«They say things are happening at the border, but nobody knows which border» (Mark Strand)
by Andrea Minto
Abstract: This paper reproduces the Opening Speech delivered at the Conference “The Transition to the FinTech Era: Survey, Challenges and a Way-Forward”, held at the University of Utrecht, 8 May 2017.
Summary: 1. Financial innovation and technological changes under a law and economics perspective. – 2. The evolution of financial regulation. – 3. Concluding remarks.
1. Traditionally, financial innovation has been regarded as a change in the type and variety of available financial products. Technological changes relating to telecommunications and data processing have spurred financial innovations that have altered bank products and services and bank production processes alike. A vast amount of literature studied the development of novel financial products and scrutinized the implications that have come with it. One strand of economic scholarship mapped out the ability of technological improvements to increase efficiency, whenever something new that reduces costs, reduces risks or provides an improved product/service is being created.
On the other hand, the 2007-2008 global financial crisis (GFC) showed that financial innovation might land far from attaining services that better satisfy financial system participants’ demand. Quite to the contrary, financial innovation could result in products which are designed to obscure the attendant risks and which are traded in opaque dealer-intermediated markets by opaque financial institutions, ultimately making end financial consumers worse off. Credit default swap, residential mortgage-backed securities, collateralized debt obligations have indeed ignited a great deal of discussion on informational asymmetry between intermediaries and investors, agency cost problems and transaction costs as well as on the relationship between financial innovation and financial stability. The negative economic and societal consequences provoked by these sophisticated products have exerted a profound influence on how to perceive financial innovation and, perhaps most significantly, revealed the intellectual challenge to adequately account for both the “good” and the “bad” of it.
From a regulatory perspective, the wake-up call made by the GFC caused policy makers to approach financial innovation as a process of change – but not necessarily one of improvement – which needs to be closely looked at.
More recently, however, along with the creation and marketing of new financial products, a more radical process of change has started off in the financial sector.
Over the past few years, in fact, new providers who combine digital technologies with financial services have been entering the market. Innovative business models, applications, processes, and products have been coming about, with an appreciable effect on competitive pressure and patterns, consumers’ experience and market dynamics.
This process is relentlessly projected to affect competition in some parts of the financial system and to impact on its structure and dynamics. Several digital-based technologies as applied to financial services, such as distributed ledger technology, usher in new products, new business models and new ways of affecting transaction and intermediation. Fintech companies are already nibbling away at incumbents’ market share and their profitability and thus changing financial industry’s competitive patterns.
2. The financial sector is thus rapidly evolving under the impetus for changes triggered by information technology. Not only had competitive pressure become more intense, but the institutional structure of financial institutions and the dividing line between institutions and financial markets have been transformed and blurred respectively.
Coupled with that, the current macro-financial environment as characterized by exceptionally low nominal interest rates makes banks face profitability pressure and growing competition from the non-banking sector. The low interest rate environment is likely to accelerate the transition towards a more “market-based” structure while increasing the odds for fintech companies to successfully establish themselves at the expense of financial institution incumbents dragged down by unsustainable business models. A joint Task Force at the ESRB-ECB has recently expressed serious concerns on how the current macro-financial scenario, along with the competitive trends technological innovation is bringing up, might entail a risk of higher sensitivity to market shocks: not only are fintechs (able to) enticing customers away from banks and so raising concerns about business models’ sustainability, but they are also more profoundly contributing in building up vulnerabilities to financial stability.
Despite considerable scholarly ink has been spilled on financial innovation, little attention, if any, has been paid on how technological innovation creates significant repercussions at industry level and causes structural change to the industry itself, opening up new markets and value networks while shaking up established market players. And nor has it been researched on whether the current regulatory “thinking” and approach (pretty much based on the traditional intermediation) is still appropriate to deal with the rise of dis-intermediation.
To my mind, the process of change ignited by FinTech should be approached as a moving target to get captured. Interestingly enough, the regulatory engagement with FinTech – and the host of societal challenges that comes with it – resembles a hunting expedition.
Let me explain you the hunting analogy.
Assume you want to figure out the best hunting technique to hit a moving target.
You will be thinking of moving the rifle such that it follows the trajectory of the target, staying slightly ahead of where the target lies. This technique is called leading the target and it is easier to accomplish when the target is barely moving, such as a deer slowly walking in the distance.
As the speed of the target increases, leading does not work out that well. You might use the trapping technique, holding still your rifle and shooting in advance such that the target basically walks into the path of the bullet. It is harder than leading, since you must accurately judge the speed of the target and its trajectory.
Either way, you try to make an estimate of your target’s moves and trajectory.
Now, the same holds particularly true for what is happening on financial markets.
