Fintech Defined Examples Use Cases And Benefits

If you’re a long-time reader of MoneySummit, you undoubtedly already know what fintech is. Still, this primer can help solidify your understanding of the term, where it comes from, and why it matters.

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What Is Fintech?
In the simplest terms possible, fintech is digital financial technology.

Chances are high that no matter who you are, you use fintech every day. When you use online banking, mobile banking, digital bill pay, robo-advisers, money management apps, financial chatbots, person-to-person payments, or even buy something online, you’re using fintech.

The term has been around at least since 1972, which is when a banker noted in a scholarly article that the term “stands for financial technology.” Interest in the term remained more or less stagnant (at least when it came to searches via Google) for decades —then exploded around 2015.

And, given that fintech startups raised a record number of $100 million rounds in Q2 of 2020, attention to the industry is not about to stop.

Since there are more than 20,000 fintech companies worldwide, there are far too many to mention here. We’ll look at just a few examples.

Founded in 1998 as Confinity by Peter Thiel, Max Levchin, and Luke Nosek, PayPal merged with Elon Musk’s online banking company X.com in 2000 and then officially became known as PayPal in 2001. The company was acquired by eBay in 2002 and was then spun off again in 2014. PayPal has acquired many fintech companies itself, most notably Braintree, which was founded by Utah-native Bryan Johnson, and which had previously acquired Venmo. Today, Venmo has more than 40 million users and PayPal has 305 million.

Two Irish brothers, Patrick and John Collison, founded Stripe in 2013 to simplify online payments infrastructure. In short, they make it easier to buy things online. Clients include Amazon, Zoom, Google, Slack, and hundreds of thousands of other companies. As a result of building Stripe, Patrick and John Collison became some of the world’s youngest billionaires.

Coinbase lets people buy and sell cryptocurrencies. By giving an intuitive interface to an otherwise esoteric financial niche, Coinbase has reached 35 million users worldwide. Founded in 2012 by Brian Armstrong and Fred Ehrsam, Coinbase has overseen the volatile cryptocurrency markets through many formative years.

SoFi started in 2011 by four Stanford students as a way to help people manage their student loans. Since then, they’ve expanded to offer mortgages and personal loans. They also acquired Galileo, a payments company based in Utah, for $1.2 billion in stock and cash, putting them in competition with a wide range of players in fintech.

MX has been called “a quiet giant in fintech” by TechCrunch. Founded in 2010 by Ryan Caldwell, MX has gone on to become an essential data partner to financial organizations including BBVA, Ally, BECU, and more than 2,000 others. MX powers the money experience for more than 30 million people via these partnerships, with the mission to empower the world to be financially strong.

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As you can see, fintech covers a lot of territory, including payments, cryptocurrencies, blockchain, loans, investing, data, and more. (We didn’t even explore credit scores, insurance, or crowdfunding here, for instance.)

What’s the Future of Fintech?
As fintech continues to evolve, a few things are almost certain:

Fintech will become more regulated. In the past, fintech hasn’t been regulated like traditional financial institutions. But as more and more users adopt fintech, whether as part of a financial institution or as part of a standalone fintech option, that’s sure to change. People have high expectations when it comes to keeping their money secure and private. They want bank-level assurance that everything will be okay, and regulators are working to make sure this is the case. In the United States, for instance, the Office of the Comptroller of the Currency (OCC), makes frequent statements about innovation in financial services. This is certain to continue.

The lines between fintechs and banks will blur. Ryan Caldwell, Founder and CEO at MX, notes that the future belongs to a new blend of organizations. “If you’re a fintech and you’re trying to scale, you can’t just stay a fintech,” he says. “And if you’re a bank and you’re trying to survive, you can’t just stay a normal bank. There’s going to be a new entity that’s not like a current bank at all and not like a current fintech at all. That will be the winner.” Open banking will play an enormous role in this evolution.

Finances will become democratized. As banking services become easier and smartphones become more ubiquitous, banking will likely become democratized. People will be able to sign up for a bank account and deposit and spend money straight from their phone. This is already happening across the world, notably with M-Pesa and other financial products. It will continue to happen as fintech becomes more pervasive.

For more on this topic read 6 Bold Predictions for the New World of Banking and Fintech.

Why Does Fintech Matter?
At a foundational level, fintech matters because money matters. We all rely on money in our lives, and when our experience with money is easier, more intuitive, and more immediate, we end up with an improved quality of life. At its best, fintech streamlines and simplifies how we experience money.

Contrast this with what banking looked like for centuries before fintech: The only option people had was to travel to a bank and deal with physical cash and coins. Bankers then had to manually count that cash and account for it on paper. As Chris Skinner, author of Digital Bank, puts it, “We built an industry on the physical distribution of paper in a localized world, and we’re now having to get to grips with the digital distribution of data in a networked world.” This networked world with its digital distribution is the world of fintech. It’s the future of money.

Want to learn more about the future of banking as it relates to fintech? See our ultimate guide on the topic.

Fintech And The New Financial Landscape

Editor’s Note: The opinions expressed in this paper are the authors’ own views and do not necessarily represent the views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

The Federal Reserve Bank of Philadelphia, the Wharton School, the Bank Policy Institute, and the FDIC jointly held a conference called “Fintech and the New Financial Landscape” this past November that focused on potential disruption that FinTechs could cause and their impact on the financial landscape.1 This article provides an overview of the broad issues facing the financial industry in light of comments made during the conference discussions, broadly encapsulated as the “FinTech revolution.”

We want to understand how disruptive FinTech lending affects the financial services industry and, more generally, the overall financial landscape and consumer behavior. The optimistic scenario is clear: FinTech could benefit underserved consumers around the globe by allowing approximately 2 billion unbanked consumers to be connected to the financial system.2 It can also make processes more efficient for currently served borrowers. However, FinTech’s potential could face substantial barriers. The regulatory structure built around the provision of financial services includes many assumptions, both stated and unstated, that new technologies are challenging. Moving to a new market equilibrium between established financial institutions and new FinTech lenders will cause regulatory and market-based frictions that could result in unintended consequences.

When we describe FinTech lending, we are not referring to all online lending. After all, technology is not new in finance. Most credit card applications are online and decisions can be reached in seconds. We define lending as FinTech only if it involves advanced technology and nontraditional processes in credit decision-making, such as utilizing alternative data about consumers (including utility payments, medical payments, rent, etc.). Below, we review the types of data that FinTech lenders use as well as their advantages and potential disadvantages.

