The growth of the financial technology also referred to as the fintech industry, continues to soar. From robo-advisers to digital-only banks to mobile payments, technology is revolutionizing the financial industry and creating a wealth of new business opportunities. Nonetheless, the lack of clear regulatory oversight remains a concern.[caption id="attachment_21186" align="aligncenter" width="550"] Photo courtesy of Stocksnap.io[/caption]
Growth of the Fintech Industry
The number of fintech companies has skyrocketed in recent years, increasing from about 1,000 in 2005 to more than 8,000 in 2016. Globally, investment in the industry has grown from $5.5 billion to $78.6 billion in just the last eleven years. According to Entrepreneur, six non-public firms — SoFi, Alipay, Avant, One97 Communications, Zenefits and Square — have attracted more than $500 million of cumulative investment since 2011.
The growth of the fintech industry is also spurring innovation by traditional financial institutions. According to a recent PWC survey, 80 percent of financial institutions believe that they are losing revenue to innovators. In response, 77 percent plan to increase internal efforts to innovate. In addition, 82 percent of the financial institutions surveyed expect to increase fintech partnerships in the next three to five years.
Uncertainty Over Fintech Compliance Obligations
Regulators have also taken notice of the growing fintech industry. However, there is currently no comprehensive scheme to regulate it. In fact, state banking regulators recently filed a lawsuit against the Office of the Comptroller of the Currency (OCC) to halt its efforts to create a special-purpose national bank charter for fintech companies. The Conference of State Bank Supervisors, the nationwide organization of state banking regulators, maintains that the OCC has exceeded its authority under the National Bank Act by creating a national bank charter for nonbank companies like fintechs.
GAO Report Details Risks
The Government Accountability Office (GAO) also recently published a study on the fintech industry. The report addresses four commonly referenced subsectors of fintech — marketplace lending, mobile payments, digital wealth management, and distributed ledger technology. The GAO study discusses the risks and benefits of each sector, as well as any current regulatory oversight.
The GAO report highlights that the technological advances of the industry provide many benefits for consumers, including lower transaction costs, faster and more convenient service, and greater access to credit. However, it also highlights several significant risks that have not yet been sufficiently addressed by regulators, including:
(1) Marketplace lending
As defined by the GAO, marketplace lending “connects consumers and small businesses seeking online and timelier access to credit with individuals and institutions seeking investment opportunities.” Its report cites payment term transparency as a potential risk, specifically highlighting that it is often difficult for small businesses to understand and compare loan terms, such as the total cost of capital or the annual percentage rate. As for oversight, the GAO notes that current federal laws and regulations applicable to marketplace lending generally apply to consumer loans and not small business loans or other commercial loans. The GAO report also highlights the risk of marketplace lenders using less traditional data in credit decisions, such as utilities, rent, telephone bills, and educational history. According to the report, the reliance on non-traditional factors may increase the risk for potential fair lending violations.
(2) Mobile payments
Mobile payments allow consumers to use mobile devices to make purchases and transfer money. While certainly convenient and efficient, the GAO report emphasizes the significant data security risks faced by this sector. According to the GAO, security concerns include “the event of a smartphone being hacked, the loss or theft of a smartphone, or if a company does not sufficiently protect mobile transactions, among other concerns.”Mobile payment providers are subject to a patchwork of federal and state regulations. As the report notes, determining which laws apply to mobile payments depends on several factors, including agency jurisdiction, mobile payment providers’ relationship to depository institutions, and the type of account used by a consumer to make a mobile payment.
(3) Digital wealth platforms
Digital wealth management platforms use algorithms based on consumers’ data and risk preferences to provide digital services, including investment and financial advice, directly to consumers. Because wealth management platforms are largely automated, the risks include obtaining insufficient or incomplete information from customers due to the reliance on questionnaires, as well as the risk that the assumptions that underlie the algorithms used by digital wealth management firms could be incorrect. In terms of oversight, the report notes that firms that provide digital wealth management platforms are typically subject to the same oversight as traditional advisers, including registration with the Securities and Exchange Commission (SEC).
(4) Distributed ledger technology
Distributed ledger technology (DLT), such as blockchain technology, represents the newest fintech sector and may ultimately be the most disruptive. As described by the GAO, DLT involves a distributed database maintained over a network of computers connected on a peer-to-peer basis, such that network participants can share and retain identical, cryptographically secured records in a decentralized manner. In terms of risks, the GAO lists operational failures and security breaches. The study also cites a Financial Stability Oversight Council report that noted that “market participants have limited experience working with distributed ledger systems, and it is possible that operational vulnerabilities associated with such systems may not become apparent until they are deployed at scale.” As for oversight, the GAO acknowledges most regulatory agencies are still studying DLT. “It is unclear whether new regulation will need to be created because DLT can present new and unique challenges”, the report states.
For startups and investors, the rapid growth of the financial technology industry presents many opportunities. However, it is important to recognize that additional regulatory and compliance burdens are likely on the horizon.
Do you have any questions regarding the Fintech industry? Would you like to discuss the matter further? If so, please contact me, Robert Marsico, at 201-806-3364.