FinTech and the law and economics of disintermediation
Fatjon Kaja, Edoardo D Martino, and Alessio M Pacces
Financial technology and disintermediation
Are banks dead? Or are the reports greatly exaggerated: Boyd and Gertler’s title article has managed to stay coherent after a quarter of a century, pushing one to rethink the dimensions of the banking industry and its future. Boyd and Gertler’s dismissal of the growing consensus according to which disruptive financial innovation, such as securitisation, was about to erase the need of banks as financial intermediaries was novel and unorthodox, but time shows us that they were right; the reports were greatly exaggerated, as the banking industry exhibited resilience and adaptiveness to technological developments.
History does not repeat itself, though we cannot help but note some similarities with the current fever for FinTech and financial applications of the blockchain technology. However, the two waves of innovations differ in scale and in scope. In fact, the current technological step forward is arguably bigger, and its target is financial intermediation as a whole.
This chapter will discuss the wave of technologically enabled disintermediation of financial services, which is broadly referred to as FinTech. We take a law and economics approach, consisting of two questions. First, what market failures does FinTech involve? Second, how can FinTech regulation cope with such market failures?
Financial intermediation refers to a heterogeneous set of financial services that facilitate the efficient allocation of funds and are carried out through professional intermediaries. Financial intermediation is costly. Despite financial and technological innovation this cost has remained relatively constant over the past 130 years.’ A broad distinction can be drawn between bank and non-bank intermediation. Banks perform Qualitative Asset Transformation (QAT) via the balance sheets, turning their short-term, liquid and safe liabilities into long-term, illiquid and risky assets. Non-bank financial intermediaries providea variety of services to facilitate participation in financial markets, matching sellers and buyers without transforming their claims.
FinTech can be defined as the use ofinformation technology to provide financial services alternative to those that financial intermediaries offer. Huge technological developments have created the possibility to provide services that were not even imaginable until a few years ago: from digital wallets for payment (eg, PayPal), to cryptocurrencies (eg, Bitcoin), to investment advice through automated algorithms (eg, ‘Robo-advice’) and many more.
Information technology can achieve significant efficiency improvements compared to traditional financial intermediation. First, it can reduce transaction costs, making financial exchange more efficient. Think, for instance, of faster and cheaper money transfers via digital wallets and lower operating costs of Peer-to-Peer (hereinafter ‘P2P’) and Peer-to-Business (hereinafter ‘P2B’) lending platforms compared to bank loans. Second, information technology can reduce information asymmetries, exploiting the growing computation powers and the amount of available data, for instance in the case of Big-Data automated credit scores. Third, information technology can provide some liquidity advantages, notably by improving the efficiency of the payment system and the transmission of monetary policy.
This chapter focuses on the risks associated with disintermediating finance via FinTechs. Financial intermediaries are regulated because the industry is particularly prone to market failures. Disintermediation potentially challenges this regulation.
Financial regulation pursues two goals in general: (1) financial stability and (2) investor protection. On the one hand, regulation deals with the negative externalities that the instability of financial institutions, banks in particular, cause. Qualitative Asset Transformation, while fostering lending and thus economic development, makes banks inherently fragile and exposed to runs on short-term, money-like debt. Moreover, banks arc leveraged and interconnected institutions, so that the failure of one can trigger contagion and generate large adverse consequence for the whole financial system and the real economy, as the failure of Lehman Brothers in 2008 exemplified. On the other hand, investor protection regulation addresses problems of asymmetric information between investors, intermediaries and borrowers which in many cases means between unsophisticated and professional market participants. If investors fear that their funds are not safe and that there is potential for fraud, then they will avoid investing in the first place.
Therefore, the first law and economics question addressed in this chapter is: will technology-enabled financial innovations generate market failures or worsen existing ones? Without the ambition to answer this question conclusively, this chapter focuses on two types of intermediation, one related to banks and the other to investment services. FinTech promises to increase competition for both banks and investment firms. More competition is usually welcomed as it fosters innovation, improves quality and reduces prices. However, in the financial industry, more competition may undermine financial stability and investor protection. This can happen both directly through FinTechs, and indirectly through the adjustments incumbent intermediaries implement to maintain their competitive edge. This brings to the second law and economics question: is the current regulatory framework efficient?
