Fintech and financial stability

Adrien Vanderlinden, Systemic Risk Executive, DTCC walks us through the firm's recent white paper on Fintech and Financial Stability, exploring how technological innovations could impact the safety and security of global markets. We also feature a video with Michael Leibrock, Managing Director, DTCC.

From the introduction of electronic stock trading in the 1970s to the rise of bank mainframe computers and the advent of high-frequency trading around the turn of the millennium, technology continues to transform the financial services industry.

Today, firms are applying distributed ledger technology, machine learning, artificial intelligence and other technological innovations – collectively known as “fintech” – in their never-ending pursuit to streamline processes, reduce frictions and drive down costs.

Much of the rhetoric around fintech has focused on its potential to serve clients better and faster – by disintermediating traditional providers and disaggregating their services. While fintech undeniably holds tremendous promise in these areas, little attention has been devoted to understanding how these technological innovations could impact financial stability.

The reality is that fintech could have far-reaching implications – in ways that could either exacerbate or mitigate risks. The 2012 Knight Capital incident, where the malfunction of an order routing system resulted in a US$440 million loss that was incurred in less than one hour, is a striking example of how quickly this type of risk can materialize. But fintech applications can also reduce risk, for example by facilitating regulatory compliance or by creating more resilient financial networks.

Now is the time to expand the discussion to include potential systemic risks posed by these innovations and to take a closer look at how they would affect financial stability. The fundamental challenge – for regulators and practitioners alike – is to balance fintech’s transformative potential with appropriately prudent risk management practices. And this challenge will only grow more important as the fintech industry continues to grow, fueled by the multi-billion-dollar investment flows it keeps attracting month over month.

Assessing Fintech and Financial Stability

Determining the impact of fintech on financial stability requires assessing how each individual application may affect the various dimensions of systemic risk.

To that end, DTCC has identified nine key factors to help evaluate how specific fintech applications could affect financial stability:

1. The extent to which fintech companies seek to perform core banking functions: While fintech companies that provide core banking functions could enhance financial stability by diversifying credit and liquidity risk, their short track record and relative lack of banking experience could also create systemic vulnerabilities in times of market stress.
2. The level of fintech-related fragmentation: The unbundling of financial services that is associated with the rise of fintech may benefit clients through increased competition and lower fees. At the same time, it may fragment the creation and delivery of financial services across additional providers and platforms, which could substantially exacerbate operational risk.
3. The impact of fintech on concentration risk: The growth of fintech could lead to a small cluster of dominant players in specific market segments, which could create pockets of concentration risk.
4. The substitutability of fintech services: Substitutability is a key concept in assessing systemic risk. Financial services that are highly substitutable (i.e., services that can easily be replaced in case a provider fails) create less systemic risk than those that are not. As such, it is important to assess to what extent a given fintech provider could be easily substituted if it were to fail.
5. The effect of fintech on financial interconnectedness: The interconnectedness of financial service providers could have a significant impact on financial stability. Therefore, it is critical to analyze how fintech developments affect financial networks.
6. The degree of competition vs. cooperation between fintech firms and incumbents: All else being equal, an environment where fintech companies and incumbents cooperate in mutually beneficial arrangements is more likely to promote financial stability than an environment characterized by outright competition.
7. The degree of reliance on automated decision-making processes: Overreliance on purely data-driven algorithms could lead to errors that may not have occurred in an environment that involves more human judgement calls. It may also be exceedingly difficult to discover hidden biases and address other potential flaws in decision-making algorithms that are based on artificial intelligence, given their opacity and complexity.
8. The sustained growth and adoption of fintech services: The impact of fintech will also depend on the extent to which the technology becomes a mainstream part of the financial ecosystem and to what extent it will ultimately be used for delivering critical financial services.
9. The evolution of the regulatory environment: Policy decisions and regulatory actions will largely determine to what extent fintech will affect financial stability for years to come.

At this point, the impact of fintech on financial stability still appears to be minimal. However, given fintech’s rapid and unpredictable growth, this could change quickly. As such, it is important to carefully monitor fintech developments. As new fintech offerings continue to evolve at breakneck speed, the remit of the risk management function must keep pace in order to identify emerging threats on a timely basis. The factors described above should help guide that process.

Read the full white paper here.

Watch this accompanying video, where Michael Leibrock, Managing Director, DTCC shares his perspective on how DTCC assesses and manages systemic risk.