We also review the target population of FinTech lenders. A common assumption is that FinTech lenders target younger borrowers, particularly millennials. However, data shows that about 60% of consumers who borrow from FinTech lenders are over 40 and that the age distribution of consumers who take loans from FinTech lenders is similar to that of borrowers from traditional lenders (banks, credit unions, and finance companies).3 One population especially served by FinTechs are people with thin credit files – those who have few pieces of data on their traditional credit report and hence are frequently assigned low or no composite credit score. FinTech lenders have been able to utilize nontraditional data to make more-informed decisions, sometimes providing credit to borrowers who otherwise would not have access to loans.4 However, there is no specific target population for FinTechs; different types of FinTech lenders aim at different populations.

We also discuss some of the legal challenges that FinTech lending faces. Consumer advocates have had concerns about the use of alternative data in predicting a consumer’s ability and willingness to pay back a loan. These concerns involve privacy and discrimination. One must balance them against the opportunity of expanding access to credit, which is valuable because many people have been left out of the financial system.

We conclude with general thoughts about future challenges and the need for active debate involving academics, practitioners, and regulators.

1. How Alternative Data, Artificial Intelligence (AI), and Machine Learning (ML) Have Transformed Lending Landscapes

FinTech lenders use technology to obtain new kinds of data that can make lending decisions more efficient and informed.

Cash-Flow Data: FinTech lenders utilize additional (that is, nontraditional) data such as cash flows and bank transactions for credit decisions, unlike the traditional approach. For example, Petal relies heavily on cash-flow data analysis for its credit decision-making, which is easy to understand because cash flows are a close proximate of a consumer’s ability to pay back a loan, perhaps more illustrative than backward-looking data on a consumer’s repayment of prior loans. Hence, this new technology has substantial opportunity to improve upon the industry-dominant model of credit report underwriting.

Cash flows could serve as (almost) a real-time update of a consumer’s financial situation through salary as well as utility and medical payments, alimony, and other fixed expenses. Unlike data from rating agencies or consumer credit panels (CCPs) (such as the Equifax, Experian, and TransUnion), cash-flow data would immediately reveal any gaps between income and expenses while the traditional CCP data would become available after a lag.

In addition, consumer behaviors observed through bank transactions could reveal additional information about the type of the consumer and the patterns of behavior. For example, some people spend quickly and never save, while others spend money slowly and put what they can into savings.

More data is needed to build a robust credit-risk model that accounts for changes in economic circumstances. CCP data could be useful to understand how consumers behaved in the past recession. A long history of data would allow for a deeper understanding of trends and a consumer’s behavior.

We need a broader ecosystem to facilitate deeper and more liquid markets for cash-flow-based loans. Secondary market structures to securitize consumer credit have been defined by FICO scores: Market participants broadly understand a securitization of loans from consumers who have FICOs in the 720s or 660s. Could similar structures exist for consumers with $300+ excess cash per month? Part of this ecosystem involves financial regulators. Regulatory rules, guidance, and experience often have been based on credit scores. Regulators could incorporate a broader set of credit risk factors in defining rules and guidance to adapt to a potential cash-flow underwriting system.

Big Data, Alternative Data, and Advanced AI Technology: Alternative data tells a lot about a consumer’s life, such as wealth (assets, equity, loan to value, tax payments, cars [brand, age, how many]), cash flow (salary, rental, utility, alimony, medical payments), lifestyle (education major, grade point average, school attended, occupation, appearance [weight/height], number of dependents), digital footprints and web tracking (where the consumer has visited, shopping habits), device tracking (how fast the consumer scrolls as well as typing speed and accuracy), and social profiles (network, topics that a person is engaged in). Over time and with technological development, an increasing amount of information becomes available and could potentially be used for credit decisions with rich-enough models.

Social Media Data: Most FinTech lenders claim not to use social media information in credit decisions, instead using this type of information for marketing and fraud-detection purposes. One concern about social media data is that the relationships are likely to be unstable, and thus models would likely fail to predict default, especially during or after economic contractions. The potential use of social media footprints as they relate to protected classes, including race, gender, and age, is another concern.

Recent Developments at Rating Agencies: Traditional credit rating agencies like FICO and VantageScore recently have attempted to incorporate some additional data into the ratings, using bank and non-bank data such as utility and rent payments. For example, FICO, through its financial inclusion initiative, has explored more-advanced modeling techniques often used by FinTech lenders. These complex models, however, often present their own set of challenges and limitations in terms of interpretability.5 Recognizing AI’s challenges, an AI tool could be used to build better models if used with appropriate controls. In addition, VantageScore is incorporating some trend data (rather than status at a point in time) as well as utility payments.6 The new approach would explore trends and look back at through a consumer’s history trying to learn more about periods where some are rated as prime but have been deteriorating, or others are rated nonprime but have been improving in credit ratings.

1. FinTech Impact on Consumer Access to Credit

FinTech lenders focus on diverse sets of consumers. Some FinTech companies chase prime consumers while others look to serve near-prime and subprime consumers.

Below Prime and the “Invisible Prime” Consumers: A presentation by Upstart’s Paul Gu shows that 33% of borrowers with FICO scores below 620 default, suggesting that the other 67% did not default. Using alternative data and AI algorithms, FinTech lenders promise to identify from the subprime pool those consumers who are less risky. In other words, FinTech lenders could identify those who will perform as prime customers but who are not identified as such.7

One example is Elevate, which has reported that it has served 2 million nonprime consumers in the U.S. and U.K., using electronic platforms and nontraditional data. Another is Petal, which uses cash-flow underwriting to identify the “invisible prime.” While cash flows and bank transactions are closely related to a consumer’s ability to pay, the data has not yet been factored into mainstream credit ratings. Petal pulls and aggregates all financial information across several sources and institutions. Through this automated process, FinTech lenders could prequalify those “invisible prime” consumers in seconds and at significantly lower cost.

Another firm, Urjanet, performs this task using data on $70 billion of utility payments for consumers in 43 countries. It argues that 100 million more consumers have been able to access credit through its utility payment information. Overall, these FinTech lenders claim to make loans to the “invisible prime” at a lower interest rate than alternatives currently available to them (for example, payday loans and subprime credit cards) and have losses below industry average.8

Students, recent graduates from universities, and immigrants usually have thin credit files. Given that some are likely to have high and stable earnings, particularly graduates of top universities or immigrants with established high-income jobs, they are a natural target of FinTech lenders. However, this category represents only a small fraction of thin-file consumers who have been served by FinTech firms.

