With the aftershocks of the last global recession just beginning to subside it seems prudent to turn our thoughts to the future and, in particular, to the risks facing global financial systems over the next few years.
The landscape of the financial industry greatly differs from how it looked the last time crisis permeated the system. Extensive financial regulation has gone someway to overcoming problems that contributed to the financial crisis and subsequent fallout. For example, ring fencing core banking activities has reduced ‘too big to fail’ attitudes in high-risk activities (such as a merchant banking and derivatives trading) that are less essential to the overall economy. However, many economists and journalists argue that regulations have not gone far enough. With deficiencies in addressing the pre-existing vulnerabilities in the financial sector still very much apparent, there is little hope for effective regulation of the developing facets of the financial sector. At the forefront of these developments are financial technology companies (fintechs), a term referring to any technological developments that disrupt the established functioning of the financial sector. The types of technology it alludes to vary hugely, from initial coin offerings (a crowdfunding method for start ups using blockchain technology) to insurtech (developments that simplify and improve the efficiency of the insurance industry). As an area that is largely populated by small start-up companies, the kind of risks it poses for developed economies differs from those of the traditional ‘too big to fail’ banks. This has led to a notable under-regulation of fintech, creating a toxic risk that threatens to overwhelm the global financial system in the next few years.
One of the foremost challenges for the growth of fintech over the next few years is the tightening credit environment in developed economies. Tim Skeet, a senior advisor at the International Capital Market Association (ICMA), noted in a recent article for Financial News how the fervor surrounding fintech ignores the inherent structural risks of lending to SMEs. Borrowers in this sector often have a high rate of default leaving the industry exposed to credit-based vulnerabilities. This has become particularly apparent over the last few years, as the gradual tightening of the Federal Reserve’s short-term interest rate has ended the era of cheap money. Whilst the established banking sector is accustomed to the credit cycle, this is a new phenomena for many fintech companies who have only ever existed in the era of near zero interest rates. Many still need the funding that they have historically had access to. Consequently, the outlook of further monetary tightening across developed economies may herald additional problems. With the failure of HBOS in 2008 partly on account of poor lending practices, it would appear that some of the issues facing the fintech industry are not so different from those that led up to the crisis of ’08. Skeet’s prediction follows that while automated lending decisions may one day eradicate the established credit market, ‘the moment is not quite here’. For meaningful disruption to be made by fintech further growth is needed and in the mean time authorities should be looking to regulate what is still a very fragile sector.
Conservative MP Adam Afriyie who heads the All Party Parliamentary Group on Fintech, disagrees with this forecast, telling Business Insider that the UK needs to maintain a ‘light touch’ with fintech regulation. Afriyie’s position on the matter is akin to that held by many of his peers who see the industry as an unequaled opportunity for employment growth. With Treasury estimates of the sector’s worth in the UK at £7 billion it is not hard to see why. The UK is a global leader in the fintech sector and fast development rates mean that incautious handling of regulation jeopardises the head start we already have. The vision Afriyie has for the industry is a relatively hands-off approach that simulates the handling of peer-to-peer lending by the Financial Conduct Authority (FCA), one of the earliest examples of fintech and thus one of the only that has been subject to regulatory scrutiny. With the development of new financial technology growing at an exponential rate in a number of diverse areas the regulatory demands are ever increasing. Following the approach taken with peer-to-peer lending would mean a few more years of unregulated growth in a number of emerging fintech trends, opening the economy up to vulnerabilities.
Whilst the UK looks to pursue an accommodating stance when it comes to fintech regulation, in the US there is firm pressure for regulatory reform in this area. Emanuel Cleaver, member of the US House of Representatives, cautioned that ‘we are setting ourselves up for problems down the road’ if there is failure to enact proper regulation on fintech companies. The Senate Banking Committee held a hearing on financial technology at the end of last year but has so far failed to decide on any meaningful change. Cleaver’s position as the most senior Democrat on the House Financial Services housing and insurance subcommittee means that his input should resound with regulators. That being said, stringent regulation on the sector does not appear to be forthcoming from either the US or UK regulatory authorities.
One of the fintech phenomena creating the most concern among policymakers is blockchain, the technology behind cryptocurrencies like Bitcoin. The US treasury has described its existence as an ‘evolving threat’ and the prime minister, Theresa May, has promised to consider governance on this issue, whilst the likes of China having already outlawed the exchange of cryptocurrencies. The central problem with the likes of Bitcoin is safety concerns, with the capacity to hack exchanges leading to plummeting cryptocurrency prices at various points over the past year. This alludes to one of the issues overshadowing the whole fintech sector: the security-access paradox. With low barriers to entry evolving from minimal regulatory requirements, innovation and technological development in this industry are rife, but what this low-cost model generates in actuality is an opportunity for exploitation by criminal enterprise. This institutes a structural vulnerability in the sector whereby even legitimate companies can be taken advantage of by those attempting to engage in criminal activities like money laundering.
Whilst unlawful practices such as these are not liable to bring about a financial crisis in themselves, they are symptomatic of the inherent structural failings of unregulated fintech. Innovation must be allowed to grow for some time free from the restrictive burden of regulation in order for it to succeed but, as a growing sector with established foundations in the UK, fintech is in need of regulatory attention in the imminent future. This is not least because of the nature of the innovation, with the handling of individuals’ money posing an indisputable responsibility on financial authorities. With the lessons of the last crisis still hanging over our heads we would do well to remember the repercussions of a seemingly thriving financial sector when it is left unregulated.