MLex Team , MLex Market Insight , MLex | Jun 2017

 

Overall risks to the financial system posed by financial technology firms are relatively negligible at this stage, but they could serve to accentuate many risks, including cyberattacks, according to a report by the Financial Stability Board.

The more connected financial institutions are, the more vulnerable they become, with fintech helping to expand the number of entry points for potential hackers to target, the Basel-based global financial standards-setter said in a comprehensive report on fintech released today.

"In this regard, some fintech activities could spread data across a large number of institutions, for example, via increased use of digital wallets and e-aggregators," the 65-page report said. It called for more collaboration among global regulators on a wide range of fronts, including contingency plans for cybersecurity.

Although there are currently no "compelling financial stability risks" given small size of fintech firms relative to the financial system, "experience shows that they could emerge quickly if left unchecked," said the report, which was prepared by the FSB's FinTech Issues Group, chaired by Bank of Canada Senior Deputy Governor Carolyn Wilson.

International and national bodies should therefore take fintech firms into account in their risk assessments and regulatory frameworks, the report said, pointing out in particular 10 broad areas in which international regulators could collaborate.

"Increased cooperation will be particularly important to mitigate the risk of fragmentation or divergence in regulatory frameworks, which could impede the development and diffusion of beneficial innovations in financial services, and limit the effectiveness of efforts to promote financial stability," it said.

The report said three key areas deserved special attention: managing operational risks posed by third-party service providers, mitigating cyber-risks, and monitoring macro-financial risks that could emerge as fintech activity increased.

Authorities, for instance, should determine whether current oversight frameworks for important third-party service providers to financial institutions were appropriate, for example in the area of cloud computing and data services.

Contagion risks

In terms of how risks could spread, for instance, peer-to-peer lending platforms could be susceptible to "reputational contagion" where "significant and unexpected losses incurred on a single fintech lending platform could be interpreted as indicating potential losses across the sector."

The use of sophisticated technology such as artificial intelligence by some fintech firms aiming to lower costs could introduce new risks into the system, the FSB said. For instance, greater automation in the trading of securities, including the use of algorithms and social media information, could lead to new and unpredictable sources of contagion in financial markets.

Fintech platforms could be particularly prone to wild, procyclical swings in sentiment, as "a sudden rise in non-performing loans could trigger a drying up of new funds."

Such a trend could be exacerbated by the presence of retail investors, leading to "greater herding behavior than traditional portfolio allocation methods," consequently introducing more volatility into the markets.

The report said that there were few incentives for fintech firms to assess credit quality and maintain lending standards, all of which could "further amplify shocks to the financial system when they arise."

In addition, the fast-moving nature of the fintech business was more likely to "exacerbate excess in the financial system" as well as make it more sensitive to news.

Tackling those priority areas would be key to supporting efforts by global bodies to safeguard financial stability while fostering more inclusive and sustainable finance, the report said.

The report elaborated in detail both the benefits and the risks associated with the fintech industry. Among the major benefits were decentralization, increased intermediation by non-financial institutions, more transparency and competition, and more inclusive finance.

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n terms of potential pitfalls, the report pointed out both specific risks that fintech could pose to individual institutions at the micro level, and macro risks that it could present to financial system more broadly due to increased connectivity.

However, the work of determining the exact implications of new financial technologies was rendered challenging by a lack of information available both officially and in the private sector, the report said.

Varying regulatory approaches

Although existing regulations in most jurisdictions cover fintech, many regulators have also announced new rules and clarifications, with the scope and scale of changes or planned changes varying substantially, the FSB said. Those changes were determined by the size of the domestic financial system and the flexibility of existing rules, and how well they were able to incorporate fintech.

Regulatory changes have been introduced from Mexico to China to Singapore, it said, with the bulk of those changes and clarifications having been made in the areas of payments, capital raising, and to a lesser extent in investment management, as many of those activities meshed well with prevailing banking rules and norms.

"Only a few regulatory changes to include fintech innovations in insurance and market support were mentioned," said the report.

The report also pointed out the challenges of regulating some fintech activities and mentioned, in particular, the challenge of establishing ownership of assets in decentralized platforms such as distributed ledger technology or blockchain.

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