Policy and law-makers and supervisors are indeed holding their rifles as to keep a close eye on financial innovation, striving to predict its pace and trajectory. And yet, what makes hunting a challenging activity goes way beyond the target itself. A good hunter should account for the specific environment they found themselves in. It all comes down to the capability of capturing a target in a given environment, in a specific setting. And in fact, before squeezing the trigger a hunter needs to carefully consider, for instance:
– The type of rifle they handle.
– The direction and strength of the wind.
– Brush, vegetation, or other obstacles between the hunter and the target.
– The movement of other animals and its influence on the movement of our target (herding behaviour)
To understand why “regulating Fintech” can be compared to hunting, it is useful to start by recognizing an awkward reality: we are way too much focused on the target, while overlooking the environment and the other factors affecting our capability to shot.
As the metaphor goes, to my mind, capturing FinTech (or the process of change behind it) requires in fact focusing on the financial environment and ecosystem, rather than on innovation itself. Not only are new species – new providers and services – entering the market and being offered respectively, but the infrastructure – the framework, platforms and structures that determine how firms, consumers and policy- and law-makers interact — is changing. Consequently, in my opinion, the regulatory approach and engagement with financial innovation should take into account that the industry itself and the environment – as a nexus of parties – are confronting technological change. Some of the recent inventions in information technology such as distributed ledger technology, big data and robo-advisors have indeed the potential to significantly affect the basic infrastructure for financial services and to change the way consumers and financial institutions interact when buying or selling financial products
In other words, to give you an example, FinTech is not about Bitcoin itself, but about re-thinking money and how commercial transaction are effected and substantiated.
Technological advancement is in fact affecting “money”, “ledgers”, “risk and time allocation”, “information” and all the basic infrastructures financial activities have been traditionally based upon.
Innovation is challenging the ability of regulators to respond and adapt. The proliferation of new market infrastructures as a result challenges academics and policymakers alike at both conceptual and operational levels of regulatory design, and calls for an alliance between different branches of knowledge. In accounting for the complexity of modern financial intermediation we need to duly foster cross-fertilisation between disciplines and methodologies. Only by building upon a rich foundation of approaches that span law, finance, economics and sociology, we are able to move the debate towards the examination of questions respecting the best policy and regulatory responses.
Utrecht University is committed to embrace such a challenge. Fintech is in fact one of the strategic themes that Utrecht University is pursuing, with the involvement of many research hubs and centres.
3. In that respect I want to close by thanking some of these research hubs who kindly sponsored this event. We wouldn’t be here today without the support of RENFORCE, RESILIENT SOCIETY PROJECT AND INSTITUTIONS FOR OPEN SOCIETY. Thank you all.
Besides, I would like to thank all the speakers for accepting my invitation and to travel across Europe, and beyond, as to join and contribute in the debate.
I am proud of having a terrific line-up, today. The key-note speech is assigned to Mr. Andrea Enria, Chairman of the European Banking Authority. I am thrilled by the idea that today the EBA is for the very first time publicly sharing their regulatory and supervisory strategy to cope with FinTech.
Mr. Andrea Enria will introduce the EBA, its objectives, tasks, scope of action and available legal instruments. He will explain the EBA’s methodological approach to FinTech innovations, using three recent case studies for illustration: Virtual Currencies, Automation in Financial Advice (“Robo-advice”); and payment initiation and account information services under PSD2. His lecture will then outline the EBA’s focus for 2017, when the EBA will be looking at the topic of FinTech more broadly, by assessing banks’ responses to FinTech challenges and opportunities; the impact of FinTech on banks’ business models; and issues around the perimeter of regulation, authorisation, and ‘sandboxes’ and similar approaches and regimes.
Creating a suitable regulatory framework for addressing financial innovation thus requires optics accurate enough to concretely evaluate and sift the functional implications of technological advancement and financial innovation on the market. Distributed ledger Technology is not making our life different in itself, but its implementation and application is capable of modifying consumption patterns, attitudes and behaviors in ways that upend market practices that demand specific regulatory responses. The pace of innovation and the uncertainties relating to the placement and interaction of fintechs with traditional financial intermediation render it more difficult for supervisors to locate, assess and oversee potential risks.
Financial innovation hence requires policy- and law-makers to examine a diverse and dynamic market ecosystem vis-à-vis expanding sets of policy goals and regulatory mandates.
I hope that this conference, through active and lively discussions, will lead to many creative and practical ideas on how to devise the best “hunting technique” as to hit a moving target.
 See, in general, E. Avgouleas, International credit markets: Players, financing techniques, instruments and regulation, in H. Bigdoli (ed.), The Handbook of Technology Management, 2009, 675-692.
 Arnoud W.A. Boot, Anjan V. Thakor, Commercial banking and shadow banking. The accelerating integration of banks and markets and its implications for regulation, Berger, Molyneux, Wilson (eds.), The Oxford handbook of banking, 2015, 47-76.
