Financial technologies and systemic risk: Some general economic observations

Anja Eickstädt and Andreas Harsch

Introduction

This chapter is dedicated to exploring the links between financial technology and systemic risk. Thus, it connects two phenomena that, technically speaking, are not inventions of the 21st century, but have become the centre of attention recently. More specifically, the crises that have dominated the financial markets since 2007^[1] have led to the present focus on financial technology and systemic risk.

Leading to the creation of new organisations and rules, financial technology and systemic risk play each already a relevant part in the ever-ongoing institutional change. Linking them might lead to additional institutional change. This primer explores potential linkages in both directions, that is, the potential of fintechs affecting systemic risk as well as systemic risk affecting fintechs. For this purpose, we proceed as follows: Section 2 discusses the evolution of the terms and contents of financial technology and systemic risk critically. Thereafter, Section 3 connects both concepts as described above, focusing on the extent to which fintechs are exposed to systemic risk and to which they can be a source of it. With particular regard to the latter, Section 4 addresses the problem of fintech regulation. Section 5 concludes.

Financial technology and systematic risk: old wine in new bottles?

From financial technologies to fintech

Addressing financial technology and systemic risk involves a particular understanding of both terms. Today, the most common understanding of financial technology refers to financial industry start-ups whose business model is offering specific financial services digitally: these innovative entrepreneurs and their organisations Ate thus called ‘fintechs’.

Although fintechs are a long way from taking over the financial system, they have become fierce competitors of traditional financial intermediaries. One of the most prominent examples showing the importance of fintech is the inclusion of the fintech Wirecard in the central German stock market index in September 2018 and the concurrent removal of traditional universal bank Commerzbank from the DAX.^[2]

Despite the extensive use of the term, there is no consensus on a definition of ‘fin-tech’ so far. As fintechs are start-ups competitors that follow a resolutely technology-based approach to offer selected financial services in innovative ways, they are process innovators according to Schumpeter. Rather than suggesting another definition, the chapter considers actual types of fintechs and their potential links to systemic risk. As they focus on particular products or processes, there are more types of fintechs than of traditional banks. One general systematisation distinguishes as follows:

• • Payment Services Providers not only making financial transfers or transactions faster (real-time transactions), cheaper and smoother (eg, not depending on opening hours or conditions of a stationary bank), primarily resulting from its underlying new technologies, but also providing payment alternatives in the form of virtual currencies.
• • Wealth Managers offering asset management services of different added value from everyday information provision (robo-advice) to automated financial portfolio management, that is, buying and selling securities on behalf of the customer.
• • Lenders helping capital seekers to find providers of capital, usually among private households contributing to (SME) corporate finance (P2B lending), or private finance (P2P lending). The larger the financing transaction’s volume, the more the group of households involved resembles a ‘crowd’, turning the transaction into crowdfunding as well.

• • Capital Market Agents specialised in traditional investment banking areas, such as capital market research, foreign exchange or (securities) trading. In doing so, they provide information and further help connect market participants using new technology, particularly mobile devices.
• • Insurers {'insurtechs') collecting customer data more dynamically and accurately than traditional insurance companies because their technical infrastructure allows them to connect to personal devices and homes of clients (‘Big Data’) and consequently to cover almost every area of an individual’s life around the clock for purposes of risk calculation.^[3]
• • Regulatory Technologies regtechs') encompass two different fintech-related phenomena. First, regtechs represent fintcch firms that provide software solutions for capturing and checking whether specific key figures of a regulated entity meet present and future regulatory requirements (almost) in real-time. Second, regtechs could also be seen as the underlying technology, computer programs, algorithms and interfaces, used by regulators for the supervision of regulated companies (‘suptechs’). Those technologies recognise, comprehend and exchange data more efficiently so that regulators can quickly assess whether firms adhere to the regulatory framework or if interventions are needed.

Fintcch firms could also be grouped according to their size and interconnectedness. Apart from the fintcch prototype of rather small start-ups described above, so-called ‘‘bigtech' or ‘ supertech' firms have evolved. The latter are large technology companies providing financial services or technological infrastructure directly to a vast number of private and corporate clients. At the same time, they employ a massive number of (primarily technical) well-experienced employees and offer self-developed software solutions, giving these firms the chance to grow exceptionally fast.

The focus of fintcchs on (digital) technologies constitutes their distinguishing feature and the most significant competitive advantage over traditional bank intermediaries. Most fintcchs do not strive for a full bank licence that would permit them to offer the complete service portfolio of‘full banks’. They instead prefer to serve niche markets with just a few selected but innovative financial services. This business model might also be partly a result of the fact that since the financial crises starting in 2008, their offline counterparts (banks) have seen a wave of crisis-driven (re-)rcgulation that significantly increased their regulatory burden (ie, transaction cost), making them retreat from some business fields, and thus

Financial technologies and systemic risk 99 opening gaps which fintechs were happy to fill.^[4] However, this raises the question in how far fintechs could - in particular by their insolvency - destabilise the financial system -or be hit by financial instability.