Middle-Income Consumers: Some FinTech lenders, including Avant and Amount, do not focus on prime or subprime customers but look to serve those in between – so-called middle-income consumers. These are not people with thin credit files; instead, they have longer histories and thicker files but do not always get access to credit easily and not usually at a good rate. Through their partnership with traditional banks, these FinTech firms provide white-label service and technology solution to bank partners – helping large and small banks digitize their lending processes. Due to banks’ legacy structures and products, it is argued that they often could not easily build their own platforms.

Prime Consumers: Some other FinTech lenders, such as Marlette Funding, focus on prime consumers who have mature credit histories and documented histories of good incomes. This segment of consumers may be viewed as currently being well served by traditional lenders. The focus of these lenders is on a more-efficient lending process, providing consumers with more convenience and transparency. Some prime consumers prefer to deal with FinTech lenders and may be willing to pay a premium for convenience – loan applications can be completed in minutes and funding can be obtained within 24 hours for three- to five-year terms. FinTech lenders apply innovative tools to consumer banking as they leverage their ability to tap into dozens of data sources (with thousands more items of data) through the API protocol and Amazon Web Services cloud base. Partner banks, such as Cross River Bank and WebBank, could originate the loans so that the FinTech lenders do not need to obtain their own license in each state. FinTech lenders could utilize technology to more accurately or more efficiently perform risk-based pricing.

Small-Business Owners: Several firms conduct small-business lending, including PayPal, OnDeck, LendingClub, Funding Circle, and Kabbage. They all have unique advantages and specialize in different small-business products – for example, loan amounts range from $5,000 to $400,000, maturities range from 30 days to seven years, and the annual percentage rate (APR) ranges from less than 10% to over 200%. FinTech lenders such as PayPal, Amazon, and Square have a comparative advantage with access to cash-flows data (through their own payment platforms) allowing for additional insights into how a borrower’s business performance compares with other similar business owners.

Tying small-business lending to payment processing also allows a greater security for the lender; while the loan is still technically unsecured by a physical or financial asset, the lender can be repaid directly through the gross receipts processed for the business. Hence, access to credit can be expanded to those small-business owners who may have a short credit history but are not likely to default. Unlike the situation for consumers, there are fewer legal or regulatory protections for small-business owners engaging in small-business borrowing. Some small-business owners had to take very short-term loans at extremely high rates, and they may not be aware of the actual APRs that they are getting. Absent federal action, state governments have attempted to increase transparency to protect small-business borrowers, leading to California passing the historic Small Business Borrowers’ Bill of Rights.9

1. How to Protect Consumers and Promote FinTech Innovations

Fast technological development has led to many challenges involving the legal framework and the boundaries delineating how lending should be conducted.

Challenges with Data Aggregators and AI Vendors: The amounts of data generated raise major questions about the future use, storage, and aggregation of this vast amount of new information. In the keynote speech that opened the conference, Federal Reserve Governor Lael Brainard noted that “the world is creating data to feed those models at an ever-increasing rate. Whereas in 2013 it was estimated that 90% of the world’s data had been created in the prior two years, by 2016, IBM estimated that 90% of global data had been created in the prior year alone. The pace and ubiquity of AI innovation have surprised even experts.”10

Indeed, this vast amount of data and advanced technology have presented the possibility for enhanced credit-risk models that would allow more consumers on the margins of the current credit system to be included in the financial system because of their improved credit standing. FinTech lenders could build and utilize more-complex models for better credit decision-making and more-accurate risk-pricing as well as bringing greater speed to credit decisions. Several data aggregators and AI vendors have also emerged to serve as white-label platforms for traditional lenders to enhance their credit decision-making process. But there exist several data consortiums that contain a gigantic amount of consumer data and are currently not regulated. It is not clear who owns the data. Consumers may not be aware of what information about them is being used, for what purpose, and by whom – thus potentially having their privacy violated.

Protecting consumer information is clearly an important goal. Recently, data aggregators and AI vendors have considered blockchain technology as a way to provide decentralized permission access to consumer data so that lenders could use the data for credit decisions without actually seeing the data – and, therefore, with little or no chance of losing data and allowing for more protection to consumers. One concern around this approach (when consumers start limiting data access to FinTech lenders) is that it might limit lenders’ ability to train the models. It is important for all the regulatory agencies to work together to find the right balance between protecting consumers and encouraging more FinTech innovations.

Defining Fair Lending and Protected Classes: According to the Fair Credit Report Act (FCRA), the use of social media data in credit decision-making may not be legal. While there has been a lot of talk about lenders using social media data for credit decisions, most lenders argue that they do not really use the data because of FCRA regulation.11 Other online data such as online footprints and shopping habits have been used in credit decisions.

AI and big data are necessary to expand credit access but not sufficient. FinTech lenders need policy guidance related to the use of ML techniques – what determines disparate impact; whether it is all right to use bank and other payment transactions; whether to use data from households versus individual accounts; use of a consumer’s character and other non-credit data to decline credit applications.

The application of AI, ML, and big data is particularly challenging given the unique and differing laws covering protected classes from illegal discrimination. For example, gender is a protected class, and its consideration in providing access to credit or the terms of credit is illegal. As Fed Governor Brainard remarked in her speech, AI can unknowingly incorporate gender factors, such as attendance at an all-woman’s college, as part of the ML process. Incorporation of such a factor in a credit algorithm would be highly problematic. However, gender is an allowable factor for underwriting in the business of insurance. Car insurance premiums explicitly differ for men and women, with substantial price differences for teenagers based on gender. Legal and regulatory protections differ even within what constitutes a protected class within financial services. These differences will translate into different adoption challenges for FinTech firms and financial institutions incorporating AI, ML, and big data.

FinTech activities are progressing fast and penetrating all areas of the financial system. Recent developments reflect increased collaboration and partnerships between traditional lenders and FinTech platforms. The use of AI/ML and data collection has been growing exponentially. While consumers could send their data to specific lenders/providers, the automation through AI/ML processes and data aggregation could enhance efficiency, reduce costs, and further expand credit access – within regulatory compliance. Several AI/ML vendors (including traditional firms such as IBM Watson and Promontory, its consulting firm) have also been serving lenders in this space. Partnership opportunities between banks and FinTech firms have been increasing.

Overall, FinTech lenders have serious concerns about the lack of clarity under the current regulatory and legal regime, as well as question about where we are headed. There are also concerns regarding compliance with too many different sets of rules. Although some aspects of the market are marching ahead, others are delayed pending regulatory approval. FinTech approaches expose issues with basic assumptions of our entire system: 1) the dual charter and regulatory regime of federal and state governments; 2) where the line is drawn between banking and commerce; 3) the ability of credit providers to comply with legal and regulatory requirements (knowing why credit is denied, disparate impact, what is/isn’t a protected class); 4) incorporating new technology that probes the boundaries of acceptable behavior while offering possibilities of benefits to many. There is room for concerted effort involving scholars, policymakers, and regulators to clarify the framework going forward.