 R.C. Merton, Financial innovation and economic performance, Journal of applied corporate finance, 1992, 4(4), 12-22; P. Tufano, Financial innovation, GM. Constantinides, M. Harris, R. Stulz (eds.), Handbook of the economics of finance, 2003, Amsterdam, 307-335; F. Allen, Trends in financial innovation and their welfare impact: An overview, European financial management 2012, 18(4), 493-514; for a legal perspective on the subject, see, i.e., C. Brummer, Disruptive technology and securities regulation, Fordham Law Review, 2015, 84, 977.
 B.J. Henderson, N.D. Pearson, The dark side of financial innovation: A case study of the pricing of a retail financial product, Journal of financial economics, 2011, 100(2), 227-247, provide recent empirical analysis of a welfare-reducing financial innovation.
 “Complexity and innovation have combined to generate significant asymmetries of information and expertise within financial markets, thereby opening the door to suboptimal contracting and exacerbating already pervasive agency cost problems”: so maintains D. Awrey, Complexity, innovation and the regulation of modern financial markets, Harvard Business Law Review, 2012, 2, 238-239. More broadly, touching upon some perverse consequences of securitization, see N. Jenkinson, A. Penalver, N. Vause, Financial innovation: What have we learnt?, Bank of England Quarterly Bulletin, 2008.
 See, i.e., N. Gennaioli, A. Shleifer, R.W. Vishny, Neglected risks, financial innovation and financial fragility, Journal of Financial Economics, 2012, 104(3), 452-468. Some scholars argue that financial innovation correlates with increased systemic risk for the financial and economic systems. Since financial innovation involves more credit creation, such increases in leverage as a systemic phenomenon often creates greater risk for all participants and could raise systemic fragility in the face of shocks or crises: T. Adam, A. Guetter, Pitfalls and perils of financial innovation: The use of CDS by corporate bond funds, Journal of Banking and Finance, 2015, 55, 204; T. Yorulmazer, Has financial innovation made the world riskier?, CDS, regulatory arbitrage and systemic risk, Federal Reserve Bank of New York Paper, 2013, available at SSRN: https://ssrn.com/abstract=2176493 .
 Z. Gubler, Instruments, institutions and the modern process of financial innovation, Delaware Journal of Corporate Law, 2011, vol. 36, 58 states that “financial innovation must be understood first and foremost as a process of change, a change in the type and variety of available financial products to be sure, but also a change in financial intermediaries and markets themselves”.
 According to a survey performed by PWC (PWC Global FinTech Survey 2016, available at http://www.pwc.com/gx/en/advisory-services/FinTech/PwC%20FinTech%20Global%20Report.pdf ), the current situation seems to combine fintechs challenging incumbent financial institutions with fintechs being bought up by incumbents which feel their business models’ viability under threat. The data collected in various segments of the markets, such as payments, banking, insurance, asset management, show that 32% of the respondents engage in joint partnerships with Fintech companies, 9% acquire them and 22% buy and sell services to Fintech companies.
 W. Scott Frame, Lawrance J. White, Technological change, financial innovation, and diffusion in banking, Berger, Molyneux, Wilson (eds.), The Oxford handbook of banking, 2015, 271-311.
 World Bank, Global Economic Prospects. Divergences and Risks, June 2016, available at http://pubdocs.worldbank.org/en/842861463605615468/Global-Economic-Prospects-June-2016-Divergences-and-risks.pdf .
 C. Borio and L Gambacorta, Monetary Policy in a low interest rate environment: diminishing effectiveness?, Journal of macroeconomics, 2017, consulted thanks to the kindness of the Authors, forthcoming.
 See the recently released Macroprudential policy issues arising from low interest rates and structural changes in the EU Financial system, November 2016.
 See, however, the pioneering study carried out by H-Y Chiu, The disruptive implications of the fintech- policy themes for financial regulators, available at SSRN: https://ssrn.com/abstract=2812667.
 See L. Lessig, Code, 2006, New York, 122. New technologies and actors caused in fact a rapid expansion of what Lawrence Lessig referred to as “architecture”—the code, protocols, platforms and structures that determine how firms, consumers and policy- and law- makers interact —and thus raising a number of innovative legal and societal issues.
 H. Nakaso, Deputy Governor of the Bank of Japan, FinTech – its impacts on finance, economies and central banking, Speech at the University of Tokyo – Bank of Japan Joint Conference on “FinTech and the Future of Money”, Tokyo, 18 November 2016, available at http://www.bis.org/review/r161214a.htm.
Andrea Minto is Assistant Professor in Economic Law at Utrecht University School of Law and Utrecht School of Economics. Besides, he is Adjunct Professor of Banking and Financial Markets Law at Ca’ Foscari University of Venice (IT), Department of Economics, and Researcher at the DG Financial Stability of the Deutsche Bundesbank Eurosystem (DE).