• [1] Of the numerous works on the financial crises since 2007, see the recent compilation of Robert Z Aliber and Gylfi Zoega (eds), The 2008 Global Financial Crisis in Retrospect - Causes of the Crisis and National Regulatory Responses (Palgrave Macmillan 2019). Sec also James R Barth and George G Kaufman (eds), The First Great Financial Crisis of the 21st Century: A Retrospective (Now Publishers 2016). 2 Most seminal on institutional change and also the distinction between rules and organisations are the contributions of Nobel laureate Douglass C North, see eg, Douglass C North, Institutions, Institutional Change and Economic Performance (Cambridge University Press 1990); Douglass C North, Understanding the Process of Economic Change (Princeton University Press 2005). 3 See European Commission, FinTech Action Plan: For a More Competitive and Innovative European Financial Sector Brussels (8 March 2018) COM(2018) 109 final 1, 2.
• [2] See eg, Olaf Storbeck, ‘Commerzbank to Be Replaced by Wirecard in Dax Index* Financial Times (London, 5 September 2018). 2 On the ‘desperate need for a common understanding of the word FinTech’, see Patrick Schueffel, ‘Taming the Beast: A Scientific Definition of Fintech’ (2016) 4(4) Journal of Innovation Management 32, 33. See also Annette Mackenzie, 'The FinTech Revolution’ (2015) 26(3) London Business School Review 50, 50. From a legal point of view, see Gudula Deipenbrock, ‘FinTech: Unbearably Lithe or Reasonably Agile? A Critical Legal Approach from the German Perspective’ (2020) 31(1) European Business Law Review 3, 5-8. 3 See, among others, Mark Carney, The Promise of FinTech - Something New Under the Sun? Speech at the Deutsche Bundesbank G20 Conference on Digitising Finance, Financial Inclusion and Financial Literacy (25 January 2017), later adopted by the Financial Stability Board (FSB), Financial Stability Implicationsfrom FinTech - Supervisory and Regulatory Issues that Merit Authorities’ Attention (27 June 2017) 1, 1, and the Basel Committee on Banking Supervision (BCBS), Sound Practices: Implications of Fintech Developments for Banks and Bank Supervisors (Bank for International Settlements (BIS) February 2018) 1, 8; see also European Commission (n 3) 1,2. 4 See Joseph A Schumpeter, Business Cycles - A Theoretical, Historical, and Statistical Analysis of the Capitalist Process (McGraw-Hill 1923) 87; Joseph A Schumpeter, ‘The Creative Response in Economic History’ (1947) 7(2) The Journal of Economic History 149, 151. 5 See eg, In Lee and Yong Jae Shin, ‘Fintech: Ecosystem, Business Models, Investment Decisions, and Challenges’ (2018) 61(1) Business Horizons 35, 38-40. Common denominator of all fintech types is the use of new technologies or technical infrastructures like cloud computing, artificial intelligence applications, the blockchain, and distributed ledger technologies as well as hereupon based cryptocurrencies or smart contracts. Elaborating these technologies in a legal context, see Deipenbrock (n 5) 3, 20-30.
• [3] 2 Abbreviation for supervisory technologies, mainly used for supervisory purposes, see Simone di Castri and others, The Suptech Generations Financial Stability Institute (FSI) Insights on policy implementation No 19 (BIS October 2019). 3 Following the second definition, see eg, Dong Yang and Min Li, ‘Evolutionary Approaches and the Construction of Technology-Driven Regulations’ (2018) 54(14) Emerging Markets Finance & Trade 3256, 3257; Hedwige Nuyens, ‘How Disruptive Are FinTech and Digital for Banks and Regulators?’ (2019) 12(3) Journal of Risk Management in Financial Institutions 217, 219. 4 See, in particular, BCBS, Sound Practices (n 6) 1, 15; FSB, FinTech and Market Structure in Financial Services: Market Developments and Potential Financial Stability Implications (14 February 2019) 1,21; Nuyens (n 11) 217, 221. 5 See Lee and Shin (n 8) 35, 37.
• [4] Greg Buchak and others, ‘Fintech, Regulatory Arbitrage, and the Rise of Shadow Banks’ (2018) 130(3) Journal of Financial Economics 453, 453 et seqq. 2 Extensively, see the works of Charles P Kindleberger (1910-2003), in particular, Robert Z Aliber and Charles P Kindleberger, Manias, Panics, and Crashes: A History ofFinancial Crises (Palgrave Macmillan 2015). For a brief retrospective on financial crises, see Franklin Allen and Douglas Gale, Understanding Financial Crises (Oxford University Press 2007) 2-5. 3 Ground-breaking empirical contributions have been those of Robert G King and Ross Levine, see eg, Robert G King and Ross Levine, ‘Finance and Growth: Schumpeter Might Be Right’ (1993) 108(3) Quarterly Journal of Economics 717, 717 et seqq.; Robert G King and Ross Levine, ‘Financial Intermediation and Economic Development’ in Colin Mayer and Xavier Vives (eds), Capital Markets and Financial Intermediation (Cambridge University Press 1993) 156; retrospectively, see also Xavier Freixas, Luc Laeven and Jose-Luis Peydro, Systemic Risk, Crises, and Macroprudential Regulation (Cambridge University Press 2015) 49, with further references. 4 See Douglas W Diamond and Philip H Dybvig, ‘Bank Runs, Deposit Insurance, and Liquidity’ (1983) 91(3) Journal of Political Economy 401,401 et seqq. Extensively on financial contagion, see the eponymous paper of Franklin Allen and Douglas Gale, ‘Financial Contagion’ (2000) 108(1) Journal of Political Economy 1, 1 et seqq., also their book chapter on contagion in Allen and Gale, Understanding Financial Crises (n 15) 260-295. 5 For an early yet extensive overview, see Olivier de Bandt and Philipp Hartmann, ‘Systemic Risk: A Survey’ (November 2000) European Central Bank (ECB) Working Paper No 35 1, 1 et seqq. For a more recent synopsis, see Sylvain Benoit and others, ‘Where the Risks Lie: A Survey on Systemic Risk’ (2017) 21(1) Review of Finance 109, 109 et seqq.