Financial innovation has been a characteristic of thriving and efficient financial systems for centuries. The latest wave of financial innovation related to digitalisation, however, has the potential to change the landscape of financial service providers quite dramatically, including with the rise of FinTech and BigTech companies disrupting the current structure of the financial system (Cornelli et al. 2020). This column introduces a new eBook from CEPR and the Korea Institute of Finance that takes stock of financial digitalisation over the past decade and applies global lessons to the regulatory debates in Korea (Beck and Park 2021).
Download Fostering FinTech for Financial Transformation: The Case of South Korea here
There is no established and widely accepted definition of FinTech, but it contains several components. In the first chapter, Stephen Cecchetti and Kermit Schoenholtz offer an implicit definition ("take different financial services, and then list the new firms that are providing them in innovative ways") and an explicit definition, which focuses on (i) the application of technology to finance, and (ii) new technology-driven players entering the financial services industry. They conclude with the following definition: "FinTech is the application of technology to finance that lowers the unit costs of providing financial services, and makes them better, faster, cheaper, broader, and more accessible."
How innovation can help reduce costs
While there has been a new entry into the financial system over the past 50 years and a markedly declining role for banks, the unit cost of financial service provision has been stuck at 1.5–2%, as Philippon (2018) shows.
Recent technological advances have the potential to overcome both cost and risk challenges: modern technologies such as mobile phones and the Internet allow transactions to take place quickly and efficiently and for economies of scale and scope to be exploited. Specifically, information technology (IT) creates what the BIS (2019) describes as the ‘DNA loop’: a tech firm uses a large stock of user data (D) to offer a range of services exploiting natural network effects (N), generating further user activity (A), which then results in more data. This DNA loop also gives BigTech companies such as Alibaba, Amazon, Facebook, Google, and Tencent a competitive and first-mover advantage, possibly resulting in market-dominating positions. Scope economies across different types of financial services are still important, even though FinTech companies have entered specific services, most prominently payment services, which have reduced the role of banks.
The impact on competition, efficiency, and stability
The second chapter, by Thorsten Beck, surveys the recent literature on the impact of these innovations on the efficiency and competition of financial systems and financial stability.
These innovations have allowed new providers to enter the financial system, including FinTech companies providing novel payment services, P2P lending platforms, and the already mentioned BigTech companies. While several recent papers have explored the relationship between traditional banks and FinTech lenders, it is not clear whether they are competitors or rather complements. One specific concern on the creation and processing of big data is whether this allows not only better targeting, but also shrouding information, cream-skimming, and discrimination (Ru and Schoar 2017). However, there are also financial stability concerns stemming from new entries. It is not clear whether banks will react with more risk-taking to the reduction in their franchise value or concentration on relationship-intensive services. Cooperation between BigTech and banks can also bring challenges in terms of aligning incentives properly. Finally, there are concerns about the possible introduction of central bank digital currencies and their impact on the banking system (Cecchetti and Schoenholz 2021).
Regulatory responses to these developments have varied. On the one hand, some regulators have openly encouraged some forms of innovation, among others through the establishment of regulatory sandboxes; on the other hand, many regulators view selected innovations as a potential threat to the safety and soundness of their financial systems, such as the recently proposed stablecoin Libra/Diem by a consortium under the leadership of Facebook. There is a variety of regulatory challenges, ranging from licensing of FinTech and BigTech providers over implications for competition and consumer protection to prudential regulators facing new types of risks related to the regulatory perimeter and IT-related sources of fragility.
Innovations in money and payments
The third chapter, written by Antonio Fatas, focuses on innovations in money and payments, specifically the combination of new forms of digital assets with new forms of payment technology. Cryptocurrencies, such as Bitcoin, are a new type of digital asset (not backed by a sovereign or any other entity) created and traded with distributed ledger technology (DLT), effectively eliminating all intermediaries of payments. Stablecoins, on the other hand, can be exchanged at a prefixed rate for a regular currency, thus avoiding the volatility of cryptocurrencies. Finally, electronic wallets (such as mobile payment networks) are closed-loop payment systems that can be accessed easily and can be used to execute payments or transfers between individuals or companies but denominated in regular currencies.
