Global reset – Monetary decoupling (Part 12: Challenges for intermediaries – Disintermediation and fintech regulation)
Phuah Eng Chye (20 November 2021)
Waves of disintermediation
Financial intermediaries regularly experience waves of disintermediation. During the 1970, the US and UK led the way in liberalising their financial sectors. The deregulation of interest rates and commissions resulted in intense competition and caused a severe industry fall-out. In the early 1980s, it was thought the entry of non-banks, such as supermarkets and conglomerates, into financial services would threaten the position of commercial banks.
The threat from non-banks receded in the 1990s as banks consolidated into large entities while the policy shift to markets, deregulation and re-regulation worked in their favour. Previously, industry was regulated along segmented lines. With deregulation, segmentation gave way to convergence as different services such as commercial, merchant and investment banking were brought under one roof within a holding company structure or universal banking. The other critical development was the shift from bank intermediation towards capital markets. By the mid-1990s, large banking groups emerged which were able to leverage their balance sheet strength by acquiring a full array of specialist skills in financing, product creation, market-making and investment banking. Deregulation ceded ground to re-regulation and the new regulatory frameworks raised entry barriers.
From 2010 onwards, disintermediation threats emerged on two fronts. The global financial crisis of 2008 saw prudential and risk controls tightened to strengthen bank balance sheet discipline. This constrained bank growth and commercial banks began to find themselves outmuscled in markets by central banks whose balance sheets were enlarged by QE; and by asset management firms whose money market funds diverted savings from banking deposits. Developments such as negative interest rates and low lending rates undermined profitability and increased risk vulnerabilities. Charles M. Kahn, Caitlin Long and Manmohan Singh point out due to corporate “concerns about the creditworthiness of European banks, by the early 2010s some of the largest and most sophisticated U.S. companies had already transferred their European cash deposits to U.S. money market funds and swapped back them to euros via the FX swaps market. The connection between the repo market and corporate payments isn’t obvious, and very little has been written about it”.
Technology firms opened up a new front. Lawrence Wintermeyer notes “banks are under attack from the likes of crypto innovators to central bank innovators with CBDCs, all of whom are seemingly seeking to reduce the role of or fully disintermediate traditional banks in the payments ecosystem”. Traditional intermediaries are being outflanked by “the evolution of cryptocurrency, digital wallets, challenger banks, stablecoins, CBDCs, DeFi protocols and other blockchain-focused payment platforms”. Disintermediation is taking place on a virtual basis “block by block, a new financial ecosystem is being constructed right alongside the old one”.
Technological disintermediation is furthest advanced in China. Zhang Yugui notes “Alibaba enjoys nearly 60% market share of China’s e-commerce while WeChat Pay and Alipay account for more than 90% of China’s mobile payment…Alibaba and Tencent utilise their platform advantage to obtain data on hundreds of millions of users at extremely low cost. In so doing, they skirt regulations to gain from arbitrage, shut out competitors using their market advantage, and infringe upon legitimate consumer rights and interests. If this increasingly evident trend of harmful development is not curtailed, systemic financial risks will be hard to avoid”.
Banks in China thus found themselves being pushed from the center to the back-end of the payment ecosystem. They were disadvantaged in having to carry the processing and compliance costs while revenue opportunities were captured by platforms and apps. As customer choice increased, bank accounts had to compete with scalable modular (micro) and smart products. However, recent regulatory interventions (anti-monopoly and entity regulations) and the pending launch of the digital yuan could tilt the playing field back in favour of traditional banks.
The fintech experience varies greatly in different countries. Thorsten Beck and Yung Chul Park relates how “at the initial stage of FinTech development, Korea’s financial regulatory authorities chose to embrace a market-led approach to fostering the FinTech industry in line with a general move towards financial liberalisation. A decade later, however, a series of market failures and inefficiencies of the laissez faire approach has begun to take its toll, with P2P lending platforms losing their credibility and reliability as they became shrouded in widespread fraud and deception of investors and borrowers, the number of FinTech startups ballooning but few of them being efficient, and the FinTech industry developing into an oligopoly controlled mostly by financial subsidiaries of BigTechs”.
