April 20, 2022 | Ali Abbas
Estimated reading time: 5 minutes
International Monetary Fund calls for regulation in FinTech
The International Monetary Fund (IMF) has published its Global Financial Stability Report, with one chapter devoted entirely to the “rapid growth of FinTech”. The Report, which looks to understand the global outlook of financial stability, recognises FinTechs as a source of pioneering transformation for financial services. However, despite the benefits, the fast growth of FinTech poses far-reaching risks which, if left untapped, could have negative implications for financial stability.
The growth of FinTech
The IMF uses FinTech as a catch-all phrase to encompass three key areas of innovation:
- Digital banks (neobanks)
- Long-established FinTech firms
- Decentralised finance (DeFi)
While FinTech has long been on the horizon, the IMF notes that over the past few years it has seen a “rapid growth of FinTech” – accelerated in part by the pandemic.
Rapid growth is a double edged sword. While the IMF recognises that FinTech can “reduce costs and frictions, increase efficiency and competitions, and broaden access financial services” it is not without risk. This is especially true in a rapid-growth environment where technology appears to be evolving at a pace and scale that regulators are unable to contend with.
The risks of rapid growth in FinTech
As the IMF notes in its Executive Summary to the report, the rapid growth of “risky business segments” can be a cause of concern. This is especially true when considering that FinTech firms are subject to less stringent regulation and often patchy supervision.
In a blog accompanying its report, the IMF adds that “while most individual FinTech firms are still small, they can scale up very rapidly”. As well as this, digital banks have gained increasing importance in local markets – but remain somewhat unable to fend off traditional risks associated with consumer lending.
The risks don’t exist solely within the FinTechs themselves. Regulators also bear the burden as “the risk management systems and overall resilience of most neobanks remain untested in an economic downturn”.
Fast growth, inadequate regulation and the “increasing importance of FinTech financial services for the functioning of financial intermediation” makes for a challenging game of risk versus reward.
What about DeFi?
The IMF is particularly interested in decentralised finance (DeFi), which it recognises as being at the “frontier of technological advancement”. In a nutshell, DeFi is a crypto-market-based financial intermediation in which financial transactions are performed on a computer network without a central intermediary.
While DeFi has grown rapidly, its decentralised nature makes it particularly difficult to regulate, meaning that any associated risks are often taken on by the consumer with little protection This poses a “challenge for effective regulation and supervision”, which is unique to the FinTech space. The problem, as is often the case with emerging innovation, is that regulation is often a barrier to innovation – and the potential benefits of DeFi for a more equitable financial future could arguable outweigh current risks.
What does the IMF recommend?
In short, risk + rapid growth = regulation for FinTechs.
The IMF recommends that policymakers should be looking to develop a comprehensive global standard for crypto assets. There should also be a “more robust oversight of fintech firms” in order to “take advantage of their benefits while mitigating their risks”.
Regulatory action should not be limited solely for FinTechs, but for financial services more generally – the face of which is changing across the board. The IMF notes that “policies that target both FinTech firms and traditional banks proportionately are needed”.
While FinTechs need regulation and supervision more broadly, regulators should recognise that for incumbent banks and established entities “prudential supervision may need greater focus on the health of less technologically advanced banks, as their business models may be less sustainable over the long term.” Indeed, the IMF highlights that in a case study of the US mortgage market, evidence showed that there was a “significant negative impact of competitive pressure from FinTechs on the income of traditional banks”.
Away from the traditional models of regulatory parameters and regulation, the IMF suggests that the DeFi industry should also be introspective and look at self-regulation. This could include industry codes as well as self-regulatory organisations which would presumably shift the focus to “we do good because we want to” rather than “we do good because we have to”.
FinTechs the world over have been waiting with bated breath for new regulations and supervisory regimes – those that haven’t are probably on the back foot. That the IMF is recognising the rapid growth of FinTech as potential challenge to the future of global financial stability is perhaps not something many would have expected, though it makes sense.
FinTechs, as we have said time and again, hold huge potential to change the face of financial services – in many respects they already are. However, arguably one of the many reasons that FinTechs have been able to achieve such high paced growth, and therefore harness this potential, is that it is not regulated in the same way that incumbent banks are. This is both a pro and a con.
On the one hand, FinTechs should be given space to innovate and grow, but this should not be at the expense of consumers or wider market vulnerability. On the other hand, there is a counter point here that FinTech’s growth is now reaching a zenith where, if allowed to continue, could topple incumbent or traditional banks. FinTech should be a friend to traditional services, though it currently looks to be a foe.
Regulation is the answer, but such regulation will need to be proportionate, flexible and share an understanding of the motivation and successes of FinTech.
CUBE manages regulatory change for FinTechs across the globe.