Fintech’s Explosive Growth Has Regulators Scrambling

(Bloomberg Businessweek) -- “There are more things in heaven and Earth, Horatio, than are dreamt of in your philosophy,” says Hamlet. The parallel in today’s mobile banking market might be, to quote one startup founder: “There are more financial products for more consumers than you could ever imagine.”

Browse potential homes for sale, and Zillow will offer you a mortgage. Buy a pair of sneakers online, you’ll be presented with 16 ways to pay at checkout, from Apple Pay to Klarna. See a stock tip on Reddit, and you can act on it, commission-free, on Robinhood. Should you want to deposit your paycheck directly into cryptocurrency trading app Coinbase, you’ll be able to. (Please don’t.)

If you want a no-frills bank account or something close to it, several hundred are vying for your attention: BankMD for physicians, Cheese for Asian Americans, Lili for freelancers. Insurance policies, employer-sponsored pensions, and portfolio management are now apps. There are 326 fintechs out there, according to one database, from one-stop shops such as PayPal Holdings Inc. and Revolut Ltd. to behind-the-scenes payment processors like Stripe Inc. and Adyen NV.

The bewildering array of financial services available at a finger tap is something way more radical than the decade-old Apple Inc. slogan of “there’s an app for that.” The new companies aren’t like your parents’ fintech: Our post-pandemic online lives, combined with the power of bounteous venture capital from such outfits as SoftBank Group Corp., are pushing digital finance deeper into our wallets than the Venmo-style bill-splitting services of old.

Zillow Group Inc. is buying houses. Square Inc. offers business loans. Such buy now, pay later firms as Klarna are turning checkout credit into something frictionless, cardless, and potentially careless. Fintech companies now originate 38% of U.S. unsecured personal loans, up from 5% in 2013. Plentiful funding also allows them to woo clients with better savings rates than banks.

Money and data travel at warp speed, compressing space and time, with less need for human intervention and more demand for products to manage the flow. In the minds of techies, this is a revolution in inclusion and democratization for those left behind by 20th century banks. Fair enough: If the best tech is like magic, banking hasn’t been magical for some time. Startups are clearly better at ginning up efficiency through innovation.

But when instant gratification meets people’s pocketbooks, risks start to sneak in. Buy now, pay later programs get more people to buy more things, but data in Australia found 1 in 5 users paying late fees after missing repayments—hardly a boon for equality. Robinhood Markets Inc., the enabler for Reddit-fueled day traders, was fined $70 million by the Financial Industry Regulatory Authority over misleading information and weak trading controls. The war for customers means fintech firms lend to people more likely to default, one study found.

Fintech firms’ use of data and models may also have benefited from the lack of a long economic downturn. “Risks associated with lending haven’t been tested,” says former hedge fund manager Marc Rubinstein. Federal Deposit Insurance Corp. data show that from 2009 to 2014 there were 482 U.S. bank failures, but only 29 since 2015. And in a world where technology is winner-take-all, the algorithms that drive fintech success could start to feel as exclusionary as the banks they seek to replace. Their power is already being blamed for pushing up home prices and discriminating against women and minorities.

This all adds up to a regulatory headache as governments struggle to hold the reins of a sector that’s growing fast and offers plenty of reward but also plenty of risk. The Covid-19 pandemic coincided with headline-grabbing fintech failures—payments firm Wirecard AG and supply chain finance company Greensill Capital—where red flags went unnoticed. The job of having to beef up rules after each crisis isn’t made easier by politicians calling on the tech sector to keep churning out unicorns to boost jobs. “When it comes to regulation, I worry,” says economist Eswar Prasad, a Cornell professor and author of The Future of Money. Regulators “seem to get overtaken by rapid developments.”

Fintech’s disruptive potential was unleashed in mature markets such as the U.S. only recently, thanks to a confluence of factors: low interest rates, better technology, rising consumer demand, and a more permissive attitude toward nonbank finance. Efficiency gains in software have kept products coming. The relentless march of e-commerce has boosted demand for new ways to pay. And venture capital is the fuel: Global VC funding in fintech reached a record $52.3 billion in the first half of this year, according to KPMG. Since 2010, fintech has raised $1 trillion in equity.

All that money pressures startups to keep growing at breakneck speed—and explains the shift from plain-vanilla payments products to more heavily regulated financial activities, according to Victor Basta, chief executive officer of investment bank DAI Magister. Regular bank accounts don’t keep people swiping, unlike the stuff keeping users awake at night: crypto trading, investing, shopping, and loans.

The pandemic was a key moment for the sector, as more people were forced to turn to their smartphones for essentials (government benefits and savings) and not-so-essentials (storming the barricades of GameStop Corp.). The fintechs that passed the test have seen their valuations soar: Stripe ($95 billion), Klarna ($45.6 billion), Revolut ($33 billion), and Nubank ($30 billion) rank among the 10 most valuable privately owned unicorns in the world. On the stock market, PayPal is worth $305 billion, Square $108 billion, and Adyen €73 billion ($84 billion).

Traditional banks have been playing defense but also striking deals. Banks are one of fintech’s big funding sources: Goldman Sachs Group Inc. and Citigroup Inc. participated in 69 and 51 fintech deals, respectively, from 2018 to 2020. Some startups have chosen to become licensed banks themselves, while big tech companies encroach into financial territory from the other direction: Amazon.com Inc. offers payments, credit, and insurance with partner firms.

And the complexity of financial regulation has opened doors for tech startups. Some have exploited rules such as the Durbin Amendment, which allows smaller banks to make more money from card payments. Others have profited from laws intended to improve competition, such as European Union rules giving fintech companies access to bank account data.

The stunning collapse of Wirecard shows how easy it can be to run rings around regulators. Here was a German bank with access to deposits, a U.K.-regulated e-money institution, and a payments firm on Visa Inc.’s and Mastercard Inc.’s networks, yet nobody acted on the red flags.

China—which had a head start on the U.S. and Europe in fintech, thanks to years of cultivating revolutionary platform companies such as Alibaba and Tencent—is likely the country to watch. After a string of fintech scandals in the mid-2010s, the government is cracking down on the platforms for perceived monopolizing of sensitive data and hindering fair competition.

Governments have to do more to reduce the risks while amplifying the benefits of fintech innovation. Stronger consumer protection and improvements to financial literacy would help. Regulators are also trying a more active approach to technology, offering sandbox-type controlled environments where fintech firms can experiment and grow. But it’s hard to escape the feeling that a lot of the risks coming down the pike are unpredictable and many-headed and that regulators won’t keep up. With central bankers determined not to be disrupted in their management of the economy, perhaps another line from Hamlet will prove prescient: “Neither a borrower nor a lender be.”
 
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