WHAT IS FINTECH: INTRODUCTION
Part I – Introduction
In recent years, technology-driven innovation in financial services, or “FINTECH”, has attracted increasing attention. FORFIRM mandated a task force to analyse financial technology innovations and emerging business models in the banking sector. This document presents the results of the analysis undertaken to identify and assess risks and related supervisory challenges, both for banks and bank supervisors. The work was conducted in two main phases. First, FORFIRM outlined the current h landscape and supervisory approaches to FINTECH developments, using industry research and surveys of member institutions. In FINTECH the second phase, FORFIRM identified the implications for banks and challenges for effective supervision, and conducted more detailed surveys on specific arrangements towards innovation and licensing practices. Using scenario analyses, the BCBS also developed its own forwardlooking exercise, and analysed specific case studies. This paper presents the main findings from the work conducted and highlights 10 key implications and considerations for banks and supervisors. When analysing the issues at stake, FORFIRM ensured that it focused not only on risks that could emerge or increase with the development of FINTECH but also on the potential benefits that technology driven innovation could bring to financial services from the perspectives of different bank stakeholders (including customers and supervisors). FORFIRM also maintained a balanced approach by considering not only the perspective of incumbent banks but also of new players. Part II of this paper provides an overview of the FINTECH landscape and the current state of the industry. Part III focuses on challenges and implications for banks. Part IV provides implications for supervisors and regulatory frameworks.
Part II – FINTECH developments and forward-looking scenarios
A. What is fintech?
FORFIRM has opted to use the Financial Stability Board’s (FSB) working definition for FINTECH as “technologically enabled financial innovation that could result in new business models, applications, processes, or products with an associated material effect on financial markets and institutions and the provision of financial services”.3 This broad definition is considered useful by the BCBS in the light of the current fluidity of FINTECH developments. That being so, the focus of the analysis and implications of this paper is on the effects of fintech that are particularly relevant for banks and bank supervisors. It is also worth noting that the term fintech is used here to describe a wide array of innovations both by incumbent banks and entrants, be they start-ups or larger technology firms. The results of a comparative survey on supervisory approaches indicate that most surveyed agencies have not formally defined fintech, innovation or other similar terms. Some of the reasoning provided for this lack of formal definitions was that other definitions already exist, such as the FSB’s, or that it would be premature to more narrowly define a field that is rapidly evolving. However, some agencies and organisations reported that they had developed definitions for these terms. An observation from the various definitions of fintech, innovation or similar terms that were identified is that they designate an innovative service, business model (which can be provided by an incumbent bank or a non-financial company) or a new-technology start-up in the financial industry. A second observation is that some definitions made clear distinctions between innovation and disruption, with innovation fitting within existing regulatory frameworks while disruption requires the development of new rules. How fintech, innovation and other similar terms are defined is important, as the definition can influence how supervisors approach fintech. While no umbrella definition may be needed in order to consider fintech developments, jurisdictions may have to define specific products and services in order to set a specific approach for possible regulation. Because of the importance of clear definitions, a glossary of terms and acronyms used in this document is provided in Annex 1.
FORFIRM conducted an informal survey of its members, asking them to identify the significant FINTECH products and services within their jurisdictions. The number of FINTECH companies reported for each sector is shown in Graph 2 below.
Source: BCBS. Respondents reported that the highest number of fintech service providers are in the payments, clearing and settlement category, followed by credit, deposit and capital-raising services. Within the payments, clearing and settlement category, retail payment services firms represented the majority of fintech firms identified, as compared with wholesale payment services providers. The number of market support servicers, meaning companies that provide support for fintech financial services, was second only to payments, clearing and settlement services in the number of players identified. While the survey identified the names and made an initial attempt to quantify the number of key fintech providers and services, the absence of further data on details such as processing volumes and transaction values limits any assessment of the potential impact that these organisations may have on the incumbent banks as well as on financial systems. This exercise allowed supervisors to get a better understanding of the emerging fintech firms in the various jurisdictions and to identify the types of products and services with higher levels of entrants, and showed that, for most services, fintech firms are focused on markets at a national or regional level.
How big is FINTECH?
Quantifying the size and growth of FINTECH and its potential impact on the banking industry is difficult as the necessary data are often lacking, as noted above. One growth measure that can be used is venture capital (VC) investment in FINTECH companies. A KPMG report shows that, in 2016, global venture investment in FINTECH companies reached $13.6 billion across 840 deals (Graph 3). In addition to the investment made by VC funds, many of which are backed by financial institutions, banks and other institutional investors are also making large direct investments in FINTECH companies.
