Oct 4, 2018

Why We Have to Get FinTech Regulations Right

Financial services are undergoing a badly-needed tech makeover, and many consumers are pleased with the progress. Developments in financial technology, or fintech, have made simple commercial processes easier, faster, and often cheaper.

The government is developing a keen interest in this sector, as a recent 223-page report from the Treasury Department can attest. My colleague Brian Knight, who directs our Innovation and Governance Program, has thought a lot about the promise of fintech. Last week, he testified to the Senate Committee on Banking, Housing, and Urban Affairs about the best policy posture to guide this growing sector.

It is always important to leave enough regulatory room for entrepreneurs and consumers to converge on new and better ways of doing things. But as Knight points out, when it comes to fintech, there are good reasons to be especially careful about how we set out our policies from the start.

First, fintech is unique because is it disruptive. Many of these developments have been spearheaded by non-bank start-ups, like consumer loan platforms Lending Club and Prosper, investment platforms Robinhood and Betterment, transfer apps like Square Cash and Venmo, and of course the burgeoning cryptocurrency industry. Tech titans have also gotten into the game, with big names like Facebook and Amazon leveraging existing network infrastructure to offer new payment options. Traditional financial institutions have taken notice, embracing technologies like APIs, machine learning, and cloud infrastructure while offering new consumer-facing options like the payment app Zelle. There are also developments in cryptocurrency, which aim to minimize the influence of third-party institutions altogether.

People have long grumbled about the costs and delays associated with traditional institutional processes, which seemed to have been a decade or so late to many now-standard technological developments. Some of this low-tech inertia can be attributed to the generally conservative nature of finance. Another part may be a product of previous regulations.

Fintech is also special because of the possible social benefits it can provide. Policymakers and researchers have long agonized over the problem of the “unbanked.” These are people that lack access to traditional financial products because of a lack of confidence, stable income, or willingness to shoulder bank fees.

The Federal Deposit Insurance Corporation (FDIC) has undertaken biennial surveys on financial participation since 2009. The most recent report from 2015 finds that roughly 7 percent of households were fully unbanked, while another 19.9 were “underbanked,” which means that they sought alternative financing from non-bank institutions that may be risky or carry extraordinary interest, like payday lending. Lower-income, less educated, minority, and disabled households constitute the bulk of these underserved communities.

These surveys indicate that many people forgo interacting with the financial system—and therefore considerable employment and lifestyle opportunities—because of a “lack of trust” and “high fees.” Perhaps some of this cohort may be more willing to interact with non-bank financial service providers that charge lower or no fees. Many fintech applications are still fairly new, so the long-term effects on unbanked populations remain to be seen. Perhaps future reports like the FDIC’s can shed more light on how effective these products are at reaching underserved consumers.

So there are a lot of reasons to be excited about fintech. But not everyone has embraced the “move fast and break things” ethos of Silicon Valley for the financial sector. Fintech critics argue that finance has important technical and structural distinctions that make it a bad candidate for a mostly permissionless approach. Another scholar who testified at the Senate hearing, Cornell University law professor Saule Omarova, provided a good overview of these critiques.

For one, most financial services involve a lot of sensitive data. The subject of data usage has been controversial enough in non-financial applications. It is understandable that people are even wearier of these risks when applied to something as critical as their access to their money, credit, and capital.

Then there are questions about how technologies like algorithmic credit scoring will affect existing social divisions or create new ones. Critics discuss how algorithms can disproportionately harm protected identity groups—based on characteristics like race, gender, disability, and age—under a legal concept known as “disparate impact.” Perhaps the way that the code is structured may unintentionally disenfranchise a certain group’s access to mortgages, or charge them higher interest rates for a vehicle purchase. Whatever the disparate impact, the argument is that the algorithms would contribute to social inequality in an unaccountable and sometimes indeterminate way.

And there are arguments that new and barely-tested fintech programs may contribute to structural economic instability as well. It is not controversial to say that consumers benefit from and even demand these new kinds of services. But critics argue that this may not be rational, as it can contribute to the kinds of “too big to fail” and predatory lending problems seen in the 2008 crisis.

Perhaps these new developments do not have the level of high regulation that some might like. Still, it’s incorrect to say that fintech is “unregulated.” In some cases, existing regulations are adequate and appropriate. In others, the rules may need to be tweaked. Perhaps policymakers will find that some regulations need to be scaled back on legacy providers as well. But in general, fintech is hardly a “wild West.”

As Knight pointed out in his testimony, there will always be risks with any new innovation. It is still fairly early in the fintech revolution, so it is hard to separate which perceived risks are true threats and which are mere speculation. For this reason, it is critical that policymakers, entrepreneurs, scholars, and consumers keep a clear line of communication on growing developments and risks.

But it would be a grave mistake to rush to regulate these developments out of existence. In some situations, crafting harsh rules for disruptive new technologies that look like those of the industry they intended to out-compete had the unhappy result of quashing innovation.

This was the case with New York’s infamous BitLicense, which imposed requirements on cryptocurrency exchanges that could be more onerous than their traditional analogs. Unsurprisingly, many firms exited the state in response. Not only were consumers—and especially underserved consumers—robbed of a potentially inclusive alternative to the current system, the problems that critics warn about could still be present with the few options that remain. This is a situation that helps no one.

There is a better way. One regulatory idea to allow room for fintech development while allowing policymakers to keep a sharp eye on potential pitfalls is regulatory sandboxes. Arizona has already put one into place. As Knight has described them, a sandbox is a “program that allows companies to offer products and services in a limited way under a modified regulatory regime while providing information on the experiment to their regulator.” This gives policymakers a better idea of which concerns are valid and which are just baseless worries and places them in a better position to craft tailored policies to address them.

Then there is the idea of special charters. The Office of the Comptroller of the Currency (OCC), which charters and regulates national banks, kicked off a new program that would allow fintech firms to receive special charters and operate similarly to banks. This is a bold move in the world of Washington and is a promising sign that regulators are beginning to understand the promise of fintech innovation.

The future of fintech looks bright. Not only can it improve the speed and convenience of financial processes for everyday commerce, but it can also provide badly needed access for underserved populations. If more policymakers look to the examples of Arizona and the OCC, the future of fintech regulation may be just what we need.

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