The disintermediation threat posed by technology is nonetheless more severe than in previous challenges. In earlier disintermediation face-offs, traditional intermediaries like banks, brokers and insurers maintained an information-processing advantage relative to non-bank competitors. Now they are facing new competitors such as platforms, fintech start-ups, asset managers and even central banks which possess possibly superior information capabilities and cultures. History demonstrates that it is easier for tech firms like Amazon and Tencent to venture into non-tech businesses rather than for non-tech firms to venture into technology. In the retailing, travel, taxi and content industries, incumbents have yet been able to achieve the right mindset, cultures and skill sets to exploit data as skilfully as the tech firms. In addition, finance is just one part of a platform’s information business.
Thorsten Beck and Yung Chul Park explains “banks and other financial institutions have faced considerable difficulty in recruiting or training FinTech engineers and designers. These specialists are not financiers and do not belong to the mainstream of asset-liability management, and hence mostly play a supporting role. Understandably, their career prospects in the incumbent financial institutions are somewhat limited and they know they would have better opportunities at newer FinTech firms than at incumbent firms burdened with large investments in older technologies”.
The question is whether traditional financial intermediaries will end up sharing the fate of legacy business models like newspapers. They may have better odds of competing as banks are themselves involved in “information businesses” and can rightly be considered the oldest information industry. Unlike newspapers, they have reasonable information capabilities in collection, analysis and use and can exert significant influence on gatekeeping control and reach to their customers.
While tech firms may understand information, they are handicapped by their disdain for regulation. The regulatory goals of protecting customers, keeping markets fair and orderly and maintaining financial soundness will not change regardless of how financial services are delivered. The fluidity introduced by the fintech revolution suggests financial regulation is likely to be expanded to curb fintech recklessness. The advantage of traditional intermediaries is that they understand regulation well and have forged a mutual understanding with their oversight regulators.
The biggest competitive threat posed by fintech is the pressure on intermediation margins and the value add of intermediaries. In the 1990s, intermediaries responded to margin pressures from regulatory-driven capital and compliance costs by shifting “low-margin” commercial loans off their balance sheets (into market and derivative products) and expanding the high-margin retail lending business. They augmented their profits from advising, investing and trading; though some of the riskier activities were curtailed after the 2008 global financial crisis.
Fintech threatens bank margins and value add across many fronts – deposit-taking, lending, investment products while digital currencies threaten payment dominance and related income due to its super-fast latency. Some of this arises due to regulatory arbitrage by fintech firms. These loopholes will be closed and regulatory reform will likely extend the application of traditional principles to cover fintech and digital activities. This will guide the reshaping of the intermediation landscape.
The challenge of fintech regulation
Disruption re-routs information flows and repositions gatekeeping controls over information. The advent of fintech augurs a radical transformation of the intermediation landscape. Andrew Sheng notes “big tech has muscled its way into traditional banking, especially in payment services, lending and asset management…Given the combined growth of NBFIs and big tech, traditional bank regulators find they regulate less of the financial system, although central banks are still responsible for overall financial stability”. In addition, “blockchain technology, cryptocurrencies and central bank digital currencies are now increasingly coming on stream, making possible payments and transactions that rely less on official currencies and also outside the purview of regulation”.
Traditional financial intermediaries are the main vehicles to implement government policies relating to savings mobilisation, financing economic growth and safeguarding monetary stability. In this regard, information-driven disintermediation created a largely-unsupervised ecosystem that parasites the traditional financial network – comprising currency, assets, markets and the payment infrastructure. Regulators would not stand aside while their regulatees are enfeebled and risks build up in a non-visible ecosystem. Regulators have already been actively assessing these developments.
Johannes Ehrentraud and Denise Garcia reviewed “policy responses to fintech developments in approximately 30 jurisdictions worldwide”. “To date, technological developments have not yet resulted in any major upheaval in the structure of financial regulation…Fintech developments present issues that are beyond the traditional scope of financial authorities, and the speed of innovation makes it difficult for regulators to respond in a timely manner. In addition, important trade-offs may arise between different policy objectives. Achieving an orderly application of new technologies in the financial system will probably remain a desirable outcome of regulatory actions. At the same time, policy actions need to be consistent with the preservation of financial stability, market and financial integrity, competition and consumer protection”. Hence, “designing a policy framework for fintech will require finding a balance that maximises its benefits while minimising potential risks to the financial system”.
Johannes Ehrentraud and Denise Garcia proposed “a novel conceptual framework – the fintech tree – that distinguishes three categories: fintech activities, enabling technologies, and policy enablers”. This approach covers “establishing fintech-specific licencing regimes or other regulations to providing guidance to the industry. For enabling technologies, regulators have mostly adjusted their existing regulations to add technology-specific elements to existing laws, regulations, or guidelines. On a broader level, public policies that enable the provision of digital services have also received considerable attention”.
Tanai Khiaonarong and Terry Goh notes “financial technology (Fintech) has prompted authorities to consider their potential financial stability benefits, risks, and effective regulation. Recent developments suggest that regulatory approaches and their legal foundations need to augment entity-based regulation with increasing focus on activities and risks as market structure changes”. Their approach to modernizing legal and regulatory frameworks for payment services is based on a four-step analytical framework: “(i) identifying payment activities; (ii) licensing entities and designating systems; (iii) analyzing and managing risks, and (iv) promoting legal certainty”.
Erik Feyen, Jon Frost, Leonardo Gambacorta, Harish Natarajan and Matthew Saal point out “the growing diversity of financial services providers and business models often requires expanding the regulatory perimeter…Particularly the entry of big techs may require more, not less, entity-based regulation, for instance to address risks around competition and operational resilience…This may extend to the perimeter of financial safety nets. Data reporting perimeters may need to be expanded even further, given the disaggregation of finance and the embedding of financial services into non-financial activities”.
Erik Feyen, Jon Frost, Leonardo Gambacorta, Harish Natarajan and Matthew Saal explain “the disaggregation and reconfiguration of finance value chains introduces new challenges in day-to-day supervision. For a traditional, vertically integrated bank, it is clear where responsibility lies for the financial soundness, cybersecurity, and consumer impacts of a product. When the financial services value chain is spread across different players with, for example, one holding the customer relationship, another holding the customer funds, a third providing data analytics and deciding which customers get services, and a fourth providing technology infrastructure, it is more difficult to pin down responsibility for mishaps or misdeeds and to ensure that consumers’ interests are protected. Moreover, when customer interactions are handled by entities that are not directly subject to extant consumer protection regulations, any shortcomings such as unfair practices may not surface through traditional supervision focused on the regulated entity. This can lead to undetected consumer protection risks. This becomes even more challenging when services are provided across borders. Complex processes and interactions across different players and systems can create new points of failure. Multiple entities and interlinkages create a wider attack surface for cybercriminals, which requires a strong regulatory approach to promote cyber security. The balance of power in these partnership relationships is very different than in a traditional outsourcing relationship, so the ability of the regulated financial institution to enforce its own policies might be challenging. Multi-tiered access to regulated systems…requires that regulators ensure that the…provider has sufficient visibility through the value chain to ensure compliance. In some circumstances, regulators may need to extend their supervision past the first-tier regulated entity, downstream to the customer interface entity or upstream to infrastructure providers”.
In addition, “reconfiguration of value chains is creating concentration risks at the technology services level that need to be monitored from both competition and systemic stability perspectives. The cloud services market is highly concentrated. While provision of services to financial institutions has long been subject to concentration (for example, limited numbers of mainframe, ATM, cash transport, and payments network providers), growing reliance by a large swath of the financial sector on a small number of cloud services providers has been flagged as carrying the potential for new concentration or single-point-of-failure risks. Notably, four players control around two thirds of the global market for cloud services. While cloud providers generally have deep expertise in systems architecture and cyber security, an operational or cyber incident at one major cloud provider could have systemic implications for the financial system. Open infrastructure, including API hubs, KYC utilities, and changing access policy for existing payment systems and credit reporting infrastructures, can mitigate concentration risks, increase contestability, and dilute data concentrations. However, there are indicators that a number of B2B fintech services may be equally prone to concentration; the example of API middleware providers”.
Erik Feyen, Jon Frost, Leonardo Gambacorta, Harish Natarajan and Matthew Saal advise “some of the issues related to disaggregation and the incorporation of new players into financial product value chains can be addressed through regulatory guidance on governance of partnerships and outsourcing, including clear allocation of responsibilities and supervisory reporting, applied to each individual institution. Traditionally, regulators have placed responsibility for regulatory compliance with the licensed institution. However, as mentioned before, this may not work in a scenario where the licensed institution has much less scope to enforce specific requirements – for example a small niche player partnering with a big tech or using a global cloud provider. Thus, many challenges, such as up- or downstream concentration risks, may need to be addressed at the sector level, eg through enhanced oversight of systemically important providers. Further, regulatory authorities might need to increase their ongoing scrutiny of the operational and process model of licensed institutions and introduce changes to ensure that they are able to discharge their consumer protection responsibilities”. They conclude that “market forces are already being shaped by minimum capital, licensing requirements, activity restrictions and other policies. Pretending that market forces are just running their course is inaccurate at best, and at worst could lead to negative outcomes for consumers and macro stability”.
It is a major challenge to set the regulatory boundaries because fintech business models are fluid and constantly permutating; often without regard to regulatory concerns or requirements. Under these circumstances, prescriptive and level-playing field regulations are inappropriate. The more effective approach is to adopt generic or principle-based regulations that provides licensed intermediaries the flexibility to configure their operations but ensure accountabilities are clearly located and that there is effective regulatory reach. This can be combined with a size approach that ensures fintechs with a systemic footprint are subject to more stringent regulatory oversight and capital and risk requirements.
Zhang Yugui notes though “China has yet to build the corresponding capabilities to manage the complex financial systems and cutting-edge fintech. Therefore, there are blind spots and shortcomings in financial business development and the regulation of platform companies, involving the scope of regulation, management and control of core data and information, coordination of monitoring systems, and timeliness in responding to sudden financial events”. “The central bank and the relevant regulatory agencies have repeatedly warned some technology companies about providing financial products and services. Several companies have obtained the necessary licenses but others continue to provide credit and payment services and sell insurance products without the necessary licenses, possibly causing issues of competition and bringing about financial stability risks”. Recently, regulators conducted meetings with the large platform companies “to formulate rectification and restructuring plans. The regulators aim to lower systemic financial risks by imposing fines on companies while emphasising the need to promote stable and healthy development of the platform economy, strengthen anti-monopoly measures and prevent the disorderly expansion of capital”.
The most critical area relates to regulatory oversight over data. Zhang Yugui points out the large platform companies “have long refused to provide essential data and related financial information to the central bank and regulatory agencies in the name of protecting user privacy. Under normal circumstances, Ant Group is only required to submit simplified monthly transaction records, comprising mainly consolidated data, to the PBOC’s Credit Reference Center. However, despite talks with the regulators, it has expressed willingness to share only a small amount of data and information, making it impossible for the regulators to effectively evaluate risks given the insufficient information and incomplete data. Consequently, as the ultimate lender, the PBOC is not fully aware of the magnitude of Ant Group’s financial risks and the latent risks involved”. “Platform companies are in possession of massive data and technological advantages, and are adept at regulatory capture or getting the upper hand over the regulators. The regulators suffer from inadequate regulatory capabilities and hence do not know how and what to regulate”. “Therefore, it is not technology that holds back progress. Rather it is the difficulty in managing judiciously the boundaries of technological applications”. Recent events demonstrate regulators are already strengthening their data oversight in line with their objectives of protecting consumers and investors, ensuring market fairness and ensuring financial stability.
In addition, there is concern over data sovereignty; instances where corporate entities may be compelled by foreign authorities to hand over sensitive local data, Global Times reports the General Office of the Central Committee of Communist Party of China and the General Office of the State Council jointly issued guidelines to strengthen the “rules and regulations for data security, cross-border data flow and management of classified information…The guideline also vowed to amend the rules covering Chinese companies’ overseas fundraising and IPOs, as well as take measures to cope with risks related to Chinese companies that are listed overseas”. The guideline was issued two days after app stores were ordered “to remove ride-hailing app Didi Chuxing, which just launched its IPO in the US…over cybersecurity issues”. As at May 2021, “there were 248 Chinese companies listed on the three largest US exchanges, with a total market capitalization of $2.1 trillion…giving foreign investors greater access to the core of their operations and easier access to relevant data. Under such circumstances, the economic and national security risks arising from the cross-border flow of data, a major product of the digital economy, cannot be ignored.”
Andrew Sheng points out “the regulatory trend towards open financial data in which banks open up their client databases to allow new players to access customer accounts and data will provide new products and services. But this also raises concerns about client privacy and data security. No country has yet figured out how to manage competition fairly in the fintech world when five firms – Amazon, Microsoft, Google, Alibaba and IBM – dominate 70 per cent of cloud-related infrastructure services”.
From an information perspective, there isn’t yet a level playing field between banks and tech firms. Thorsten Beck and Yung Chul Park explain “the emergence of the new digital technologies – IoT, sensing, cloud computing, and big data processing – has enabled the two BigTechs to collect and analyse much more customer data from their non-financial business sources than was previously possible. The new technologies, ample data and network externalities of the non-financial platform services have combined to lay the ground for providing various new digital services, mostly in consumer finance”. Hence companies backed by “the BigTechs with a multi-sided business platform. This relationship allows access to a vast amount of data on customers of their parent companies. This access, in turn, helps them benefit from economies of scale and scope. At the same time, their direct interactions with two or more distinct types of other customers in different businesses across the BigTech organisations they belong to create a positive feedback loop that furnishes each other with network benefits. These network advantages will help the two big techs turn the financial platform market into another oligopoly as the leading players”.
In contrast, banks are not, and are unlikely to be ever, allowed to source, aggregate and use their data the way platforms or fintech have. In fact, banks are subject to considerable restrictions on data use and are generally not allowed to sell customer data to third parties. It is likely regulators would eventually ringfence fintech businesses to ensure they are subject to the same guardrails as banks in relation to customer privacy and anti-competition risks.
Future competitive outcomes in the financial intermediation landscape will be shaped by new regulations on licensing, data and algorithms. Consideration will be given as to how best to manage intermediation and consumer risks. Tech firms will find the regulatory forbearance that allowed them to build market share will dissipate and be replaced by insistence that tech firms play by the same rules as traditional financial intermediaries. Tech firms will likely be required to ringfence their “financial” activities into licensed entities subject to fitness requirements. They may even be forced to divest ownership to separate ownership from conglomerate interests. Eventually, there will be a shakeout as the financial industry will not be able to accommodate so many players with a high likelihood of synthesis between traditional intermediaries and fintech firms.
The regulatory battle is not confined to fintech newcomers and incumbents but is also breaking out between the government and private sector; and among countries. Governments increasingly recognise data as a vital national resource that should be judiciously guarded. In this context, platform control of data will be perceived as an intrusion of private claims over sovereign rights on citizens’ data. With digital currencies, governments have the ability to extend their control or facilitate crypto-based disintermediation. But this will disrupt legacy financial institutions and the resulting “stranded asset” effect could trigger financial instability. Growing national security concerns over the “leakage” of citizens’ data to other countries will prompt governments to strengthen their sovereign claims and oversight on data, players and networks in an era of decoupling.
Andrew Sheng (16 July 2021) “Why the global financial landscape is undergoing a seismic shift”. SCMP. https://www.scmp.com/comment/opinion/article/3141334/why-global-financial-landscape-undergoing-seismic-shift
Charles M. Kahn, Caitlin Long, Manmohan Singh (31 July 2020) “Privacy provision, payment latency, and role of collateral”. International Monetary Fund (IMF). https://www.imf.org/en/Publications/WP/Issues/2020/07/31/Privacy-Provision-Payment-Latency-and-Role-of-Collateral-49613
Erik Feyen, Jon Frost, Leonardo Gambacorta, Harish Natarajan, Matthew Saal (July 2021) “Fintech and the digital transformation of financial services: Implications for market structure and public policy”. Bank of International Settlements (BIS). https://www.bis.org/publ/bppdf/bispap117.pdf