According to KPMG’s study, the value of new fintech investments fell from $47 billion in 2015 to $25 billion in 2016 (Graph 4). Data quoted in an IOSCO report7 point to cumulative investments of over $100 billion in more than 8,800 fintech companies as at November 2016.
Although VC-invested capital has continued to increase, including in 2016, last year’s apparent decline in volumes and total capital investment have led some to speculate that the enthusiasm regarding fintech has reached the initial peak of the “hype cycle” (Box 1). That is, there is typically a tendency to overestimate the implications of new technologies or innovations in the short term and underestimate the implications in the longer term. In addition, the above figures do not capture internal investments incumbent banks have made to develop their own fintech innovations as a result of an increasing strategic focus on digitisation in the past years. Based on information available, the BCBS notes that, despite the hype, the large size of investments and the significant number of financial products and services derived from fintech innovations, volumes are currently still low relative to the size of the global financial services sector. That being said, the trend of rising investment and the potential long-term impact of fintech warrant continued focus by both banks and bank supervisors.
Comparison with previous waves of innovation and factors accelerating change
As discussed, FINTECH firms currently represent a relatively small portion of the global banking services market. Regionally, however, some FINTECH companies already provide a considerable part of local banking services (eg M-Pesa in Kenya and Tanzania, and Alipay in China).8 Whether new entrants could potentially take a significant share of more developed banking markets and thus challenge incumbent banks remains an open question. To get a better sense of current developments, FINTECH can be compared with previous waves of innovation, such as automated teller machines (ATMs), videotex, electronic payments and internet. The report draws on some examples from specific private firms involved in FINTECH. These examples are not exhaustive and do not constitute an endorsement by the BCBS or their members for any firm, product or service. Similarly, they do not imply any conclusion about the status of any product or service described under applicable law. Rather, such examples are included for purposes of illustration of new and emerging business models in the markets studied. banking. Although not all of these innovations may have been successful, they have cumulatively changed the face of banking. Compared with the late 1960s, for instance, there are fewer branches and bank employees, larger IT budgets, longer opening hours (even 24/7), and shorter transaction times. Technological innovations have also historically tended to follow the “hype cycle”. A prime example is the internet, which went through a boom-bust cycle around the turn of the century. When the dotcom bubble burst in 2001, it seemed to blow away the promise of the internet as a major marketplace. Today, the internet has become a major platform for business, and large parts of the global population could not envisage their lives without it. Thus fintech in general may well be hyped and some innovations may already be entering the “trough of disillusionment” but, as history shows, this does not necessarily mean that fintech will have no lasting effect on the banking sector. When assessing the recent impact of new technologies on the banking industry, two factors are especially relevant, namely (i) the adoption rate of the underlying technology in society, and (ii) the degree and pervasiveness of technological know-how within the general population. The current pace of innovation is arguably faster than in previous decades,9 and there are clear signs that the pace of adoption has also increased. For instance, when comparing the length of time for adoption of different banking innovations, ATM adoption occurred over two decades, while internet banking and mobile banking have taken root over progressively shorter intervals. In addition, a generation of digital natives is growing up with a technological proficiency that is at the heart of FINTECH innovation. In fact, changing customer behaviour and demand for digital financial services are the key drivers for change. The faster pace of change means that the effects of innovation and disruption can happen more quickly than before, implying that incumbents may need to adjust faster.
1. Background to the scenarios .To assess the impact of the evolution of FINTECH products and services on the banking industry, five stylised scenarios describing the potential impact of FINTECH on banks were identified as part of an industry-wide scenario analysis (see Graph 5). It should be noted that at a more granular level the way these scenarios play out would certainly vary with the size or geography of the different actors. In the same vein, FORFIRM does not see these scenarios as being mutually exclusive and comprehensive, and in fact, the evolution of the banking industry may result in a combination of scenarios. In addition to the banking industry scenarios, six case studies focus on specific innovations, with three assessing enabling technologies (big data, distributed ledger technologies –DLT- and cloud computing) and three assessing FINTECH business models (innovative payment services, lending platforms and neo-banks). The aim is to obtain a better understanding of the individual risks and potential opportunities of a specific FINTECH development through the different scenarios.
