Separating hype from reality was the theme of Ms Carolyn Wilkins, Senior Deputy Governor of the Bank of Canada, speech, in which she argues FinTech, has created a lot of excitement, but also quite a lot of hype, depending on your perspective. Google searches for “finTech” have increased by more than 30 times in the past six years. FinTech has also attracted real money: over the same period, around 100 fintech start-ups in Canada have raised more than $1 billion in funding. At a global level, almost $20 billion was poured into fintech last year alone. She says now is the time for financial institutions, new entrants and policy-makers to work together. The opportunity cost of sitting back and waiting for the dust to settle is too great.
Financial institutions and infrastructure operators are making important strategic decisions about which parts of their businesses they want to defend and grow and which ones they want to scale back. This urgency is not only coming from fintech contenders. Banks are also dealing with a more demanding regulatory environment and exceptionally low interest rates around the world that are squeezing profit margins. Banks already spend close to $200 billion a year on IT globally, so replacing legacy systems will mean difficult and critical investment decisions.
For the Bank of Canada, our priority is to see upgrades made to the core payment systems that the financial system relies on and that the Bank oversees: the Large Value Transfer System (LVTS) and the Automated Clearing Settlement System (ACSS). These systems have served us well, but both require investments that are needed to fully meet our oversight requirements. Investment will also help the systems better meet the modern needs of participants and their customers.
Take the ACSS, for example, which still handles most retail transactions today. It was implemented over 30 years ago, when everyone wanted a Commodore 64. The ACSS may have been at the forefront in 1984, but we are far from the efficient frontier now. Cheques take up to four days to clear, and some information needs to be re-entered manually.
Now is the time to make our core systems more efficient and competitive. For consumers and business users, we need to move closer to real-time access to funds. In both the ACSS and LVTS, we need to collect richer data on transactions and, ideally, make them interoperable to avoid having to manually re-enter information. This effort is not change for change’s sake. If we can leverage some of the existing infrastructure and still achieve our goals, that is all the better.
For our part, policy-makers and regulators need to address innovation in financial services in a few proactive ways.
The first is to develop a solid analytical framework to understand and assess the benefits and challenges of something so new. This is something the Financial Stability Board is working on. Authorities will make their assessments through many lenses, including consumer protection, financial inclusion, market integrity, competition policy and financial stability. That is why other international groups such as the Committee on Payments and Market Infrastructures, the Basel Committee on Banking Supervision, and the International Organization of Securities Commissions are also involved. The Bank of Canada, together with our domestic colleagues, is actively contributing to these efforts. Since fintech is a global phenomenon, it is critical that this regulatory effort be global. We must also learn from emerging-market economies that are further along in some areas.
While fintech innovations promise to solve some current problems, they could also create new ones. Let me give you an example: I worry that network effects, which underpin the success of many payment applications, could lead to an excessive concentration of payment service providers. If this happens, households and businesses may not benefit from cost savings. This is clearly an issue for competition authorities.
It also is an issue for financial stability because “too big to fail” could emerge in a new form outside the current regulatory perimeter. Once again, payments are a great example. I worry that players not covered currently by regulation could become important to the system even if they never take on bank-like risks, such as maturity transformation or leverage, or become big enough to be considered systemically important. The move to increased direct access means that even smaller players could very well create critical dependencies within the financial system, particularly if they connect directly to core payments infrastructure. This could give rise to moral hazard. At a minimum, authorities need to put a large enough weight on operational dependencies when looking at systemic importance, particularly in light of cyber risk. When a payment system grows to be prominent or systemically important, the Bank of Canada’s job is to oversee it. Even before we reach that point, regulatory measures should be considered to address specific issues, such as operational resilience and consumer protection.
I also wonder how DLT-based infrastructures could affect the financial ecosystem. Ever-increasing automation through, say, smart contracts, could increase efficiency and certainty but could also increase financial volatility. Would that volatility be short-term, such as flash crashes? Or would it entail procyclical dynamics or new channels of contagion?
There are also questions about whether the regulatory perimeter is adequate, given new entrants and risks of regulatory arbitrage. In my view, the field of inquiry should include the inherent risk and systemic importance of an activity, regardless of what entity is performing it. Even as we strive to implement a regulatory response that is proportionate to the risk, we need to keep in mind that maintaining a level playing field is important. Some of these issues are not too different from those that authorities face in their work on shadow banking, another area where new entrants are challenging traditional players.16 And, big or small, operational risk deserves much greater attention.
The second way to address innovation in financial services is active engagement between authorities and the private sector. Some countries, such as the United Kingdom, Australia and Singapore, have created official regulatory “sandboxes.” These sandboxes allow start-ups to experiment with services without jumping through all the usual regulatory hoops.
Here in Canada, we are consulting with fintech entrepreneurs. The Bank of Canada is also partnering with Payments Canada, Canadian banks and R3 – which leads a consortium of financial institutions – to test drive distributed ledgers. Our only goal at this stage is to understand the mechanics, limits and possibilities of this technology. The plan is to build a rudimentary wholesale payment system to run experiments in a lab environment.
Our experiment includes a simulated settlement asset used as a medium of exchange within the system. It is very much like the settlement balances in LVTS, except it is using DLT. Because it cannot be used anywhere else, it is a different animal altogether from a digital currency for widespread use.
This is an experiment in the true sense of the word. I cannot think of a better way to understand this technology than to work with it. Other frameworks need to be investigated, and there are many hurdles that need to be cleared before such a system would ever be ready for prime time.
The third way to address innovation proactively is to do fundamental research on the effects of new technology. The Bank of Canada’s research over the past few years has focused on new payment methods, the adoption and competitiveness of digital currencies, and the essential benefits of private e-money. We are continuing this work and broadening it to include other developments, such as peer-to-peer lending and uses of DLT.
We also want to understand how new financial technologies will address the underlying forces that created the need for financial intermediation in the first place. In theory, new technology could enable a different framework for addressing the same frictions, potentially one that does not require financial intermediaries at all. The names and faces may change, but I do not see technology changing the need for maturity transformation, loan monitoring, intermediation of borrowers and lenders, and trust. This is a good question for academics.
