lastly, consumers now have direct access to financial advisor services courtesy of Robo-advisors. All these changes affect the financial system differently, and previous laws may not be suitable for their management. Their effects can also create disorder and consequently, a crisis if not well managed. For example, if a new currency is to be introduced into the system, there need to be rules guiding its use. The creators of the coin cannot make it and regulate it. It will lead to biases hence unfair treatment by the financial institutions. The latter is one of the purposes of government regulation.

The Potential of FinTech to Undermine Financial Stability

Apart from restructuring the system, both micro and macro analyses reveal that FinTech is a threat to financial stability. The micro financial analysis shows that potential risks originate from financial and operational sources. On the other hand, macro-financial risks are due to contagion, systemic importance, excess volatility, and procyclicality. These risks impair the functional capability of the system rendering it unstable.

According to the Financial Stability Board, FinTech can undermine stability because of the micro financial risks that accompany it. Micro financial risks are those that make financial market infrastructures or sectors and individual firms susceptible to shocks. If the dangers manifest, they can initiate distress in firms or the whole industry causing a systemic impact on the financial system. Potential risks can arise from financial sources such as maturity mismatch, liquidity mismatch, and leverage. The former creates financial instability when loans extend past the period contracted for, generating rollover risks. If it happens that the sector providing the loans provides critical services and functions, such extensions can lead to systemic impacts. FinTech innovations create liabilities and assets of diverse liquidity features that force financial institutions to want to liquidate, as fast as possible, the relatively illiquid assets. The differences also result in run-risks. All these disrupt the markets. Lastly, the FSB indicates that with high leverage, firms are exposed to losses because of a low equity states that also makes them incapable of absorbing losses from credit, market realization, and other risks.

According to Financial stability can also be undermined through operational sources such as through process control, third-party reliance, cyber risks, regulatory risk, and business risks of critical FMIs. About the first one, the FSB indicates that FinTech can cause increased risks of direct disruption of vital infrastructure or provision of financial services from process control and poor governance. The second risk occurs when systemically critical financial institutions rely on the same third parties for financial services. Because of the use of new technology platforms, gadgets, software and other systems, it increases the susceptibility of the financial system to cyber-attacks. The risk is further increased when there are so many different institutions connected.

The third risk to financial stability concerns the debate about regulation. FinTech is characterized by a variety of technology and constantly changing systems influenced by consumer demand and changing technology. It means that the activities are continually evolving making it difficult to regulate. As such, it poses a risk to the financial system because of the uncertainty around liability for losses. It may be difficult to build and maintain trust in an order where providers can easily seek regulatory arbitrage. Lastly, financial management institutions are prone to external factors that may affect their balance sheet and impair their functionality. As indicated earlier, some FinTech non-bank institutions provide intermediation services without using their balance sheets. Therefore, those whose balance sheets are used are susceptible to external factors unknown to them.

Macro-financial risks associated with FinTech also make it undermine financial stability. These vulnerabilities appear in the whole system and amplify shocks. They are those linked to the interaction between investors, firms, and clients that are responsible for essential transmission channels. As described earlier, they include contagion, systemic importance, excess volatility, and procyclicality. Just as in the case of traditional financial systems, FinTech systems are prone to contagion. A single firm's distress can spread to others paralyzing the whole system. The same applies to distress to a single sector. Being that traditional financial systems are regulated should not be a valid reason for regulation, but because they bear the same risks, it is appropriate to have rules that will sustain stability in the new technology system.

The Financial Stability Board states that being viewed as systemically important intensifies risks through the moral hazard. For example, such institutions sometimes take high risks with confidence that they have public support. FinTech is an example of such systemically important institutions. New technology has influenced and almost taken over the way financial services are offered. Additionally, the presence of such institutions sometimes paralyzes competition leading to predatory pricing and eliminating the possibility of success for other providers. The systemically important entity can end up suffering distress.

Excess volatility happens when a financial institution's response to influencing factors is highly flexible. The board also records that when the latter overreact to financial news, it may lead to adverse results such as liquidity or solvency problems. It is most likely possible in a case where businesses have common exposures or, business models are homogeneous. FinTech is characterized by both uniformity and common exposures. Therefore, it can experience the risks of excess volatility that can spiral through the whole financial system.

Lastly, if unregulated, FinTech can exacerbate the impact and degree of fluctuations in market prices and economic growth. For example, sometimes banks can provide credit excessively following an upswing in the economy. This contributes to the widespread systemic financial instability. There are so many risks that FinTech is exposed to and can contribute to financial instability. It provides an essential point in considering regulation. As explained in the following section, one of the reasons for regulating the financial systems is to sustain stability.

The Purpose of Regulation

To Understand the why FinTech should be regulated, it is essential to explain the purpose of regulation. It is from such that the impacts of FinTech will be recognized as threats to the new financial system that needs by-laws. As indicated earlier, regulation is categorized into compliance and safety-and-soundness. Compliance rules are intended to hinder crimes such as money laundering and many more and to protect consumers from unfair practices from the financial markets and by the institutions. Safety-and-soundness regulations are meant to help the financial institutions remain stable and to protect fixed amount creditors from losses when the institutions owing respective amounts become insolvent.

Other Reasons Why FinTech Should Be Regulated

Globalization of Financial Services

FinTech can internationalize financial services by improving financial inclusion. Although the financial services are not widespread in emerging and developing economies, Nakaso indicates that the spread of smartphones and cell phones has made it possible for such services to reach the former destinations through FinTech. The widened scope of operation needs regulation considering that each economic region will influence the financial systems differently. Cross-border payments differ from domestic payments. There are specific standards for local payments. On the other hand, cross-border payments are made through ad-hoc arrangements between banks. Now that a new system is transforming the manner in which such payments are made, regulation is only a logical necessity. Additionally, new challenges and risks emerge in new areas of operation and the use of new gadgets. The use of cell phones and smartphones, for example, need regulations to prevent fraud, cyber-attacks, and other criminal activities.

Free Market-Regulation

Some scholars argue that FinTech should be left to regulate itself. One of the reasons for such a view is the fact that new technology is being used as a regulatory tool, specifically, Regtech. Therefore, people do not...