2. Overview of banking industry identified scenarios. The key questions considered when developing the banking industry scenarios for the purposes of this paper were (i) which actor manages the customer relationship or interface, and (ii) which actor ultimately provides the services and takes the risk. The rise of FINTECH innovation has resulted in what some have dubbed the battle for the customer relationship and customer data. The outcome of this battle will be crucial in determining the future role of banks. The other key consideration surrounds potential changes in banks’ business models and the different roles incumbent banks and other fintech companies, including major technology companies (“bigtech”, Box 2), may play in either owning the customer relationship or, as service providers, supporting the processing of banking activities. The second question concerns who will be primarily responsible for what may be seen as traditional core banking services, such as lending, deposit-taking, offering payment and investment services, and managing risk. Importantly, the FORFIRM is aware that future regulation will both result from and shape these scenarios and the way they interact. An overview of the five scenarios of the industry-wide forward-looking analyses is provided in Graph 5, while the individual scenarios are discussed in more detail in the next section.
Bigtech refers to large globally active technology firms with a relative advantage in digital technology. Bigtech firms usually provide web services (search engines, social networks, e-commerce etc) to end users over the internet and/or IT platforms or they maintain infrastructure (data storage and processing capabilities) on which other companies can provide products or services. Just like fintech companies, bigtech firms typically have a highly automated operation and an agile software development process, giving them the agility to quickly adapt their systems and services to users’ needs. Bigtech firms have typically established global operations and a large customer base. They can use a vast amount of information about their customers to provide them with tailored financial services. Thus, bigtech firms may have a considerable competitive advantage over their competitors, eg incumbent banks, in the provision of financial services. These companies can rapidly gain a significant global market share when launching a new financial product or service. Given the size of their operations and their investment capabilities, bigtech can also influence markets. Many banks, financial institutions and fintech companies are partnering with bigtech firms, which then become relevant third-party providers in the financial system. It will therefore be important to properly monitor and assess the concentration risk, given that bigtech firms could become systemically important. Examples of bigtech firms in the western world are Google, Amazon, Facebook and Apple, collectively known as GAFA. Similarly, BAT refers to three of the largest Chinese technology companies, namely Baidu, Alibaba and Tencent. In addition, traditional companies such as Microsoft and IBM are also tech companies relevant to the financial system and may be included in any analysis regarding bigtech.
Description of the scenarios
The better bank: modernisation and digitisation of incumbent players In this scenario the incumbent banks digitise and modernise themselves to retain the customer relationship and core banking services, leveraging enabling technologies to change their current business models. Incumbent banks are generally under pressure to simultaneously improve cost efficiency and the customer relationship. However, because of their market knowledge and higher investment capacities, a potential outcome is that incumbent banks get better at providing services and products by adopting new technologies or improving existing ones. Enabling technologies such as cloud computing, big data, AI and DLT are being adopted or actively considered as a means of enhancing banks’ current products, services and operations.
Banks use new technologies to develop value propositions that cannot be effectively provided with their current infrastructure. The same technologies and processes utilised by non-bank innovators can also be implemented by incumbent banks, and examples may include:
• New technologies such as biometry, video, chatbots or AI may help banks to create sophisticated capacities for maintaining a value-added remote customer relationship, while securing transactions and mitigating fraud and AML/CFT risks. Many innovations seek to set up convenient but secure customer identification processes.
• Innovative payment services would also support the better bank scenario. Most banks have already developed branded mobile payments services or leveraged payment services provided by third parties that integrate with bank-operated legacy platforms. Customers may believe that their bank can provide a more secure mobile payments service than do non-bank alternatives.
• Banks may also be prone to offer partially or totally automated robo-advisor services, digital wealth management tools and even add-on services for customers with the intention of maintaining a competitive position in the retail banking market, retaining customers and attracting new ones.
• In this scenario, digitising the lending processes is becoming increasingly important to meet the consumer’s demands regarding speed, convenience and the cost of credit decision-making. Digitisation requires more efficient interfaces, processing tools, integration with legacy systems and document management systems, as well as sophisticated customer identification and fraud prevention tools. These can be achieved by the incumbent by developing its own lending platform, purchasing an existing one, white labelling or outsourcing to third-party service providers. This scenario assumes that current lending platforms will remain niche players. While there are early signs that incumbents have added investment in digitisation and modernisation to their strategic planning, it remains to be seen to what extent this scenario will be dominant.
