How Should We Regulate Fintech?

William Magnuson is an Associate Professor at Texas A&M Law School. This post is based on a recent article by Professor Magnuson, forthcoming in the Vanderbilt Law Review.

In the last decade, financial technology (or “fintech”) has revolutionized the way that finance works. Robo-advisors have turned the art of investing into an automated process run entirely by algorithms. Crowdfunding firms have harnessed the wisdom of crowds to make it easier than ever for individuals and companies to raise capital. And virtual currencies such as Bitcoin have emerged to challenge the very idea of money.

But how does the changing landscape of finance affect our views of the industry? Does fintech present different risks and concerns than those raised by more conventional financial institutions? And, just as importantly, does current financial regulation adequately address these risks and concerns?

In a recent article, Regulating Fintech, I argue that existing financial regulation fails to take into account the rise of fintech and the fundamental changes it has ushered in on a variety of fronts, from the way that banking works, to the way that capital is raised, even to the very form of money itself. These changes call for a wide-ranging reconceptualization of financial regulation in an era of technology-enabled finance. In particular, I argue that regulators’ focus on preventing the systemic risk associated with “too big to fail” institutions overlooks the conceptually distinct systemic risks associated with small, decentralized fintech markets.

The global financial crisis of 2008 ushered in the most sweeping reform of financial regulation in the United States since the New Deal. Alarmed by the systemic risk that financial institutions posed to the broader economy, as well as perceived abuses engendered by the “too big to fail” mindset among banking executives, legislators moved quickly to impose a slew of new requirements on the financial sector. These reforms, passed under the umbrella of the Dodd-Frank Act, drastically altered the regulatory landscape for financial institutions. Wall Street firms found themselves subject to a bewildering array of new regulatory requirements, from restrictions on proprietary investing (the so-called Volcker Rule) to obligatory stress testing of banks’ ability to withstand various crisis scenarios to more stringent reporting requirements.

But the rise of fintech poses a challenge for this financial framework. The Dodd-Frank reforms aimed primarily at preventing traditional banks from repeating the excesses of the pre-crisis era. They labeled certain financial institutions “systemically important” and imposed a variety of reporting and structural requirements on these actors. They created new regulators to police Wall Street and protect investors from their depredations. But they did not foresee the shift away from Wall Street that fintech firms had already started. The locus of financial services is becoming increasingly de-centralized, with more and more areas of the financial sector being provided by small smart-ups focused on narrow segments of the financial market. The financial reforms of the post-crisis years are ill-suited to handle the challenges presented by this new model of financial institution.

The rise of fintech undermines the widespread assumption that the primary source of systemic risk in the financial sector is the domination of large, “systemically important” banks and other financial institutions. This conventional view is based on a few simple observations. Large banks have grown to such gargantuan proportions, and have become so intricately connected with other sectors of the economy, that their failure would have drastic consequences on economic growth and activity. Governments, aware of this fact, thus have strong incentives to bail out struggling banks that are deemed “too big to fail.” This fact alone, of course, might not be cause for concern—ex post, it is quite rational and, indeed, desirable for governments to act to protect their citizens from economic harm. But ex ante, the knowledge that governments will do so has important, and perverse, effects on decisionmaking. In particular, it incentivizes excessively risky behavior by banks and their counterparties, who recognize that the implicit government guarantee for large banks insulates them from any harmful repercussions of their risky behavior. This dynamic came to a head in the financial crisis of 2008, when risky bets on the subprime housing market, shoddy lending standards, and the widespread use of complex derivatives led to unprecedented losses in the financial sector. Ever since, the guiding principle of financial reform has been that systemic risk is a product of large, dominant financial institutions and the “too big to fail” phenomenon. This belief has led to significant shifts in both substantive regulation and regulatory priorities.

But this conventional wisdom about the source of systemic risk in the financial sector underestimates the extent to which systemic risk can be generated, not just by large, concentrated actors, but by small, disaggregated ones. Markets characterized by atomized and decentralized actors present unique risks, ones that may be more worrisome than the risks presented by centralized markets. And regulations aimed at preventing the risks of centralization may lead to increases in the risks associated with decentralization.

Fintech presents a particularly acute problem from the perspective of systemic risk for three reasons. First, fintech firms, because of their size and business model, are more vulnerable to adverse economic shocks than large financial institutions, and those shocks are more likely to spread to other firms in the industry. Second, fintech firms are more difficult to monitor and constrain than typical financial institutions because regulators lack reliable information about the structure and operations of fintech markets. Third, fintech markets suffer from collective action problems that inhibit cooperation among market actors. All of these problems suggest that fintech presents a set of regulatory concerns that are different from, and in many cases more severe than, the concerns presented by more conventional financial institutions.

I conclude the article by sketching out a set of reforms that better correspond to fintech’s particular risks and rewards. Among other things, financial regulation should be revised to (1) produce more and better information about fintech companies; (2) limit the mechanisms by which contagion may be propagated in fintech markets; (3) incentivize better self-policing of problematic behaviors in fintech markets; and (4) improve international coordination and communication. These reforms would go a long way towards reducing the systemic risk that fintech poses to the broader economy.

The complete article is available for download here.

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