Fintech and Digital Financial Innovations: Evolution, Relationship with Banks, and Regulation

DEFINITION AND ADOPTION OF FINTECH

Definition of Fintech (FSB): The Financial Stability Board (FSB) defines fintech as ‘technology-enabled innovation in financial services that could result in new business models, applications, processes or products with an associated material effect on the provision of financial services.’
Fintech Adoption Rate: This metric measures fintech users as a percentage of the digitally active population.
- Global Trends: The average adoption rate rose from $10\%$ in $2015$ , to $33\%$ in $2017$ , and reached $64\%$ in $2019$ .
- By Country (2019): China and India lead with $87\%$ adoption. Russia and South Africa follow at $82\%$ . The United States rate is $46\%$ , while Belgium and Luxembourg are at $42\%$ .
- Usage Categories: Money transfer and payments are the most common services, with a $75\%$ global consumer usage rate. In China, this specific adoption rate is $95\%$ .
Small and Medium-sized Enterprises (SMEs): Fintech interest in SMEs is growing. China leads in SME fintech adoption at $61\%$ , followed by the US at $23\%$ . The global average for SME adoption is $25\%$ .
Investment and Funding Trends:
- Global venture capital (VC)-backed fintech funding increased from $3.9\,billion$ in $2013$ to $41.4\,billion$ in $2018$ , dipping slightly to $35.0\,billion$ in $2019$ .
- Active U.S. bank investors includes Goldman Sachs, Citigroup, JPMorgan Chase, Morgan Stanley, Wells Fargo, and Bank of America Merrill Lynch.

THE EVOLUTION OF FINANCIAL TECHNOLOGY

1865: Giovanni Caseli invented the pantelegraph, an early form of fax machine used to verify signatures in banking transactions via telegraph cables.
1866: The first trans-Atlantic telegraph cable was laid, providing infrastructure for financial globalization.
1918: The Federal Reserve Banks established Fedwire (Federal Reserve's Wire Transfer Network) to connect all $12$ Reserve Banks via telegraph using a Morse code-based system.
1933: The German Reich mail service trialed the world's first telex (contraction of "teleprinting" and "exchange") network.
1958: Western Union began building a telex network in the United States.
1960: Quotron Systems introduced the Quotron, the first electronic system to provide real-time stock quotes on screens instead of printed ticker tape.
1966: Telex replaced the telegraph as the standard for long-distance instantaneous communication.
Late 1960s & 1970s (Electronic Payments):
- 1967: Barclays Bank installed the first automated teller machine (ATM) in London. Security involved paper checks marked with carbon-14, a radioactive isotope, because magnetic coding did not exist yet.
- 1968: Inter Bank Computer Bureau (later BACS) established in the UK.
- 1970: Clearing House Interbank Payments System (CHIPS) established in the US.
- 1973: Society for Worldwide Interbank Financial Telecommunications (SWIFT) established.
1971: National Association of Securities Dealers Automated Quotations (NASDAQ) was established as the world's first electronic stock market. It helped reduce bid-ask spreads and ended fixed securities commissions in $1975$ .
1980s – 2000s:
- 1980s: Rise of electronic trading and bank mainframe computers.
- 1990s: Internet and e-commerce led to online retail stock brokerage.
- Early 2000s: Stock market decimalization (minimum tick size changed from $\frac{1}{16}$ of a dollar or US$0.0625 to US$0.01) and the rise of algorithmic trading and high-frequency trading (HFT).
Bank Branch Reversal: The number of US bank branches grew from $4,200$ in $1948$ to over $82,400$ in $2008$ . Since $2013$ , this trend has reversed, with branch counts falling steadily.

THEORETICAL DRIVERS: SUPPLY AND DEMAND FACTORS

Supply Factors:
- 2008 Financial Crisis: Bank brand images were shaken. Post-crisis regulatory burdens and increased risk aversion caused banks to pull back from certain lending activities.
- Macroeconomic Conditions: A low interest rate environment pressured profits, forcing financial institutions (FIs) to cut costs through technology.
- Innovation: New players (like P2P lenders) used technology to target borrowers banks had abandoned, such as small businesses and riskier consumers.
Demand Factors:
- Mobile Technology Revolution: Launched by the iPhone ( $2007$ ) and Android devices. Global smartphone penetration reached $66.9\%$ in $2019$ . Rates by country: US ( $86\%$ ), China ( $82\%$ ), Indonesia ( $73\%$ ), Brazil ( $68\%$ ), Mexico ( $63\%$ ), India ( $52\%$ ).
- App Explosion: Apple’s App Store grew from $500$ apps in $2008$ to $2.2\,million$ in $2019$ . Google Play reached $2.6\,million$ in $2019$ .
- Demographics: Millennials became the largest generation in the US labor force in $2016$ ( $35\%$ ). As digital natives, they have high technological fluency and a lingering distrust of banks due to the $2008$ crisis.
- Transaction Habits: A $2017$ study found millennials make $2.26$ weekly financial transactions on smartphones versus $0.83$ through branches.