In addition to the AI/ML algorithms, there has been a lot of hype about how blockchain technology could potentially disrupt the entire financial service industry. Blockchain platforms have been used in several applications, most notably for cryptocurrencies and initial coin offerings. However, there may have been misunderstandings about the blockchain applications and their potential as a mainstream technology for the future. For example, the conference highlighted that smart contracts can exist independently without a blockchain.12 In addition, a speaker from Cambridge Quantum Computing explained that current encryption technology might no longer be effective because quantum computing will be fast enough to hack even the blockchain platforms; the only effective encryption process of the future would require quantum computing technology. There are many uncertainties regarding the rapid advance in technology.

A final issue to consider relates to financial stability. Unlike banks, FinTech firms do not take deposits, and thus they need to rely on private investors (through peer-to-peer or marketplace lending) and capital market funding through securitization or loan sale to financial institutions. Through securitization, they are also required to self-fund part of the loan pools on their balance sheets (as required by the Dodd-Frank Act). Like any new business model, there are concerns that FinTech lending has not gone through an entire economic cycle. During a recession, FinTech funding could dry up – thus potentially driving most of the FinTech lenders out of business. Another concern is that risks are sent off the balance sheet for the FinTech and into the capital markets, and so the impact of a downturn on FinTech firms themselves may be limited, but the effects will spill over to other players who have purchased the loans. Technology can improve lending, but risk cannot be completely eliminated.

This is an opportune time for academics, practitioners, and regulators to engage in debate over the landscape of the financial industry’s future. What will the market structure become? Will the new FinTech players threaten the existence of established financial institutions? What will be the response of these institutions to such threats? What are the effects of FinTech on the well-being of different participants, and will it ultimately lead to better outcomes for borrowers and consumers? These are all questions that need to be evaluated using empirical and theoretical analysis that could be conducted by academics and relying on the hands-on experience of practitioners and regulators. The conference was a great opportunity to catch up on some of these issues, and we are sure that much more debate will follow in future events and writings. n

ENDNOTES
1      More information about the conference (including papers, presentation slides, speaker bios, and videos) are available from the conference website: /bank-resources/supervision-and-regulation/events/2018/fintech

2     This has been documented in Julapa Jagtiani and John Kose, “Fintech: The Impact on Consumers and Regulatory Responses,” Journal of Economics and Business 100 (2018): 1-6.

3      See TransUnion (TU) study by John Wirth (2018), “Fact Versus Fiction: Fintech Lenders,” presentation slides and video are available through the conference website.

4      See Julapa Jagtiani and Cathy Lemieux (2018a), “The Roles of Alternative Data and Machine Learning in Fintech Lending: Evidence from the LendingClub Consumer Platform,” Federal Reserve Bank of Philadelphia, Research Working Paper #18-15.

5      See FICO study by Gerald Fahner (2018), “Developing Transparent Credit Risk Scorecards More Effectively: An Explainable Artificial Intelligence Approach,” presentation slides and video are available through the conference website.

6      See VantageScore study by Nick Rose and Jeff Richardson (2018), “Impacts of Trended Data on Consumer Risk Scores,” presentation slides and video are available through the conference website.

7     See Jagtiani and C. Lemieux, op cit.

8      See Upstart’s presentation by Paul Gu (available on the conference website) and see [email protected] (2018) “How Fintech Serves the ‘Invisible Prime’ Borrower,” interview of Ken Rees, CEO of Elevate (November 27, 2018). Available at this link: /article/fintech-serving-invisible-prime-borrower/

9      For more detail, see presentation by Louis Caditz-Peck (Director of Public Policy, LendingClub) on “Responsible Small Business Lending,” available on the conference website.

10    See Governor Lael Brainard’s speech titled “What Are We Learning about Artificial Intelligence in Financial Services?” given at the conference on “Fintech and the New Financial Landscape,” at the Federal Reserve Bank of Philadelphia, PA (November 13, 2018). Link: /newsevents/speech/brainard a.htm

11    Facebook, for example, has an agreement with all users to not use Facebook data for credit decisions.

12              See Hanna Halaburda (2018), “Blockchain Revolution Without the Blockchain,” Bank of Canada Staff Analytical Note ; video of the discussion is also available from the conference website.

About the Authors:

Itay Goldstein
Itay Goldstein is the Joel S. Ehrenkranz Family Professor in the Finance Department at the Wharton School of the University of Pennsylvania. He is also the coordinator of the Ph.D. program in Finance. He holds a secondary appointment as a Professor of Economics at the University of Pennsylvania. Goldstein has been on the faculty of the Wharton School since 2004. He earned his Ph.D. in economics in 2001 from Tel Aviv University. He is an expert in the areas of corporate finance, financial institutions, and financial markets, focusing on financial fragility and crises and on the feedback effects between firms and financial markets. Before joining Wharton, Professor Goldstein served on the faculty of Duke University’s Fuqua School of Business. He had also worked in the research department of the Bank of Israel.

Julapa Jagtiani
Dr. Julapa Jagtiani is Senior Special Advisor at the Federal Reserve Bank of Philadelphia and a fellow member of the Wharton Financial Institutions Center. Previously, Jagtiani was Senior Economist at the Chicago Fed and Kansas City Fed, and she was Associate Professor of Finance at Baruch College, City University of New York. At the Federal Reserve, Jagtiani has participated in several supervisory policy projects, including serving on the Basel Qualification Team, CCAR Stress Testing team, and, recently, on the Federal Reserve FinTech Task Force. Jagtiani received her Ph.D. and MBA from the NYU Stern School of Business.

Aaron Klein
Aaron Klein is a Fellow in Economic Studies and serves as Policy Director of the Center on Regulation and Markets. He focuses on financial regulation and technology, macroeconomics, and infrastructure finance and policy. Previously, Klein directed the Bipartisan Policy Center’s Financial Regulatory Reform Initiative and served at the Treasury Department as Deputy Assistant Secretary for Economic Policy.

Before his appointment as Deputy Assistant Secretary in 2009, he served as Chief Economist of the Senate Banking, Housing, and Urban Affairs Committee for Chairmen Chris Dodd and Paul Sarbanes. Klein is a graduate of Dartmouth College and the Woodrow Wilson School for Public Affairs at Princeton University.

