FinTech and Market Structure in Financial Services: Market Developments and Potential Financial Stability Implications

After completing this reading, you should be able to:

• Differentiate between potential changes to market structure and financial stability risks as a result of financial innovation through traditional providers, BigTech, Fintech providers, and third-party tech servicers.
• Discuss the technological developments impact and risks in the areas of APIs, mobile banking, and cloud computing on payment systems along with the scope of the EU’s Payment Services Directive.
• Analyze the market structure impact and risks of China’s NPI’s online MMFs in the areas of same day cash availability, deposit guarantee mechanisms, and concentration risk along with the effort of Chinese authorities to address these risks.

Potential Changes to Market Structure and Financial Stability Risks due to Financial Innovation via various Service Providers

Traditional providers, BigTech, FinTech, and third-party tech servicers are among the parties who drive financial innovation. Financial innovation involves the creation of new financial products, services, or processes. These innovations are a result of advances in financial instruments, payment systems, among other securities used in lending and borrowing of funds. Financial innovation generates updates in technology, risk transfer, and credit and equity generation.

Financial technology (Fintech) describes a firm using any form of technology to channel financial services from businesses to consumers. This technology may involve software, mobile payment apps, cryptocurrency, among others. On the other hand, BigTech refers to the largest and most dominant companies in the information technology industry. BigTech companies include Amazon, Facebook, Apple, Microsoft, eBay, Google, among others. Contrary to BigTech, traditional financial service providers are regulated financial institutions, such as banks and credit unions. They provide services such as checking, savings accounts, home mortgage, auto loans, among others.

Lastly, third-party tech service providers are independent contractors who render technological services to a firm, subsidiary, or an affiliate. These providers are neither connected to the offer and sale of the firm’s securities nor do they promote or maintain a market for the firm’s securities.

Potential Challenges

The following are some of the potential changes that accompany financial innovation by the above service providers:

Partnership with BigTech firms

BigTech firms provide financial services complementary to those offered by existing financial institutions, increasing the attractiveness of the existing services. This may be through enabling payments that utilize existing networks and probably increase existing transaction flows for the incumbents.

Competition from BigTech firms

As highlighted in the previous paragraph, BigTech firms may offer services provided by the incumbent financial institutions, leading to competition. This may encourage the incumbents to embrace technology, thus decreasing their costs. Additionally, they may improve their products and hence profitability in the long run.

Reliance on third-party providers for cloud services

Increased reliance on third-party providers for cloud computing offers commercial benefits to firms rather than competition. Due to low operational costs, there are intense commercial pressures for banks to engage with these services. However, the banks are constrained by their risk management or supervisory restrictions.

Financial Stability Risks Resulting from Financial Innovation

The changes in the financial industry resulting from technological innovations could pose some risks, as discussed in this section:

Competition: Increased competition might affect institutions’ ability to generate capital internally through retainment of profits. It can also lead to potential mispricing of risk; for example, competitive pricing can potentially decrease interest rates on loans, which encourages excessive borrowing.

Dependencies: BigTech firms’ partnering with existing financial institutions could create new operational or financial links and dependencies. The linkage scale may increase the complexity of the financial system providing new mechanisms for the propagation of risks. In turn, this might increase the risk of contagion from an operational failure or a financial shock.

Issues arising from scale: BigTech firms providing direct financial services could reach a scale in which their failure could cause extensive disruption to other parts of the financial system or the economy as a whole.

Technological Developments Impact and Risks on Payment Systems Along With the Scope of the EU’s Payment Services Directive

Application programming interfaces (APIs) enable the flow of information between applications giving institutions the ability to access customer data, create innovative products for the consumer, market, and regulatory needs. Mobile banking, on the other hand, is a service provided by a financial institution to allow its customers to transact remotely using a mobile application. Cloud computing refers to using a network of remote servers – hosted on the internet – to store, manage, and process data.

There are technological developments in the areas mentioned above that have an impact on the banking system. The revised European Union’s Payment Services Directive (PSD2) have made regulations intending to make it safer and easier to use internet payment services that protect customers against fraud, abuse, and payment problems as well as promote innovative mobile payment services. The following are some of the effects of this development on payment systems of financial institutions.

Fast payments

APIs have been used for decades to enable personal finance management software. The software presents billing at bank websites and also connects developers to payments networks. It is now used to facilitate service improvements, providing faster payment methods. There is a significant increase in the usage of this technology in recent years.

Combination of APIs with smartphones

With this combination, smartphones can now be built with payment capabilities in their operating systems, enabling the client interface to be captured once they purchase the phone. Under PSD2, customers should be able to see the list of all their accounts by opening one app for one account (including those with other banks). This should be done by authorizing licensed third parties to access some of their payment-related banking details without providing login credentials. Moreover, customers should also be allowed to decide which information they want to share with what provider and for how long.

