Fintech as a Systemic Phenomenon

Saule T. Omarova is Professor of Law at Cornell University. This post is based on a recent paper by Professor Omarova.

Fintech is the hottest topic in finance today. Bankers are racing to adopt it, policymakers are debating how to facilitate it, investors are pouring money into it, and academics are writing about it. Fintech is visibly “disrupting” the way we conduct financial transactions. Invisibly, it is also changing the way we think about finance. The rise of fintech is gradually recasting our shared understanding of the financial system in seemingly objective terms, as simply another sphere of targeted application of normatively neutral information technologies and computer science. Targeting solutions for concrete “frictions” in market transactions, fintech refocuses our attention on clearly functionally defined, programmable business processes and tools, rather than complex systemic dynamics and difficult policy tradeoffs. By making financial transactions faster, cheaper, and more easily accessible, new technology promises not only to eliminate all manner of market inefficiency but also to democratize finance. In short, it promises a micro-level “win-win” solution to the financial system’s many ills.

My new working paper, New Tech v. New Deal: Fintech as a Systemic Phenomenon, challenges these narratives and offers an alternative account of fintech as a systemic, macro-level phenomenon. Widening the lens beyond the mere transactional effects of specific technologies, the paper examines the rise of fintech as an integral part of, and a logical stage in, the nearly century-long development of modern financial markets and regulation. This shift in perspective exposes a far more complex interplay between disruption and continuity in the process of financial and technological innovation. It also reveals the deeper normative and political significance of the current fintech moment as a potentially transformative point in the underlying public-private balance in the financial system.

This balance is a product of what I call the New Deal settlement in finance: a politically-derived set of judgments about the optimal division of public and private actors’ core powers, competencies, and functions in the financial market. Under this arrangement, which took its institutional shape in the U.S. during the New Deal era and has since been largely replicated in most advanced economies, private market actors retain control over substantive decisions on how to allocate financial capital to various productive uses—and thus the ultimate power to determine the volume and structure of financial claims in the system. The public, on the other hand, bears the primary responsibility for maintaining the overall stability of the financial system and enabling markets to function smoothly and efficiently. Government regulation is the indispensable mechanism through which the public manages the obvious moral hazard built into this arrangement.

The practical difficulty of neatly separating these two intimately connected functions—allocation and modulation of credit-money in the financial system—explains the fundamental tension at the core of the New Deal settlement. In essence, the entire history of U.S. financial markets and regulation since the New Deal era has been the history of continuous renegotiation and readjustment of this underlying public-private boundary. Driven by their economic incentives, private market actors continuously seek to expand their freedom to create and trade financial claims. To the extent regulation lags behind these efforts, the scope and intensity of public backing of financial risk increases disproportionately to its ability to control private risk generation. The history of “financial innovation” since the 1980s and the global financial crisis it brought about in 2008 aptly illustrate the corrosive effect of these dynamics on the New Deal settlement.

Rather than repeating this familiar story, however, the paper offers a coherent conceptual framework for explaining these deep-seated market dynamics. The paper deliberately shifts the analytical focus from primary markets, in which firms raise capital by issuing financial claims, to secondary markets in which such claims are traded. The paper shows how the fundamental public-private division of roles under the terms of the New Deal settlement renders secondary, rather than primary, markets the principal sites of both relentless “innovation” and chronic over-generation of systemic financial risk. It also explains why secondary markets in financial assets currently dwarf primary markets in terms of size, complexity, and systemic significance. Therefore, the paper posits, the key to understanding what drives today’s complex financial system is to understand what drives the continuous growth and proliferation of secondary markets.

Operationalizing this insight, the paper identifies the principal mechanisms and techniques that enable private actors to create and grow—continuously and virtually unconstrained—secondary markets for financial risk trading. It argues that, at the most abstract level, the growth of financial markets is best understood by reference to two interrelated system-wide practices: (1) continuous synthesizing of new tradable financial assets, and (2) scaling up the volume and velocity of trading activity in financial markets. Furthermore, the paper offers a novel taxonomy of core mechanisms, or transaction meta-technologies, used to synthesize financial assets and to scale up financial transactions: pooling and layering of claims, and acceleration and compression of trades.

As the paper shows, system-wide deployment of these core transactional techniques enables the constant growth and complexification of the financial market. By the same token, it magnifies the extent and urgency of the public’s obligation to accommodate privately created claims and to manage macro-financial risks. In this sense, these four principal mechanisms for synthesizing financial assets and scaling up trading activity—pooling, layering, acceleration, and compression—persistently undermine the delicate public-private balance at the heart of the New Deal settlement.

The paper examines today’s key fintech applications—cryptocurrencies, distributed ledger technology, marketplace lending, initial coin offerings (ICOs), and robo-advising—from the perspective of their potential to facilitate and amplify these long-standing systemic trends and tensions in finance. Without drawing definitive conclusions, it argues that these new technologies are poised to skew the balance further in favor of private actors’ unrestrained freedom to generate—and over-generate—financial risk. In particular, the paper shows how new technological tools enable private market participants to engage in the continuous synthesizing of crypto-assets that are (a) untethered from, and thus unconstrained by, any productive activity in the real economy, and (b) tradable in potentially infinitely scalable virtual markets. What is commonly seen as the key micro-level advantage of fintech—its ability to eliminate transactional “frictions” and to circumvent traditional market boundaries—also operates to boost the system’s capacity to fuel financial speculation on an unprecedented scale. On a macro-level, therefore, the key risk posed by fintech lies in its—still not fully known—potential to exacerbate the financial system’s dysfunctional tendency toward unsustainably self-referential growth.

To be clear, the purpose of my paper is not to over-dramatize potential dangers, or to deny potential benefits, of fintech. It is still too early to predict what fintech’s ultimate impact on society is going to be, or what specific risks individual technologies are going to pose to financial stability. It is critical, however, to take an informed systemic view of the unfolding fintech “revolution” well before these risks materialize—and to start thinking about the ultimate viability of the nearly century-old political arrangement underpinning our rapidly transforming financial system.

The complete paper is available for download here.

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