Innovations relying on existing currencies but creating new payment technologies still have to be linked to the existing payment system. These innovations constitute new challenges for central banks and regulators alike regarding how to treat the new types of assets and which players to allow access to the payment system (Fatas and Weder di Mauro 2018).
The regulation of cryptocurrencies
The fourth chapter, written by Demelza Hays and Andrei Kirilenko, focuses on cryptocurrencies and their regulation in Europe and the US. The regulation of cryptocurrencies is made difficult by the fact that they are incorporeal rights to a digital object with no intrinsic value and that the ledger of transactions is not only distributed but also decentralised. This implies that cryptocurrencies like Bitcoin are not regarded as securities, while other cryptocurrencies might if they pass the Howey test that an investment contract exists if there is an "investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others", which is the case for many ICOs, utility tokens, and other crowdfunding efforts. Finally, the authors provide an overview of recent legal and regulatory developments in anti-money laundering and know-your-customer regulations concerning cryptocurrencies, securities laws and taxation across US federal and state law and European legal systems.
Financial digitalisation in Korea
The final chapter, co-authored by Thorsten Beck, Taiki Lee, Yong Tae Kim, and Yung Chul Park, focuses on Korea. The authors start by documenting the oligopolistic structure of Korean banking and the limited innovation that has taken place within the sector. This reluctance of banks to move aggressively into the digital space contrasts with the high take-up of digital service across Korean society. At the same time, FinTech companies have started to offer more convenient and faster payment solutions, while several BigTech companies have started to offer various intermediation and non-intermediation services.
Using global experience for regulatory reform in Korea
Fintech services have been regulated in Korea under a specific framework established in 2006, which has turned out too narrow. At the initial stage of FinTech development, Korea's financial regulatory authorities chose to embrace a market-led approach to fostering the FinTech industry in line with a general move towards financial liberalisation. A decade later, however, a series of market failures and inefficiencies of the laissez-faire approach has begun to take its toll, with P2P lending platforms losing their credibility and reliability as they were shrouded in widespread fraud and deception of investors and borrowers, the number of FinTech startups ballooning but with few of them being efficient, and the FinTech industry developing into an oligopoly controlled mostly by financial subsidiaries of big techs.
The financial regulatory authorities have reacted to these problems with a law restricting entry and lending in the P2P sector, which has effectively driven all platform operators out of business. The FSC also plans to establish a ‘fintech assistance centre’ as part of the programme arranging policy loans, business consulting, and startup support for small FinTech firms. In addition, there are current discussions underway to reform the broader legislative and regulatory framework for fintech.
Some of the recent regulatory interventions could be justified to rectify market failures, but others not. What could be concerning is that once the regulatory authorities start intervening, they are likely to acquiesce to political pressure to introduce other financial regulations for social harmony and distributive equity to eradicate much of the gains from financial liberalisation over the past two decades in Korea.
Continuous technological innovations result in ongoing and rapid financial innovation and a changing landscape in financial service provision. As a result, there is a need for a flexible regulatory framework that can accommodate these changes while safeguarding stability. The chapters in this book provide a snapshot of where research and policy discussion currently stands, but the debate will certainly continue in the next years and decades.
Beck, T and Y C Park (2021), Fostering FinTech for Financial Transformation: The Case of South Korea, CEPR and Korea Institute of Finance.
BIS – Bank for International Settlements (2019), Annual Economic Report, June.
Cecchetti, S and K Schoenholtz (2021), “Central bank digital currency: The battle for the soul of the financial system”, VoxEU.org, 8 July.
Cornelli, G, J Frost, L Gambacorta, R Rau, R Wardrop, T Ziegler (2020), “Fintech and big tech credit markets around the world”, VoxEU.org, 20 November.
Fatás, A and B Weder di Mauro (2018), “Cryptocurrencies’ challenge to central banks”, VoxEU.org, 14 May.
Philippon, T (2016), “The Fintech Opportunity”, NBER Working Paper 22476.
Ru, H and A Schoar (2017), “Do Credit Card Companies Screen for Behavioral Biases?”, Working Paper.