Use of cloud for managing the customer relationship, human resources, and financial accounting

In addition to this, there is a chance of other services running on the cloud, including consumer payment, credit scoring, among others. Authorities, including financial services authorities and self-regulatory entities, are also using cloud computing and related services in some cases. PSD2 authorizes open access to certain types of customers’ banking data for non-bank licensed providers of account information services (AIS) and payment initiation services (PIS). AIS providers are therefore allowed to acquire information concerning personal online banking accounts if the customers explicitly so choose.

APIs have led to increased market structure fragility

More frameworks for applying APIs are being developed. APIs provide support for a variety of unbundling of services. Lack of proper deployment and security management in the usage of APIs could lead to market structure fragility.

China’s Non-bank Payment Institutions’ Online Money Market Fs

Money Market Fund (MMF) is a kind of mutual fund that invests only in short-term debt securities with high credit quality such as cash equivalent securities and high credit rating debt-based securities with short-term maturity. These funds are highly liquid and have a very low level of risk.

With the rapid growth of the payments business in China, non-bank payment institutions (NPIs) have risen to respond to the rising consumption by businesses and technological innovation to address the diversified retail payment needs of the public. The Chinese NPIs started their online MMF business in 2013. Motivated by easy access, convenient payment services, and higher yield, the Chinese NPIs online MMF products grew significantly. The following are some of the characteristics of Chinese NPIs online MMFs:

1. The NPIs sell online MMF shares to the NPIs’ clients, and the sale proceeds invested in MMFs.
2. The Chinese online MMFs are widely regarded as safe, just like bank deposits but with a higher yield.
3. The integrated services through the e-wallet apps provide a smooth and low-threshold access to MMFs.

The Market Structure Impact and Risks of China’s NPI’s Online MMFs

The following are some of the impacts and risks resulting from Chinese NPIs online MMFs.

The Chinese NPI’s online MMFs have profited from the massive difference between borrowing and lending interest rates and increased financing costs for banks. These MMFs put large sums of money into banks in form of inter-bank certificates of deposit or structured deposits. This generates profits that they would not have enjoyed if they went for the demand deposit accounts with commercial banks.

The Chinese NPI’s online MMFs have capitalized on regulatory gaps. Although these MMFs are similar to deposit-taking institutions, they are not subject to a similar regulatory framework. However, the NPIs accept money from current accounts that are repayable on-demand or a short notice. Furthermore, the Chinese MMFs extend longer-term credit that is funded by assets that can be redeemed on-demand. This raises the potential for maturity and liquidity transformation. The Chinese MMFs are, however, not subject to macroprudential requirements, which include reserve requirements and taxes. The MMFs have operational and compliance costs that are lower than those of banks and similar deposit institutions.

The Chinese NPIs’ online MMFs could raise potential liquidity risks as a result of potential maturity mismatches. The assets of these MMFs usually mature after several months. Therefore, the “T+0” redemption is financed by the NPIs or the MMFs with their cash in advance.

Furthermore, if there were a sudden and significant demand for redemptions, in a period of market stress, a Chinese MMF might be forced to sell assets into an already falling market at prices below market value to meet redemptions. The demand and redemption volumes can surge to a point where the only way to meet redemption is by selling the most liquid shorter-term assets. This increases maturity mismatch in the MMF, posing increased liquidity risks.

The Effort of Chinese Authorities to Address the Online MMF Risks

People’s Bank of China (PBC) and the China Securities Regulatory Commission (CSRC) are introducing regulation on the online MMFs based on ‘substance over form’ and ‘same business, same rules’ principles. This will be done to:

1. Address the potential susceptibility in stress times;
2. Improve their ability to manage redemptions; and
3. Increase the transparency of their risks.

The regulations are introducing redemption gates and liquidity fees to reduce potential run risks. The critical components of the measures introduced by the authorities in June 2018 include the following.

1. They have restricted the selling of online MMFs to only commercial banks or licensed MMF sale agents.
2. They have capped instant T+0 redemption at (US$1,560) from a single fund and prohibited NPIs or MMFs from letting investors make online payments with such funds shares directly.
3. They are prohibiting NPIs or MMFs from using their cash in advance to realize a de facto same-day redemption. Only qualified commercial banks are eligible to provide financing services to facilitate the T+0 redemption of MMFs.
4. They are prohibiting NPIs from engaging in the sales of money market funds either directly or indirectly.

Practice Question

Which of the following is a potential risk resulting from the involvement of FinTech in financial institutions?

A. Lack of financial inclusion

B. Lack of transparency

C. Risk of contagion

D. None of the above

The correct answer is: C).

Risk of contagion is a potential concern for FinTech, especially where there is a direct interaction between activities and businesses. For example, unexpected and significant losses incurred on a single FinTech lending platform could be easily interpreted as an indicator of potential losses across the sector. 

A is incorrect: Quite the contrary, FinTech has enabled access for customers through enhancement of infrastructure, innovating in new products, and lowering costs, that were excluded from the traditional financial system.

B is incorrect: Increased and better uses of data have reduced information asymmetries in many areas of FinTech. The creation of smart contracts provides transparency to the customer side as well as the provider.