Policy Principles for Fintech

The financial services industry is an information industry, where money is simply a nominal representation of real value (goods or services). Yet, compared with some information industries that reaped disruptive gains from information technology (IT), the financial-services industry has experienced mostly incremental innovation. For example, the creation of the Internet enabled innovators to route voice traffic over Internet Protocol networks, changing telephony from an expensive, intermediary-driven system into the more efficient, globally interconnected system we have today. The financial services industry is potentially at a similar inflection point, where expensive, single-purpose networks and systems are giving way to cheaper, general-purpose ones.

Collectively referred to as “fintech,” the businesses pushing this transformation promise productivity improvements in the financial-services industry, greater value at lower prices, and greater access for those now underserved by the financial-services sector. These innovations are poised to radically improve how consumers and businesses transfer money and make payments, record the value of their assets, save and invest, borrow, and insure themselves against risk. But achieving this will require policymakers to actively support fintech transformation.

Fintech, a combination of the words “financial technology,” is a somewhat nebulous term that refers to the set of companies focused on using the latest innovations in information technology to improve financial services. These improvements benefit consumers and businesses by creating more convenient, higher-quality, and cheaper services. By lowering costs, more consumers can not only save money, but also take advantage of financial services and have greater access to capital; this includes those traditionally underserved by the financial industry.

Many fintech companies are experimenting with new business models. For example, companies such as Taulia Inc. offer alternative-lending services, such as supply supply-chain finance, which gives businesses easier access to capital to help with paying their bills while they wait for their customers’ payments to process. Similarly, peer-to-peer lending marketplaces, such as Prosper, establish direct channels between borrowers and lenders, taking a small fee for each transaction. Alternative lending is not the only business-model innovation, however, fintech companies are also changing their business models for payments, transfers, personal finance, and insurance.

Fintech companies, including start-ups and established financial-services organizations, also offer solutions that are reducing costs and boosting the performance of financial services, such as by eliminating intermediaries. For example, crowdfunding platforms connect entrepreneurs directly with small investors, circumventing the traditional banking system and reducing intermediation costs associated with bank loans. Optimistic about the potential benefits of fintech, investors poured $22.3 billion into fintech start-ups worldwide in 2015, an increase of 75 percent from the year before.

As a result, competition is increasing in the fintech sector. In 2015, the Economist estimated that there were over 4,000 active fintech start-ups, and more than a dozen are were valued at over $1 billion. McKinsey estimates that new entrants will increasingly battle for customers with incumbents over the next decade, with the top five banking businesses (i.e., consumer finance, mortgages, lending, retail payments, and wealth management) at risk of losing between 20 and 60 percent of their profits by 2025. Existing financial institutions have also embraced fintech, although some at a slower pace. The percentage of banks with an innovation strategy—a plan to use advancements in technology to gain competitiveness—increased from 37 percent in 2009 to 73 percent in 2015. Some financial institutions are forming strategic partnerships with technology companies. Others have set up their own venture capital firms to acquire or invest in start-ups, or have created innovation labs, incubator and accelerator programs, and in-house development departments to develop technological solutions.

There are a number of challenges confronting the development of fintech. Fintech companies face a complex regulatory environment that was designed for older business models and is slow to adopt change. As fintech firms operate internationally, they must also contend with restrictions on where they can store and transmit data and with regulations designed to protect domestic incumbents. And the broader financial-services sector continues to face a number of evolving security threats, from data breaches to large-scale theft and fraud.

To address these challenges and capture the full benefits of financial innovation, policymakers should work to encourage the growth of fintech. This report offers 10 principles to guide policymakers in their approach to this innovative new sector:

1. Support fintech transformation.
2. Work to ensure that regulations encourage innovation in financial services.
3. Remove duplicative regulations in financial services.
4. Regulate fintech at the national level.
5. Use regulatory enforcement actions to incentivize fintech companies to protect consumers.
6. Create tech-neutral rules for fintech.
7. Create a level playing field between incumbents and new entrants.
8. Promote cybersecurity in fintech.
9. Support standards development and financial data interoperability.
10. Promote international harmonization of laws affecting the financial services sector.