Financial Technology

Subset of technologies used in finance

Financial technology (abbreviated fintech or FinTech) is the technology and innovation that aims to compete with traditional financial methods in the delivery of financial services.[1][2][3] It is an emerging industry that uses technology to improve activities in finance.[4] The use of smartphones for mobile banking, investing, borrowing services,[5] and cryptocurrency are examples of technologies aiming to make financial services more accessible to the general public. Financial technology companies consist of both startups and established financial institutions and technology companies trying to replace or enhance the usage of financial services provided by existing financial companies. A subset of fintech companies that focus on the insurance industry are collectively known as insurtech or insuretech companies.[6][7]

Definition[edit]
After reviewing more than 200 scientific papers citing the term “fintech”, a study on the definition of fintech concluded that “fintech is a new financial industry that applies technology to improve financial activities.”[8] Fintech is the new applications, processes, products, or business models in the financial services industry, composed of one or more complementary financial services and provided as an end-to-end process via the Internet.[5]

Key areas[edit]
Financial technology has been used to automate investments, insurance, trading, banking services and risk management.[9]

The services may originate from various independent service providers including at least one licensed bank or insurer. The interconnection is enabled through open APIs and open banking and supported by regulations such as the European Payment Services Directive.

Robo-advisers are a class of automated financial adviser that provide financial advice or investment management online with moderate to minimal human intervention.[10] They provide digital financial advice based on mathematical rules or algorithms, and thus can provide a low-cost alternative to a human advisers.

Global investment in financial technology increased more than 12,000% from $930 million in 2008 to $121.6 billion in 2020.[11] 2019 saw a record high with the total global investment in financial technology being $215.3 billion, of which Q3 alone accounted for $144.7 billion in investment.[12]

In H1 2021, Fintech deal volume hit a new high of 2,456 deals accounting for $98 billion in investment. Global VC investment was higher than $52 billion in H1’21 — very close to the annual record of $54 billion seen in 2018.[13]

H1’21 saw $21 billion in corporate-affiliated VC investment. CVC deal volume reached a high of 284 in Q1’21, and then grew further to 312 in Q2’21.[14]

The Americas saw about $51.4 billion of fintech investment in H1’21, with the US alone accounting for $42.1 billion. In the EMEA region, investment in fintech was very robust at $39.1 billion. In Asia-Pacific, fintech investment grew between H2’20 and H1’21 — rising from $4.5 billion to $7.5 billion, although it was subdued in comparison with previous record highs.[15]

The nascent financial technology industry in London has seen rapid growth over the last few years, according to the office of the Mayor of London. Forty percent of the City of London’s workforce is employed in financial and technology services.[16] As of April 2019, about 76,500 people form the UK-wide FinTech workforce, and this number is projected to rise to 105,500 by 2030. Of the current fintech workforce in the UK, 42% of workers are from overseas. [17]

In Europe, $1.5 billion was invested in financial technology companies in 2014, with London-based companies receiving $539 million, Amsterdam-based companies $306 million, and Stockholm-based companies receiving $266 million in investment. After London, Stockholm is the second highest funded city in Europe in the past 10 years. Europe’s fintech deals reached a five-quarter high, rising from 37 in Q to 47 in Q1 2016.[18][19] Lithuania is starting to become a northern European hub for financial technology companies since the news in 2016 about the possible exit of Britain from the European Union. Lithuania has issued 51 fintech licenses since 2016, 32 of those in 2017.[20]

Fintech companies in the United States raised $12.4 billion in 2018, a 43% increase over 2017 figures.[21]

In the Asia Pacific region, the growth will see a new financial technology hub to be opened in Sydney, in April 2015.[22] According to KPMG, Sydney’s financial services sector in 2017 creates 9 per cent of national GDP and is bigger than the financial services sector in either Hong Kong or Singapore.[23] A financial technology innovation lab was launched in Hong Kong in 2015.[24] In 2015, the Monetary Authority of Singapore launched an initiative named Fintech and Information Group to draw in start-ups from around the world. It pledged to spend $225 million in the fintech sector over the next five years.[25]

While Singapore has been one of the central Fintech hubs in Asia, start ups in the sector from Vietnam and Indonesia have been attracting more venture capital investments in recent years. Since 2014, Southeast Asian Fintech companies have increased VC funding from $35 million to $679 million in 2018 and $1.14 billion in 2019.[9]

Technologies[edit]
Fintech companies use a variety of technologies, including artificial intelligence (AI), big data, robotic process automation (RPA), and blockchain.

AI algorithms can provide insight on customer spending habits, allowing financial institutions to better understand their clients. Chatbots are another AI-driven tool that banks are starting to use to help with customer service.[26]

Big data can predict client investments and market changes in order to create new strategies and portfolios, analyze customer spending habits, improve fraud detection, and create marketing strategies.[27][citation needed]

Robotic Process Automation is an artificial intelligence technology that focuses on automating specific repetitive tasks.[28] RPA helps to process financial information such as accounts payable and receivable more efficiently than the manual process and often more accurately.[29]

Blockchain is an emerging technology in finance which has driven significant investment from many companies.[30] The decentralized nature of blockchain can eliminate the need for a third party to execute transactions.[31]

Awards and recognition[edit]
Financial magazine Forbes created a list of the leading disruptors in financial technology for its Forbes 2021 global Fintech 50.[32] In Europe there is a list called the FinTech 50,[33] which aims to recognise the most innovative companies in fintech.[34]

A report published in February 2016 by EY commissioned by the UK Treasury compared seven leading fintech hubs: the United Kingdom, California, New York City, Singapore, Germany, Australia and Hong Kong. It ranked California first for ‘talent’ and ‘capital’, the United Kingdom first for ‘government policy’ and New York City first for ‘demand’.[35]

For the past few years, PwC has posted a report called the “Global Fintech Report”. The 2019 report covers many topics of the financial technology sector, describing the landscape of the “Fintech” industry, and some of the emerging technologies in the sector. And it provides strategies for financial institutions on how to incorporate more “fintech” technologies into their business.[36]

Outlook[edit]
Finance is seen as one of the industries most vulnerable to disruption by software because financial services, much like publishing, are made of information rather than concrete goods. In particular blockchains have the potential to reduce the cost of transacting in a financial system.[37] While finance has been shielded by regulation until now, and weathered the dot-com boom without major upheaval, a new wave of startups is increasingly “disaggregating” global banks.[38] However, aggressive enforcement of the Bank Secrecy Act and money transmission regulations represents an ongoing threat to fintech companies.[39] In response, the International Monetary Fund (IMF) and the World Bank jointly presented Bali Fintech Agenda on October 11, 2018[40] which consists of 12 policy elements acting as a guidelines for various governments and central banking institutions to adopt and deploy “rapid advances in financial technology”.[41]