THE CHANGING RELATIONSHIP BETWEEN BANKS AND FINTECHS

Initial Fear of Disruption: Analysts predicted bank demise, fearing a transition to "narrow banking" where banks only hold safe liquid assets while fintechs match savers and borrowers. Jamie Dimon (JPMorgan Chase CEO) warned in $2015$ that "Silicon Valley is coming."
Bank Advantages (The Three Cs):
- Customers: Decades of existing relationships with tens of millions of users.
- Compliance: Vast experience with regulations and legal teams.
- Capital: Cost of capital is close to zero for banks, whereas fintechs face higher costs due to capital funding structures.
Phases of Symbiosis (AMTD Asset Management):
- Stage 1 - "Rent a Bank": Partnerships like LendingClub/Prosper with WebBank.
- Stage 2 - Direct Investment: Banks buying assets or taking equity (e.g., BNP Paribas acquiring Compte-Nickel).
- Stage 3 - Infrastructure Provision: Fintechs providing tech to banks (e.g., OnDeck and JPMorgan Chase serving small businesses).
- Stage 4 - In-house Development/Charters: Banks launching digital arms (e.g., Goldman Sachs launching Marcus); Fintechs applying for bank charters (e.g., SoFi).

BANKING-AS-A-SERVICE (BAAS) AND OPEN BANKING

BaaS Definition: An end-to-end process allowing fintechs and third parties to connect with a bank’s systems via APIs to build offerings on top of regulated bank infrastructure.
Open Banking Definition: A system providing a network of FI data using APIs, enabling third parties to build new services using existing customer information.
Monetization Strategies: Charging monthly access fees for the platform or charging a la carte for specific services.
Market Growth: The global digital banking platform market is projected to reach $8.67\,billion$ by $2027$ .
Regulatory Examples:
- BBVA (US): Launched "Open Platform" in $2018$ .
- HSBC (UK): Launched "Connected Money" app in $2018$ , allowing users to view accounts from different banks in one place.

TYPES OF FINTECH INNOVATIONS: PAYMENTS, CLEARING, AND SETTLEMENT

Innovative Sectors (BCBS): Payments, Clearing, and Settlement Services ( $41\%$ of providers); Market Support Services ( $27\%$ ); Credit, Deposit, and Capital-Raising ( $18\%$ ); Investment Management ( $9\%$ ).
Mobile Wallets: Apps storing credit/debit card data using Near Field Communication (NFC).
- Market Share: Apple Pay ( $77\%$ of transactions), Samsung Pay ( $17\%$ ), Google Pay ( $6\%$ , a rebrand of Android Pay and Google Wallet).
Peer-to-Peer (P2P) Payments:
- PayPal: $267\,million$ active accounts; transfers up to $10,000$ . Charges $2.9\% + 30\,cents$ for card-based transfers.
- Venmo: Popular with millennials; acquired by PayPal via Braintree.
- Zelle: Bank-consortium app (Chase, BoA, Citi, etc.) offering same-day transfers.
- Facebook Payments: Zero-fee transfers via Messenger on iOS, Android, and desktop.

DIGITAL CURRENCIES AND ASSET CLASSES

Cryptocurrency: Digital tokens generated, stored, and transacted securely and anonymously via cryptography, operating independently of central banks.
Key Examples:
- Bitcoin (BTC): White paper by Satoshi Nakamoto ( $2008$ ); first mined in $2009$ .
- Altcoins: Modified versions of Bitcoin (Litecoin, XRP, Ether).
- Ethereum (ETH): A crypto-asset network enabling "smart contracts" via the Ether token.
Volatility and Performance:
- Average daily return volatility ( $2016-2019$ ): Bitcoin ( $3.82\%$ ), Ether ( $5.85\%$ ), S&P 500 ( $0.73\%$ ).
- 2018 Crash: Global crypto market cap lost at least US$342\,billion in Q1 $2018$ . By September $2018$ , the market had collapsed $80\%$ from its January peak, worse than the dot-com bubble's $78\%$ collapse.
Central Bank Digital Currencies (CBDCs): Digital central bank money distinct from bank reserves. Issuance would not necessarily alter basic monetary policy implementation but could enhance financial inclusion.
Crypto Exchanges:
- Fiat Gateways: Exchanges accepting USD/HKD etc. (Coinbase, Kraken, Gemini). They are highly regulated.
- Crypto-to-Crypto: Exchange of one token for another (Binance, Bittrex).
- Risks: Cybertheft (e.g., Coincheck lost nearly $500\,million$ in $2018$ ). Two hacker groups are estimated to have stolen over $1\,billion$ in total crypto hacks.

MARKET SUPPORT SERVICES: DISTRIBUTED LEDGER TECHNOLOGY (DLT)

Mechanism: A digital system for recording transactions where details are recorded in multiple places (nodes) simultaneously. It has no central store or administration.
Blockchain: A specific DLT organizing data into blocks chained together in an append-only structure using consensus voting and cryptography.
Benefits: Reduces complexity; improves speed; decreases reconciliation needs; increases transparency/immutability; improves network resilience.
Risks: Operational/security uncertainty; lack of interoperability; legal ambiguity; data privacy issues.
Consortiums:
- R3 (Corda): