“Fintech,” or financial technology," is a term that seems to be on everyone's lips these days, from bankers to global finance ministers. Dramatic advances in computing power, speed, interoperability, and nearly instantaneous internet communication are changing the ways banks, brokers, and other financial institutions relate to their customers, investors, regulators, and each other. But what do these changes mean to the future of financial markets and regulation? In February 2017, the International Organization of Securities Commissions (IOSCO) published a document that ambitiously charts the bewildering array of fintech innovations and describes how these innovations are beginning to intersect with securities markets regulation. Based on industry surveys, the report looks at the most important technological innovations affecting global finance and makes some observations about regulatory responses.
IOSCO based its study on a series of three surveys conducted by the organization’s various committees eliciting responses from financial firms spanning the globe. The resulting data led IOSCO to examine fintech trends in five different areas:
- alternative financing platforms
- retail trading and investment platforms,
- institutional trading platforms,
- distributed ledger technologies, and
- the effects of fintech on emerging markets.
Alternative Financing Platforms
IOSCO believes that one of the more notable developments in recent years has been a trend toward disintermediation and the emergence of online alternative financing platforms, particularly peer-to-peer (P2P) lending and equity crowd funding (ECF). P2P lending employs technology to put vastly more borrowers and lenders in direct contact. Likewise, ECF brings together firms and individuals looking for capital and others that have money to invest, opening up equity investing opportunities previously only available to venture capitalists and angel investors to a much wider range of individual investors.
According to the report, P2P lending has grown dramatically, propelled by a series of supply and demand factors including:
- reduced technology costs,
- demand for financing by borrowers previously underserved by traditional lenders,
- low interest rates pushing investors to find alternative sources of return, and
- opportunity for risk diversification afforded to P2P lenders.
IOSCO found that the growth of ECF, though smaller than P2P lending, was driven by similar factors.
Despite their novelty, P2P lending and ECF do not operate outside of regulatory oversight altogether. IOSCO points out that, "P2P lending platforms often are issuers of securities of interests in collective investment schemes, and consequently, often enter the securities regulatory remit.” Firms employing ECF tend to be smaller than those taking the usual IPO route to raise capital. But they are still engaging in public offerings of securities, albeit in a non-traditional way, and regulators have taken notice.
IOSCO has determined initially that these alternative financing platforms are presently too small and insufficiently interconnected to pose systemic risks to the global financial system. But they warn that growth in P2P lending and ECF could in a short time create or transmit risks well outside their more local financial markets.
"As for interconnectedness with other parts of the financial system, securitization of P2P loans is increasing in certain markets such as the U.S., and bank involvement is growing. This opens the P2P lending market to new investment but also connects the rest of the financial market to exposure to packaged P2P loans that are often unsecured. While this segment of the market is still small, and therefore currently not a source of systemic risk, it may warrant continued monitoring."
Retail Trading and Investment Platforms
As technology becomes more ubiquitous and affordable, online investment and trading platforms have become more common as traditional brokerage firms compete to provide their clients with trading and distribution platforms. In addition to online brokerage, asset management, and exchange-based platforms, brokerage firms are now providing their customers with new analysis and comparison tools, automated or artificial intelligence (AI) driven investment advice, as well as ways to interact and share information with others via social media.
IOSCO warns that, as with any online or cloud-based platform, all of these are vulnerable to cybersecurity risks. They also warn that over-reliance on computerized or algorithmically derived investment advice could lead to recommending unsuitable investments on the part of their clients. Computers have come a long way, IOSCO seems to be saying, but they have not yet replaced the judgment of human advisers and brokers. Regulators, IOSCO found, are struggling to marshal the expertise necessary to evaluate investment advice algorithms and AI advice applications.
"As retail trading and investment platforms grow in number and size and the advice rendered and the automation involved becomes more complex, traditional sample audits may become less adequate. Regulators may need to hire specialized staff that understands and can assess the technology and algorithms driving the trading and advice. Regulators may also need to adopt a different approach towards surveillance, including asking for more frequent or different data filings."
Institutional Trading Platforms
IOSCO’s surveys revealed that institutional participants in fixed income markets are more and more employing fintech solutions for electronic trading. They note, however, that multiple and sometimes competing protocols are emerging to promote price discovery, including order books with live and executable orders, session-based trading, and platform-determined midpoint pricing. These new platforms and technology providers are increasingly focusing on identifying and matching firm orders (rather than quotes) and connecting all market participants (including buy-side to buy-side). This proliferation of market protocols and trading venues has introduced a buyer’s dilemma of sorts for institutional investors in the fixed income market, highlighting the need for ways to make these various systems communicate with one another:
"The recent proliferation of electronic trading platforms has created a set of challenges for market participants in identifying which are the best counterparties and platforms to utilize for any given trade. These challenges highlight the importance of addressing connectivity as a market infrastructure issue in order to provide access to appropriate platforms and counterparties, as well as to allow aggregation and search functions across individual liquidity pools.”
The fragmented nature of the fixed income market coupled with recently increased electronification has also raised the importance of integrating these many platforms in order to allow re-aggregation of liquidity across disparate liquidity pools.
IOSCO also notes that regulators’ market monitoring activities have benefitted from the electronification of fixed income transaction data. At the same time, however, regulators face the similar challenges that institutional investors do regarding how to access so many different fixed income trading platforms and how to assess the comparability of the data from each.
Distributed Ledger Technologies
Distributed ledger technologies (DLT) are yet another facet of the move toward disintermediation being driven by fintech. IOSCO’s report finds a dramatic increase in interest in and use of DLT systems by mainstream financial institutions, with 80% of banks predicted to have started DLT initiatives by the end of 2017. The authors point out that there is not just one kind of DLT technology, and banks and financial institutions are still working toward finding and refining DLT systems to make them useful on a large scale. While DLT and blockchain have been functioning in the context of Bitcoin for some time now, application of DLT and smart contracts still need some customization to make them suitable to do things like settle OTC derivatives, track repo transactions and rehypothecation, trade short-term debt, etc.
DLT platforms theoretically could reduce settlement times and costs and increase reliability and traceability of records. They could even benefit regulators by allowing of instantaneous and automatic reporting and creating unalterable audit trails that regulators could monitor at will. DLT is still a very immature technology. And while it may benefit them in the long run, IOSCO believes that most legislators and regulators will not begin to develop oversight policies and regulations unless or until DLT use is more widespread.
Fintech Developments in Emerging Markets
IOSCO found that firms in emerging markets are embracing fintech due to the cheap cost of technology and the proliferation of mobile computing devices. Financial firms in emerging markets no longer have to build an infrastructure to reach customers and potential customers.
"A trend particularly pronounced in emerging markets is the correlation between mobile-based innovation and Fintech development. Close to half of the respondents to the GEMC survey expect mobile and internet technology to drive the growth of digitalisation and innovation in capital markets."
The authors found that firms in these markets are able to harness mobile-based innovation through financial applications that are challenging traditional incumbents (such as banks) and offering online digital banking, investing and lending services. Among these services are P2P lending and ECM, which the surveys revealed were the fastest growing areas because they meet the needs of small and medium-sized entities that are traditionally underserved by banks and other lenders. The report notes that regulators in these emerging markets are struggling to keep up with these new developments, observing a "high divergence of regulatory approaches, likely due to the still nascent nature of these business models and the fact that the full benefits and opportunities, as well as the risks and challenges, are not yet fully known.” IOSCO recommends a continued regulatory dialogue on the evolution of oversight in this area.
Rapid developments in technology and innovation make tracking the evolution of fintech an almost daily challenge. IOSCO’s report provides a thorough snapshot and accurately describes the profound effects that changes resulting from fintech are having on financial markets. They have also identified how fintech trends like disintermediation are pushing regulatory boundaries, bringing with it new risks and rewards as well as a potentially new and technology-driven regulatory landscape.
The full text of IOSCO’s report is available via: http://www.iosco.org/library/pubdocs/pdf/IOSCOPD554.pdf
 The direct contact between counterparties in the P2P context is made possible by computer platforms using algorithms to match putatively suitable borrowers and lenders. IOSCO's research did not assess these platforms, and consequently the report expresses no opinions about their relative strengths and weaknesses.