The New York Venture Capital Association (NYVCA) hosts annual summits to educate those interested in learning more about fintech.[42] In 2018 alone, fintech was responsible for over 1,700 deals worth over 40 billion dollars.[43] In 2021, one in every five dollars invested by venture capital has gone into fintech.[44]

Challenges and solutions[edit]
In addition to established competitors, fintech companies often face doubts from financial regulators like issuing banks and the Federal Government.[45][46] In July 2018, the Trump Administration issued a policy statement that allowed FinTech companies to apply for special purpose national bank charters from the federal Office of the Comptroller of the Currency.[47] Federal preemption applies to state law regarding federally chartered banks.[48]

Data security is another issue regulators are concerned about because of the threat of hacking as well as the need to protect sensitive consumer and corporate financial data.[49][50] Leading global fintech companies are proactively turning to cloud technology to meet increasingly stringent compliance regulations.[51]

The Federal Trade Commission provides free resources for corporations of all sizes to meet their legal obligations of protecting sensitive data.[52] Several private initiatives suggest that multiple layers of defense can help isolate and secure financial data.[53]

In the European Union, fintech companies must adhere to data protection laws, such as GDPR. Companies need to proactively protect users and companies data or face fines of 20 million euros, or in the case of an undertaking, up to 4% of their total global turnover.[54] In addition to GDPR, European financial institutions including fintech firms have to update their regulatory affairs departments with the Payment Services Directive (PSD2), meaning they must organise their revenue structure around a central goal of privacy.[55]

Any data breach, no matter how small, can result in direct liability to a company (see the Gramm–Leach–Bliley Act)[56] and ruin a fintech company’s reputation.[57]

The online financial sector is also an increasing target of distributed denial of service extortion attacks.[58][59] This security challenge is also faced by historical bank companies since they do offer Internet-connected customer services.[60]

Many FinTech technologies have very high start-up costs but very low marginal costs for adding additional customers, effectively necessitating many FinTechs to act as natural monopolies.[61]

See also[edit]
References and notes[edit]
Further reading[edit]
* Teigland, R., Siri, S., Larsson, A., Puertas, A. M., & Bogusz, C. I. (Eds.) (2018). The Rise and Development of FinTech (Open Access): Accounts of Disruption from Sweden and Beyond. Routledge. ISBN  .{{cite book}}: CS1 maint: multiple names: authors list (link)
*

Financial Technology Investment Bank San Francisco

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Financial Technology Fintech Definition

What Is Financial Technology – Fintech?
Financial technology (Fintech) is used to describe new tech that seeks to improve and automate the delivery and use of financial services. ​​​At its core, fintech is utilized to help companies, business owners and consumers better manage their financial operations, processes, and lives by utilizing specialized software and algorithms that are used on computers and, increasingly, smartphones. Fintech, the word, is a combination of “financial technology”. 

When fintech emerged in the 21st Century, the term was initially applied to the technology employed at the back-end systems of established financial institutions. ​Since then, however, there has been a shift to more consumer-oriented services and therefore a more consumer-oriented definition. Fintech now includes different sectors and industries such as education, retail banking, fundraising and nonprofit, and investment management to name a few.

Fintech also includes the development and use of crypto-currencies such as bitcoin. While that segment of fintech may see the most headlines, the big money still lies in the traditional global banking industry and its multi-trillion-dollar market capitalization.

Understanding Fintech
Broadly, the term “financial technology” can apply to any innovation in how people transact business, from the invention of digital money to double-entry bookkeeping. Since the internet revolution and the mobile internet/smartphone revolution, however, financial technology has grown explosively, and fintech, which originally referred to computer technology applied to the back office of banks or trading firms, now describes a broad variety of technological interventions into personal and commercial finance.

Fintech now describes a variety of financial activities, such as money transfers, depositing a check with your smartphone, bypassing a bank branch to apply for credit, raising money for a business startup, or managing your investments, generally without the assistance of a person. According to EY’s 2017 Fintech Adoption Index, one-third of consumers utilize at least two or more fintech services and those consumers are also increasingly aware of fintech as a part of their daily lives.

Key Takeaways
* Fintech refers to the integration of technology into offerings by financial services companies in order to improve their use and delivery to consumers.
* It primarily works by unbundling offerings by such firms and creating new markets for them. Startups disrupt incumbents in the finance industry by expanding financial inclusion and using technology to cut down on operational costs.
* Fintech funding is on the rise but regulatory problems abound.

Fintech in Practice
The most talked-about (and most funded) fintech startups share the same characteristic: they are designed to be a threat to, challenge, and eventually usurp entrenched traditional financial services providers by being more nimble, serving an underserved segment or providing faster and/or better service.

For example, Affirm seeks to cut credit card companies out of the online shopping process by offering a way for consumers to secure immediate, short-term loans for purchases. While rates can be high, Affirm claims to offer a way for consumers with poor or no credit a way to both secure credits and also build their credit histories. Similarly, Better Mortgage seeks to streamline the home mortgage process (and obviate traditional mortgage brokers) with a digital-only offering that can reward users with a verified pre-approval letter within 24 hours of applying. GreenSky seeks to link home improvement borrowers with banks by helping consumers avoid entrenched lenders and save on interest by offering zero-interest promotional periods.

For consumers with no or poor credit, Tala offers consumers in the developing world microloans by doing a deep data dig on their smartphones for their transaction history and seemingly unrelated things, such as what mobile games they play. Tala seeks to give such consumers better options than local banks, unregulated lenders and other microfinance institutions.

In short, if you have ever wondered why some aspect of your financial life was so unpleasant (such as applying for a mortgage with a traditional lender) or felt like it wasn’t quite the right fit, fintech probably has (or seeks to have) a solution for you. For example, fintech seeks to answer questions like, “Why is what makes up my FICO score so mysterious and how it is used to judge my creditworthiness?”

As such, loan originator Upstart wants to make FICO (as well as other lenders both traditional and fintech) obsolete by using different data sets to determine creditworthiness. They include employment history, education, and whether a would-be borrower knows their credit score to decide on whether to underwrite and how to price loans. Similar treatment is given to financial services that range from bridge loans for house flippers (LendingHome), to a digital investment platform that addresses the fact that women live longer and have unique savings requirements, tend to earn less than men and have different salary curves that can leave less time for savings to grow (Ellevest). 

