Fintech's decentralized nature challenges regulators as industry transforms banking

NEW YORK (Thomson Reuters Regulatory Intelligence) - The ambiguous role of financial technology in transforming the banking sector, tenuous collaboration among banks and fintech companies, and regulatory challenges presented by fintech’s decentralized nature are common themes emerging where industry participants and regulators gather.

The International Monetary Fund logo is seen during the IMF/World Bank spring meetings in Washington, U.S., April 21, 2017.

“It has ended banking as we know it,” said Chris Church, chief business development officer of Digital Asset, a fintech company specializing in building encrypted processing tools, at an International Monetary Fund spring meeting this year.

The amalgam of technological innovations that go under the label fintech began in the back office but has since moved to the front line. Banks are taking multiple approaches to developing systems, and any kind of collaboration on standards is at a very early stage. Key finech advances, including distributed ledger technology such as blockchain, require regulators to devise new strategies for oversight.

“Fintech will hinder regulatory efforts because it is based on a decentralized model,” said Marco Santori, a partner at Cooley, a law firm, at a recent conference on the topic. “Regulators are likely to fail not only because they lack technical expertise regarding fintech, but also because they have always been targeting nodes in the system, and never had to face such a peer-to-peer network.”


Fintech’s influence was initially confined to back office services, such as record maintenance, regulatory compliance, accounting, IT services, settlements, and clearances, along with minimal client services such as online access to bank accounts and remote deposits.

Banks have been discarding error-prone manual processes, in favor of machine learning and artificial intelligence, to better manage operational risk and comply with regulations, as the flood of data makes reliance on human processes nearly impossible. Fraud evaluation in payments, for example, is now mostly done through artificial intelligence, with human intelligence or experience used mainly to design policy parameters.

Fintech’s impact now is most keenly felt in front-office, client services functions, such as mobile payments, loans, asset-management, capital raising, and money transfers.

Crowdfunding allows small businesses to raise money quickly and cheaply from all over the world, often bypassing onerous collateral and credit requirements. New peer-to-peer systems eliminate intermediaries and speed up payments via instruments such as bitcoin. Lending is dramatically hastened through data-driven algorithms that quickly pre-qualify borrowers based on a handful of data points such as personal credit scores, deposit account data, tax returns, and recent bank statements.


In addition to this expediency offered by online loan application processes, there is also a growing untapped demand among small and medium enterprises (SME) for non-traditional loan types akin to credit lines.

Such lending is unprofitable for many banks because of difficulty in loan pricing, high capital requirements and high unit costs. Indeed, as a Harvard Business School study indicates, this is where the fintech firms are moving to fill the gap.

A Morgan Stanley study(here) estimates that the untapped potential for online SME lenders is $280 billion, and that the industry will grow at a 47 percent annual rate through 2020.

Such prospects are fueling investment in fintech, which reached $23.2 billion in 2016 according to an Accenture annual report.


Given their advantages, fintech firms can pose a challenge to banks’ market share.

Although slow to react at first, banks have come to recognize the critical role of fintech, and that of the distributed ledger technology (“DLT”) in particular. DLT helps banks become more efficient by reducing cost, eliminating the need for reconciliation, increasing transparency, reducing settlement time, and freeing up capital.

Banks’ responses to fintech have not been uniform, however, in terms of how much investment they were willing to make and the level of integration they want between the new digital activities and their traditional operations.

Some banks have adopted a “low integration” strategy, that is, an arms-length approach where they rely on contracting with fintech companies or investing in them.

Others have taken a bolder “high integration” approach through partnership arrangements –- such as the small-business lending deal between JPMorgan Chase and OnDeck -- and integrating new technologies into their loan-application and decision-making processes.

Less common among banks are those that choose to develop their own systems. This typically involves a more significant investment to automate underwriting processes, synchronize bank proprietary account data with new algorithms, and create a more customer-friendly design.

Currently, banks remain relatively reluctant to pursue beneficial partnerships with fintech companies, however. This is largely because of the “third party oversight” regulations, which hold banks accountable to at least three different federal regulators for the activities of their fintech partners.


Fintech provides a decentralized web for financial agents to transact with one another in a transparent, verifiable, fast, and an efficient way.

In theory then, fintech can provide regulators with more insight into potential systemic risk areas – by allowing them to track ownership and risk of assets in real time.

Despite its benefits, however, fintech’s decentralized model is also making it harder for regulators to understand its various components, and to design adequate rules because they have traditionally been dealing with central hubs of activities.

Indeed, such natural hubs simply do not exist in the world of fintech.

The most salient example of fintech’s decentralized use is bitcoin, a digital currency based on the distributed ledger technology. Multiple financial players use bitcoin as a peer-to-peer payment system, where no central administrator or data storage exists.

Cognizant of this, the federal Office of the Comptroller of the Currency has been active in trying to cope with fintech’s advances, and has taken a principle-based approach.

The agency published a set of principles(here) to guide the development of framework for evaluating innovations in financial services based upon technology. It established an Office of Innovation with the goal of improving its ability to identify, understand, and respond to financial innovation affecting the federal banking system.

More recently, the OCC has also issued a draft licensing manual(here) to pave the way for fintech companies to obtain special purpose national bank charters, that is, limited banking licenses.

The OCC initiative has, however, touched off debate within the industry and among other state and federal regulators. Opponents say it could stifle innovation or limit state authority to protect. The model for fintech regulation, whether principles-based or prescriptive, and how will cope with the challenges of decentralization, are far from settled.

--Harvard Business School study:here

--Accenture annual report:here

(Bora Yagiz, FRM is a New York-based Regulatory Intelligence Expert for Thomson Reuters Regulatory Intelligence, specializing in risk. He is a certified Financial Risk Manager. Mr. Yagiz has held positions as a bank examiner for the Federal Reserve Bank of New York, as senior consultant with Ernst & Young and vice president at Morgan Stanley. Follow Bora on Twitter @Bora_Yagiz. Email Bora at