This chapter will articulate the theoretical framework to answer these questions, highlighting the role financial regulation plays and making recommendations on the legal tools and strategies to determine the optimal level of disintermediation. The scope of the analysis is particularly broad. Therefore, we do not strive to be exhaustive. This chapter will only lay down the analytical foundations to discuss different FinTechs and their regulatory implications.
This chapter is structured as follows: Section 2 discusses disintermediation of banking services. It highlights the crucial features of banking intermediation and focuses on two distinct cases of disintermediation: P2P Lending and cryptocurrencies. Section 3 discusses disintermediation of investment services and focuses on the opportunities and challenges of disintermediating non-banking services. Section 4 presents the law and economics analysis in two parts: first, the market failures of FinTechs and second, a regularity strategy towards FinTechs. Section 5 concludes.
-  Although this chapter is entirely the result of joint work, Sections 2 and 3 should be attributed to Edoardo Martino. We thank Balazs Bod6, Iris Chiu, Gudula Deipcnbrock and Luca Enriques for valuable input and feedback. All errors are our own. 2 John H Boyd and Mark Gertler, ‘Are Banks Dead? Or Are the Reports Greatly Exaggerated?’ (National Bureau of Economic Research 1995). 3 This adaptiveness had costs attached to it. Sec Gary Gorton and Andrew Mctrick, ‘Securitized Banking and the Run on Repo’ (2012) 104 Journal of Financial Economics 425. 4 Alessio M Pacces, ‘A Law and Economics Perspective on Normative Analysis’ in Sanne Taekema et al. (eds), Facts and Norms in Law (Edward Elgar Publishing, 2016) 171. 5 Thomas Phiiippon, ‘Has the US Finance Industry Become Less Efficient? On the Theory and Measurement of Financial Intermediation’ (2015) 105 American Economic Review 1408. 6 Sudipto Bhattacharya and Anjan V Thakor, ‘Contemporary Banking Theory’ (1993) 3 Journal of Financial Intermediation 2.
-  Franklin Allen and Anthony M Santomero, ‘What Do Financial Intermediaries Do?’ (2001) 25 Journal of Banking & Finance 271. 2 Anjan V Thakor, ‘Fintech and Banking: What Do We Know?’ (2020) 41 Journal of Financial Intermediation 100833, 1. 3 One of the main reasons for the existence of financial intermediaries is to cope with the information asymmetry problem, where perspective lenders cannot reliably distinguish good from bad borrowers. See, Richard Brealey, Hayne E Leland and David H Pyle, ‘Informational Asymmetries, Financial Structure, and Financial Intermediation’ (1977) 32 The Journal of Finance 371. Another issue related to intermediaries and information asymmetry relates to relationship banking and its benefits. See Arnoud W A Boot and Anjan V Thakor, ‘Can Relationship Banking Survive Competition?’ (2000) 55 The Journal of Finance 679. These aspects will be better detailed in Section 2. 4 The net contribution of FinTechs to liquidity is unclear, as many technological applications (eg, cryptocurrencies) seem to dramatically increase volatility. 5 See Markus Konrad Brunnermeier and others, The Fundamental Principles of Financial Regulation (ICMB, Internal Center for Monetary and Banking Studies 2009) Vol 11. 6 John Armour and others, Principles of Financial Regulation (Oxford University Press 2016) Ch 3. 7 Douglas W Diamond and Philip H Dybvig, ‘Bank Runs, Deposit Insurance, and Liquidity’ (1983) 91 Journal of Political Economy 401. 8 For a functional overview of the main cornerstones of financial regulation, see Brunnermeier and others (nil).
-  For a comprehensive introduction, see Armour and others (n 12) Ch 5. 2 Notably, the UK Financial Conduct Authority has promotion of competition in the financial sector as an additional goal to the aforementioned ones. Whether these objectives are compatible and how to strike the appropriate balance between them remains an open question. Stephen Dickinson, David Humphry, Paolo Siciliani, Michael Straughan and Paul A Grout, ‘The Prudential Regulation Authority’s Secondary Competition Objective’ (2015) Bank of England Quarterly Bulletin, Q4. 3 Allen and Santomero (n 7) 273.