The new bank: replacement of incumbents by challenger banks In the future, according to the new bank scenario, incumbents cannot survive the wave of technologyenabled disruption and are replaced by new technology-driven banks, such as neo-banks, or banks instituted by bigtech companies, with full service “built-for-digital” banking platforms. The new banks apply advanced technology to provide banking services in a more cost-effective and innovative way. The new players may obtain banking licences under existing regulatory regimes and own the customer relationship, or they may have traditional banking partners. Neo-banks seek a foothold in the banking sector with a modernised and digitised relationship model, moving away from the branch-centred customer relationship model. Neo-banks are unencumbered by legacy infrastructure and may be able to leverage new technology at a lower cost, more rapidly and in a more modern format (see Box 3). Elements of this scenario are reflected in the emergence of neo- and challenger banks, such as Atom Bank and Monzo Bank in the United Kingdom, Bunq in the Netherlands, WeBank in China, Simple and Varo Money in the United States, N26 in Germany, Fidor in both the United Kingdom and Germany, and Wanap in Argentina.11 That said, no evidence has emerged to suggest that the current group of challenger banks has gained enough traction for the new bank scenario to become predominant.
Neo-banks make extensive use of technology in order to offer retail banking services predominantly through a smartphone app and internet-based platform. This may enable the neo-bank to provide banking services at a lower cost than could incumbent banks, which may become relatively less profitable due to their higher costs. Neo-banks target individuals, entrepreneurs and small to medium-sized enterprises. They offer a range of services from current accounts and overdrafts to a more extended range of services, including current, deposit and business accounts, credit cards, financial advice and loans. They leverage scalable infrastructure through cloud providers or API-based systems to better interact through online, mobile and social media-based platforms. The earnings model is predominantly based on fees and, to a lesser extent, on interest income, together with lower operating costs and a different approach to marketing their products, as neo-banks may adopt big data technologies and advanced data analytics. Incumbent banks, on the other hand, may be impeded by the scale and complexity of their current technology and data architecture, determined by factors such as legacy systems, organisational complexity and historical acquisitions. However, the customer acquisitions costs may be high in competitive banking systems and neo-banks’ revenues may be offset by their aggressive pricing strategies and their less-diverse revenue streams.
The distributed bank: fragmentation of financial services among specialised fintech firms and incumbent banks
In the distributed bank scenario, financial services become increasingly modularised, but incumbents can carve out enough of a niche to survive. Financial services may be provided by the incumbents or other financial service providers, whether FINTECH or bigtech, who can “plug and play” on the digital customer interface, which itself may be owned by any of the players in the market. Large numbers of new businesses emerge to provide specialized services without attempting to be universal or integrated retail banks – focusing rather on providing specific (niche) services. These businesses may choose not to compete for ownership of the entire customer relationship. Banks and other players compete to own the customer relationship as well as to provide core banking services. In the distributed bank scenario, banks and FINTECH companies operate as joint ventures, partners or other structures where delivery of services is shared across parties. So as to retain the customer, whose expectations in terms of transparency and quality have increased, banks are also more apt to offer products and services from third-party suppliers. Consumers may use multiple financial service providers instead of remaining with a single financial partner. Elements of this scenario are playing out, as evidenced by the increasing use of open APIs in some markets. Other examples that point towards the relevance of this scenario are:
• Lending platforms partner and share with banks the marketing of credit products, as well as the approval process, funding and compliance management. Lending platforms might also acquire licences, allowing them to do business without the need to cooperate with banks.
• Innovative payment services are emerging with joint ventures between banks and FINTECH firms offering innovative payment services. Consortiums supported by banks are currently seeking to establish mobile payments solutions as well as business cases based on DLT for enhancing transfer processes between participating banks (see Box 4 for details of mobile wallets).
• Robo-advisor or automated investment advisory services are provided by fintech firms through a bank or as part of a joint venture with a bank.
