October 20, 2017

DTCC Explores Impact of FinTech on Global Systemic Risk

The Depository Trust & Clearing Corporation ("DTCC") published a brief survey on the current state of FinTech and a framework of nine factors to consider in assessing how specific FinTech applications may impact financial stability.

In a Report (the "Report") titled FinTech and Financial Stability – Exploring How Technological Innovations Could Impact the Safety & Security of Global Markets, DTCC provides the following theses: FinTech developments (i) have the potential to enhance, transform and/or disrupt business models and markets, (ii) are still in the early stages of experimentation and development, (iii) have the potential to be unusually transformational, (iv) are charting a path that is highly unpredictable (as ramped-up investments now are likely to generate rapid transformations in five to ten years), (v) must be assessed on a case-by-case basis as they occur and may be systemically beneficial or harmful, and (vi) require coordination by policy makers.

With a focus on mitigating the risks, the Report provides a list of nine key factors to consider when evaluating a FinTech offering's potential to impact financial stability:

  • The impact on provision of core banking functions. FinTech companies that provide core banking functions may contribute to diversification of credit and liquidity risk, but also could create systemic vulnerabilities due to their short track records and lack of banking experience. DTCC notes that companies in this space currently are not predominantly balance sheet lenders, which limits their impact on financial contagion through the credit or liquidity channel.

  • The level of fragmentation. While unbundling of financial services through FinTech innovations may lead to increased competition and lowered fees, it can also fragment delivery of financial services. This could potentially exacerbate cybersecurity risk, complicate determinations of liability for distributors and manufacturers of financial services, and otherwise hinder efficiency.

  • The impact on concentration risk. With the rise of FinTech, some market segments or geographies may become increasingly concentrated while others become more diverse. The impact on risk will depend on levels of concentration and substitutability.

  • The impact on substitutability. Substitutability must be evaluated on an ad hoc basis, as substitutability of FinTech offerings depends on a variety of factors.

  • The effect on financial interconnectedness. FinTech developments typically increase financial interconnectedness on several levels, which has the potential to facilitate lower concentration risk and higher resilience but can create new points of failure and introduce additional cybersecurity risk.

  • The degree of competition vs. cooperation between FinTech firms and incumbents. Although FinTech companies initially competed with each other, the partnership model is now more common. Cooperation is more likely to promote stability as competitive pressures could adversely affect profitability and spur increased risk-taking.

  • The degree of reliance on automated decision-making processes. There are risks related to over-reliance on automated financial services processes. These include the potential for complex data-driven algorithms to (i) produce errors that human judgment would not and (ii) conceal biases.

  • The sustained growth and adoption of FinTech services. The FinTech sector is experiencing exponential growth, but its ultimate impact on financial services is difficult to predict. The ultimate outcome of FinTech's evolution will greatly influence its effect on systemic risk.

  • The evolution of the regulatory environment. Policy decisions and regulatory actions will be crucial in determining the evolution of FinTech. The ability of regulators to manage risk while facilitating enhancements to the financial services industry is extremely important. Cross-border harmonization is also a factor.

Commentary

The DTCC Report is a thoughtful addition to the debate on FinTech and is worth reading. The DTCC is not an entirely disinterested observer but, as a non-bank market intermediary making very significant technology investments, its perspective is unusually well-informed. The Report also provides a useful bibliography and appendices on work in the space.

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