Fintech’s Expanding Horizons
Up until now, financial services institutions offered a variety of services under a single umbrella. The scope of these services encompassed a broad range from traditional banking activities to mortgage and trading services. In its most basic form, Fintech unbundles these services into individual offerings. The combination of streamlined offerings with technology enables fintech companies to be more efficient and cut down on costs associated with each transaction.

If one word can describe how many fintech innovations have affected traditional trading, banking, financial advice, and products, it’s ‘disruption,’ like financial products and services that were once the realm of branches, salesmen and desktops move toward mobile devices or simply democratize away from large, entrenched institutions.

For example, the mobile-only stock trading app Robinhood charges no fees for trades, and peer-to-peer lending sites like Prosper Marketplace, Lending Club and OnDeck promise to reduce rates by opening up competition for loans to broad market forces. Business loan providers such as Kabbage, Lendio, Accion and Funding Circle (among others) offer startup and established businesses easy, fast platforms to secure working capital. Oscar, an online insurance startup, received $165 million in funding in March 2018. Such significant funding rounds are not unusual and occur globally for fintech startups.

Entrenched, traditional banks have been paying attention, however, and have invested heavily into becoming more like the companies that seek to disrupt them. For example, investment bank Goldman Sachs launched consumer lending platform Marcus in 2016 and recently expanded its operations to the United Kingdom.

That said, many tech-savvy industry watchers warn that keeping apace of fintech-inspired innovations requires more than just ramped up tech spend. Rather, competing with lighter-on-their-feet startups requires a significant change in thinking, processes, decision-making, and even overall corporate structure.

Fintech and New Tech
New technologies, like machine learning/artificial intelligence, predictive behavioral analytics, and data-driven marketing, will take the guesswork and habit out of financial decisions. “Learning” apps will not only learn the habits of users, often hidden to themselves, but will engage users in learning games to make their automatic, unconscious spending and saving decisions better. Fintech is also a keen adaptor of automated customer service technology, utilizing chatbots to and AI interfaces to assist customers with basic task and also keep down staffing costs. Fintech is also being leveraged to fight fraud by leveraging information about payment history to flag transactions that are outside the norm.

Fintech Landscape
Fintech startups received $17.4 billion in funding in 2016 and were on pace to surpass that sum as of late 2017, according to CB Insights, which counted 26 fintech unicorns globally valued at $83.8 billion. The same firm reported that there were 39 VC-backed fintech unicorns worth $147.37 billion by the end of 2018.

North America produces most of the fintech startups, with Asia a relatively close second. Global fintech funding hit a new high in the first quarter of 2018 let by a significant uptick in deals in North America. Asia, which could surpass the United States in fintech deals, also saw a spike in activity. Funding activity in Europe was at a five-quarter low in Q but surged back in Q2. 

Some of the most active areas of fintech innovation include or revolve around the following areas:

* Cryptocurrency and digital cash.
* Blockchain technology, including Ethereum, a distributed ledger technology (DLT) that maintain records on a network of computers, but has no central ledger.
* Smart contracts, which utilize computer programs (often utilizing the blockchain) to automatically execute contracts between buyers and sellers.
* Open banking, a concept that leans on the blockchain and posits that third-parties should have access to bank data to build applications that create a connected network of financial institutions and third-party providers. An example is the all-in-one money management tool Mint.
* Insurtech, which seeks to use technology to simplify and streamline the insurance industry.
* Regtech, which seeks to help financial service firms meet industry compliance rules, especially those covering Anti-Money Laundering and Know Your Customer protocols which fight fraud.
* Robo-advisors, such as Betterment, utilize algorithms to automate investment advice to lower its cost and increase accessibility.
* Unbanked/underbanked, services that seek to serve disadvantaged or low-income individuals who are ignored or underserved by traditional banks or mainstream financial services companies.
* Cybersecurity, given the proliferation of cybercrime and the decentralized storage of data, cybersecurity and fintech are intertwined.

Fintech Users
There are four broad categories of users for fintech: 1) B2B for banks and 2) their business clients, and 3) B2C for small businesses and 4) consumers. Trends toward mobile banking, increased information, data, and more accurate analytics and decentralization of access will create opportunities for all four groups to interact in heretofore unprecedented ways.

As for consumers, as with most technology, the younger you are the more likely it will be that you are aware of and can accurately describe what fintech is. The fact is that consumer-oriented fintech is mostly targeted toward millennials given the huge size and rising earning (and inheritance) potential of that much-talked-about segment. Some fintech watchers believe that this focus on millennials has more to do with the size of that marketplace than the ability and interest of Gen Xers and Baby Boomers in using fintech. Rather, fintech tends to offer little to older consumers because it fails to address their problems.

When it comes to businesses, before the advent and adoption of fintech, a business owner or startup would have gone to a bank to secure financing or startup capital. If they intended to accept credit card payments they would have to establish a relationship with a credit provider and even install infrastructure, such as a landline-connected card reader. Now, with mobile technology, those hurdles are a thing of the past.

Regulation and Fintech
Financial services are among the most heavily regulated sectors in the world. Not surprisingly, regulation has emerged as the number one concern among governments as fintech companies take off.

As technology is integrated into financial services processes, regulatory problems for such companies have multiplied. In some instances, the problems are a function of technology. In others, they are a reflection of the tech industry’s impatience to disrupt finance.

For example, automation of processes and digitization of data makes fintech systems vulnerable to attacks from hackers. Recent instances of hacks at credit card companies and banks are illustrations of the ease with which bad actors can gain access to systems and cause irreparable damage. The most important questions for consumers in such cases will pertain to the responsibility for such attacks as well as misuse of personal information and important financial data.

There have also been instances where the collision of a technology culture that believes in a “Move fast and break things” philosophy with the conservative and risk-averse world of finance has produced undesirable results. San Francisco-based insurtech startup Zenefits, which was valued at over a billion dollars in private markets, broke California’s insurance laws by allowing unlicensed brokers to sell its products and underwrite insurance policies. The SEC fined the firm $980,000 and they had to pay $7 million to California’s Department of Insurance.

Regulation is also a problem in the emerging world of cryptocurrencies. Initial coin offerings (ICOs) are a new form of fundraising that allows startups to raise capital directly from lay investors. In most countries, they are unregulated and have become fertile ground for scams and frauds. Regulatory uncertainty for ICOs has also allowed entrepreneurs to slip security tokens disguised as utility tokens past the SEC to avoid fees and compliance costs.

Because of the diversity of offerings in fintech and the disparate industries it touches, it is difficult to formulate a single and comprehensive approach to these problems. For the most part, governments have used existing regulations and, in some cases, customized them to regulate fintech.