The relegated bank: incumbent banks become commoditised service providers and customer relationships are owned by new intermediaries
In the relegated bank scenario, incumbent banks become commoditised service providers and cede the direct customer relationship to other financial services providers, such as fintech and bigtech companies. The fintech and bigtech companies use front-end customer platforms to offer a variety of financial services from a diverse group of providers. They use incumbent banks for their banking licences to provide core commoditised banking services such as lending, deposit-taking and other banking activities. The relegated bank may or may not keep the balance sheet risk of these activities, depending on the contractual relationship with the fintech company. In the relegated bank scenario, big data, cloud computing and AI are fully exploited through various configurations by front-end platforms that make innovative and extensive use of connectivity and data to improve the customer experience. The operators of such platforms have more scope to compete directly with banks for ownership of the customer relationship. For example, many data aggregators allow customers to manage diverse financial accounts on a single platform. In many jurisdictions consumers become increasingly comfortable with aggregators as the customer interface. Banks are relegated to being providers of commoditised functions such as operational processes and risk management, as service providers to the platforms that manage customer relationships. Although the relegated bank scenario may seem unlikely at first, below are some examples of a modularised financial services industry where banks are relegated to providing only specific services to another player who owns the customer relationship:
• Growth of payment platforms has resulted in banks providing back office operations support in such areas as treasury and compliance functions. Fintech firms will directly engage with the customer and manage the product relationship. However, the licensed bank would still need to authenticate the customer to access funds from enrolled payment cards and accounts.
• Online lending platforms become the public-facing financial service provider and may extend the range of services provided beyond lending to become a new intermediary between customers and banks/funds/other financial institutions to intermediate all types of banking service (marketplace of financial services). Such lending platforms would organise the competition between financial institutions (bid solicitations) and protect the interests of consumers (eg by offering quality products at the lowest price). Incumbent banks would exist only to provide the operational and funding mechanisms.
• Banks become just one of many financial vehicles to which the robo-advisor directs customer investments and financial needs. • Social media such as the instant messaging application WeChat13 in China leverage customer data to offer its customers tailored financial products and services from third parties, including banks. The Tencent group has launched WeBank, a licensed banking platform linked to the messaging application WeChat, to offer the products and services of third parties. WeBank/WeChat focuses on the customer relationship and exploits its data innovatively, while third parties such as banks are relegated to product and risk management.
The disintermediated bank: Banks have become irrelevant as customers interact directly with individual financial services providers
Incumbent banks are no longer a significant player in the disintermediated bank scenario, because the need for balance sheet intermediation or for a trusted third party is removed. Banks are displaced from customer financial transactions by more agile platforms and technologies, which ensure a direct matching of final consumers depending on their financial needs (borrowing, making a payment, raising capital etc). In this scenario, customers may have a more direct say in choosing the services and the provider, rather than sourcing such services via an intermediary bank. However, they also may assume more direct responsibility in transactions, increasing the risks they are exposed to. In the realm of peer-to-peer (P2P) lending for instance, the individual customers could be deemed to be the lenders (who potentially take on credit risk) and the borrowers (who may face increased conduct risk from potentially unregulated lenders and may lack financial advice or support in case of financial distress). At the moment, this scenario seems far-fetched, but some limited examples of elements of the disintermediation scenario are already visible:
• P2P lending platforms could manage to attract a significant number of potential retail investors so as to address all funding needs of selected credit requests. P2P lending platforms have recourse to innovative credit scoring and approval processes, which are trusted by retail investors. That said, at present, the market share of P2P lenders is small in most jurisdictions. Additionally, it is worth noting that, in many jurisdictions, P2P lending platforms have switched to, or have incorporated elements of, a more diversified marketplace lending platform business model, which relies more on the funding provided by institutional investors (including banks) and funds than on retail investors.
• Cryptocurrencies, such as Bitcoin, effect value transfer and payments without the involvement of incumbent banks, using public DLT. But their widespread adoption for general transactional purposes has been constrained by a variety of factors, including price volatility, transaction anonymity – raising AML/CFT issues – and lack of scalability.
Actual illustration of a blend of scenarios: marketplace lending
As noted above, the scenarios presented are extremes and there will likely be degrees of realisation and blends of different scenarios across business lines. Future evolutions may likely be a combination of the different scenarios with both fintech companies and banks owning aspects of the customer relationship while at the same time providing modular financial services for back office operations. For example, Lending Club,14 a publicly traded US marketplace lending company, arguably exhibits elements of three of the five banking scenarios described. An incumbent bank that uses a “private label” solution based on Lending Club’s platform to originate and price consumer loans for its own balance sheet could be characterised as a “distributed bank”, in that the incumbent continues to own the customer relationship but shares the process and revenues with Lending Club. Lending Club also matches some consumer loans with retail or institutional investors via a relationship with a regulated bank that does not own the customer relationship and is included in the transaction to facilitate the loan. In these transactions, the bank’s role can be described as a “relegated bank” scenario. Other marketplace lenders reflect the “disintermediated” bank scenario by facilitating direct P2P lending without the involvement of a bank at any stage.