Johannes Ehrentraud, Denise Garcia (19 April 2020) “Managing the winds of change: Policy responses to fintech”. Voxeu. https://voxeu.org/article/policy-responses-fintech
Global Times (6 July 2021) “China to tighten rules for firms listed overseas to enhance data protection”. https://www.globaltimes.cn/page/202107/1227993.shtml
Lawrence Wintermeyer (27 May 2021) “Crypto and blockchain startups set their sights on the global payment industry”. Forbes. https://www.forbes.com/sites/lawrencewintermeyer/2021/05/27/crypto-and-blockchain-startups-set-their-sights-on-the-global-payment-industry/?sh=4fe4efc330d0
Phuah Eng Chye (2015) Policy paradigms for the anorexic and financialised economy: Managing the transition to an information society. http://www.amazon.com/dp/B01AWRAKJG
Phuah Eng Chye (11 April 2020) “Anonymity, opacity and zones”. http://economicsofinformationsociety.com/anonymity-opacity-and-zones/
Phuah Eng Chye (5 June 2021) “Global reset – Two whales in a pond”. http://economicsofinformationsociety.com/global-reset-two-whales-in-a-pond/
Phuah Eng Chye (19 June 2021) “Global reset – Monetary decoupling (Part 1: Sterilisation and QE)”. http://economicsofinformationsociety.com/global-reset-monetary-decoupling-part-1-sterilisation-and-qe/
Phuah Eng Chye (3 July 2021) “Global reset – Monetary decoupling (Part 2: Economics of large central bank balance sheets)”. http://economicsofinformationsociety.com/global-reset-monetary-decoupling-part-2-economics-of-large-central-bank-balance-sheets/
Phuah Eng Chye (17 July 2021) “Global reset – Monetary decoupling (Part 3: Consequences of diverging policies)”. http://economicsofinformationsociety.com/global-reset-monetary-decoupling-part-3-consequences-of-diverging-policies/
Phuah Eng Chye (31 July 2021) “Global reset – Monetary decoupling (Part 4: Lessons from Plaza Accord)”. http://economicsofinformationsociety.com/global-reset-monetary-decoupling-part-4-lessons-from-plaza-accord/
Phuah Eng Chye (14 August 2021) “Global reset – Monetary decoupling (Part 5: The end of USD supremacy – Will it be different this time?)” http://economicsofinformationsociety.com/global-reset-monetary-decoupling-part-5-the-end-of-usd-supremacy-will-it-be-different-this-time/
Phuah Eng Chye (28 August 2021) “Global reset – Monetary decoupling (Part 6: The forthcoming currency war)”. http://economicsofinformationsociety.com/global-reset-monetary-decoupling-part-6-the-forthcoming-currency-war/
Phuah Eng Chye (11 September 2021) “Global reset – Monetary decoupling (Part 7: Currency wargame scenarios)”. http://economicsofinformationsociety.com/global-reset-monetary-decoupling-part-7-currency-wargame-scenarios/
Phuah Eng Chye (25 September 2021) “Global reset – Monetary decoupling (Part 8: Sovereign digital currencies and networks in the currency war)”. http://economicsofinformationsociety.com/global-reset-monetary-decoupling-part-8-sovereign-digital-currencies-and-networks-in-the-currency-war/
Phuah Eng Chye (9 October 2021) “Global reset – Monetary decoupling (Part 9: Information perspectives on digital currencies)”. http://economicsofinformationsociety.com/global-reset-monetary-decoupling-part-9-information-perspectives-on-digital-currencies/
Phuah Eng Chye (23 October 2021) “Global reset – Monetary decoupling (Part 10: CBDC implementation)”. http://economicsofinformationsociety.com/global-reset-monetary-decoupling-part-10-cbdc-implementation/
Phuah Eng Chye (6 November 2021) “Global reset – Monetary decoupling (Part 11: The future of cryptocurrencies)”. http://economicsofinformationsociety.com/global-reset-monetary-decoupling-part-11-the-future-of-cryptocurrencies/
Tanai Khiaonarong, Terry Goh (29 May 2020) “Fintech and payments regulation: analytical framework”. International Monetary Fund (IMF). https://www.imf.org/en/Publications/WP/Issues/2020/05/29/Fintech-and-Payments-Regulation-Analytical-Framework-49086
Thorsten Beck, Yung Chul Park (16 September 2021), “Fostering fintech for financial transformation: The case of South Korea”. CEPR and Korea Institute of Finance. https://voxeu.org/content/fostering-fintech-financial-transformation-case-south-korea
Zhang Yugui (3 June 2021) “Blindspots in the financial regulation of China’s tech platform companies”. Thinkchina. https://www.thinkchina.sg/blindspots-financial-regulation-chinas-tech-platform-companies
 Despite the higher default rates, banks found retail lending to be profitable due to granularity (which facilitated the use of probability and scoring) and high margins.
 See Thorsten Beck and Yung Chul Park for a review of fintech policies.