They have established fintech sandboxes to evaluate the implications of technology in the sector. The passing of General Data Protection Regulation, a framework for collecting and using personal data, in the EU is another attempt to limit the amount of personal data available to banks. Several countries where ICOs are popular, such as Japan and South Korea, have also taken the lead in developing regulations for such offerings to protect investors.

Defi Is The Next Frontier For Fintech Regulation

Regulators need a new approach to regulate Decentralized Finance.

If the existing puzzles of new financial technology—or fintech—were not enough, regulators must now confront an even deeper challenge: blockchain-based decentralized finance, or DeFi for short.

DeFi services use cryptocurrencies and smart contracts to recreate traditional financial instruments and generate new ones. They promise a dynamic, disintermediating revolution in finance. And because they employ decentralized permissionless blockchains as their settlement layer, DeFi platforms are open to anyone with access to cryptocurrencies.

DeFi promises significant benefits, including democratized access to financial products, improved market efficiency, easier access to liquidity, enhanced financial privacy, and faster innovation. DeFi, however, also poses serious and multifaceted risks.

Many of these risks are familiar to financial regulators; some are not. Given the swift growth and evolution of DeFi, regulators cannot afford to wait for market forces to mitigate the risks. I lead a project, in partnership with the World Economic Forum, that is in the process of developing a DeFi policymaker toolkit to assist governments around the world in appropriately addressing this phenomenon.

DeFi, like fintech, is a broad term for a variety of activities. From a regulatory perspective, a proper definition of scope is important. DeFi does not encompass every use of cryptocurrency for financial purposes. The World Economic Forum’s new toolkit identifies three distinctive characteristics of DeFi:

1. Trust-minimized operation and settlement (based on decentralized blockchain networks rather than traditional databases);
2. Non-custodial design (in which investors do not give up control of their assets to intermediaries); and
3. Programmable, open, and composable architecture (allowing services to be modified and combined easily through software code and interfaces).

DeFi is, in some sense, the next step beyond fintech. It does not just build financial services natively as software, but it recreates the entire ecosystem of finance on novel technical foundations. For example, decentralized exchanges, such as Uniswap, replace the market-making and custody features of exchanges with a powerful algorithm that dynamically adjusts prices and executes trades based on available liquidity. DeFi credit services, such as Compound, use dynamic applications to match lenders and borrowers. DeFi derivatives platforms, such as Synthetix, create synthetic assets that automatically track the value of commodities, stocks, indices, or any combination of financial instruments. Other DeFi platforms offer insurance, asset management, and other higher-order financial services.

And because DeFi services are programmable and composable, these examples are just the start.

Until recently, the blockchain and fintech worlds developed along parallel tracks. Even as the prices of bitcoin and other cryptocurrencies skyrocketed in recent years, the intermediaries facilitating these trades were primarily traditional trading firms and centralized exchanges, such as Coinbase, rather than DeFi platforms.

DeFi alternatives took off in 2020. That year, user wallets associated with DeFi services grew by a factor of 11.  As of early March 2021, over $40 billion of cryptocurrency were locked into DeFi collateral pools, up from less than $1 billion in 2019. One reason for the growth was the maturation of stablecoins—cryptocurrencies designed to track the value of stable assets, such as the U.S. dollar. Stablecoins addressed the market risk of investing based on volatile cryptocurrencies, such as bitcoin. A second reason was the emergence of incentive structures, such as yield farming and governance tokens, through which participants earn returns for providing liquidity to DeFi services.

From a regulatory standpoint, DeFi poses several types of risks. Blockchain networks are decentralized and global, so participation in DeFi activities does not require interaction with the regulated financial system or other national legal regimes, such as taxation and national identity systems.

Even when a corporate entity develops the software for a DeFi service, the service itself is just software code executing on a blockchain and accessible to all through the internet, making enforcement challenging. The problems of fraud, money laundering, and financing illicit activities that have long been widespread in the world of cryptocurrencies and initial coin offerings are also serious concerns for DeFi.

DeFi also poses unique regulatory challenges that will become more serious as it grows.

Although the underlying settlement layer of major blockchains—such as Ethereum—is highly secure, the smart contract code powering DeFi services may not be. There have already been many instances of attackers exploiting bugs to drain millions of dollars. Other attacks exploit the automated nature of DeFi protocols themselves. For example, oracle attacks manipulate the external price feeds flowing into DeFi trading algorithms. If an application automatically sells collateral when an index hits a certain price, an attacker can profit illegitimately if they manipulate that price. Flash loans, which create temporary liquidity as a new block is added to the blockchain, make such attacks more dangerous.

The decentralized governance of DeFi services poses significant operational challenges, such as management of cryptographic keys and game-theoretic design of token voting structures, which are not well-understood in financial risk management and compliance. In addition, DeFi is so new—and so complex due to its composable infrastructure made up of many different services—that market behavior is especially difficult to predict. The vulnerabilities and systemic risks associated with DeFi projects may differ from those in traditional finance.

To address DeFi risks, regulators must map these risks onto their matrix of public policy objectives, including investor protection, market integrity, and financial crime prevention. As with any new market, classification issues will be challenging. The panoply of existing regulatory categories arose under different statutory and administrative frameworks that were designed with centralized financial services in mind.

Regulators must adapt the current regulatory framework to DeFi services. They can learn from techniques that are proving effective for the existing cryptocurrency market. For example, specialized units, such as the U.S. Securities and Exchange Commission’s FinHub and the Commodity Futures and Trading Commission’s LabCFTC, allow regulators to gain experience in new technology, interact productively with the industry, and provide informal regulatory guidance. Disclosure requirements or safe harbors can encourage market participants to provide regulators with information that helps them better understand market dynamics and develop best practices.

Regulatory sandboxes, such as the one the United Kingdom’s Financial Conduct Authority established for fintech, create a safe space for regulators and innovative services to work through issues. In addition, regulators should clarify relatively easy cases first to provide guidance to the industry. This can give regulators space to take on the harder questions later, while ensuring market participants remain confident in the broad contours of the regulatory environment.

In 2017, regulators waited too long to speak out about what was clearly a speculative bubble around blockchain initial coin offerings. Although regulators’ desire to avoid chilling innovation was admirable, some market participants took the lack of clear statements as a decision not to regulate what were, in some cases, obviously regulated investment contracts.

The potential for fraud and excessive risk always exists in financial markets. Regulators have the opportunity early on to shape expectations by working with responsible entities, while taking aggressive enforcement action against bad actors. The window to do so is open for DeFi. It will not remain open for long.

This essay is part of an 11-part series, entitled Regulation In the Era of Fintech.