Technological innovation in financial services has the potential to transform the financial system. That’s a good thing if it leads to better and cheaper services for people and businesses and the risks are properly managed.
It’s clear that change is in the air. Customers are more demanding these days. They want financial services that mesh well with their mobile devices and online activities. Large, well-funded companies like Apple and Google are starting to offer financial services. And the combination of inefficient legacy systems of the incumbents and new technology has opened the door even wider to competition.
That’s left people wondering just how much and how fast the financial landscape will change.
It’s early days, so no one knows for sure. I think that, even though some of the technology may be revolutionary, its overall effect on the financial system is likely to be evolutionary.
That’s because the most transformative technologies, like distributed ledger technology (DLT), still have many hurdles to clear. That gives financial institutions time to adapt as new service providers join the financial ecosystem.
In the end, those with the best business models will survive.
Change is coming
I know that some readers envision a future in which decentralized currencies will replace state currencies. It’s an edgy idea, but I think this is highly unlikely, if for no other reason than they can’t outshine the competition as a store of value and a medium of exchange. And national authorities will want to continue to implement an independent monetary policy.
Applications outside of digital currencies – payments, trade finance, among others – appear more promising. In some cases, the benefits could extend beyond efficiency and cheaper processing, to reduce counterparty risk, free up capital for other uses and increase transparency.
That’s why companies are investing a lot of money and effort into this type of technology. And since the Bank of Canada oversees core financial market infrastructure and participates in the payments system, the potential for change is pushing us to take a closer look.
So, we’re partnering with Payments Canada, Canadian banks and R3 to test drive an experimental application of DLT to wholesale payments. Our goal at this stage is to understand the mechanics, limits and possibilities of this technology.
I can’t think of a better way to understand this technology than to work with it.
Road to innovation
Other frameworks need to be investigated, and many hurdles need to be cleared, before a DLT system is ready for prime time. Whether they’re based on DLT or simply interesting twists on existing technologies, financial innovations could solve some old problems.
But they could also create new ones. So, while authorities like me support innovation, we also have a duty to make sure risks are properly managed.
It’s a tough line to walk. It’s best walked with the private sector. That’s why consultations and joint projects are so important to us. Some countries, like the UK and Singapore, have regulatory sandboxes.
We also need a clear analytical framework to understand and assess the benefits and challenges of something so new. Authorities will make their assessments through many lenses, including consumer protection, financial inclusion, market integrity, competition policy and financial stability. Since FinTech is global, this regulatory effort also has to be global. A clear and consistent regulatory framework will support innovation if it’s designed properly.
For now, most of the issues don’t relate to financial stability. I do worry, though, that “too big to fail” could emerge in a new form outside the current regulatory perimeter.
Payments are a great example. Players not covered currently by relevant regulation could become important to the system even if they never take on bank-like risks, such as maturity transformation or leverage, or become big enough to be considered systemically important. The move to increased direct access means that even smaller players could create critical dependencies within the financial system, particularly if they connect directly to core payments infrastructure.
This could give rise to moral hazard. At a minimum, authorities need to put a large enough weight on operational dependencies when looking at systemic importance, particularly in light of cyber risk.
I think it’s great we’re seeing more interest in fundamental research questions from academic and central bank researchers.
Our own research over the past few years has focused on new payment methods, the adoption and competitiveness of digital currencies, and the essential benefits of private e-money. We’re broadening it to include other developments, like DLT and peer-to-peer lending.
We also want to understand how new financial technologies will deal with the underlying forces that created the need for financial intermediation in the first place.
Some think it’s possible, at least in theory, that new technology could enable a different framework for addressing the same frictions, potentially one that does not require financial intermediaries at all.
In practice, I think it’s unlikely to turn out like this. The names and faces may change, but I don’t see technology changing the need for trust, maturity transformation, loan monitoring and intermediation of borrowers and lenders.
Now’s the time for financial institutions, new entrants and policy-makers to work together. That has to be best way to create the right environment for modernizing the financial sector and sensibly managing the risks that arise.
For us at the Bank of Canada, the focus will be on preserving financial stability and maintaining the safe and sound operation of core financial market infrastructures.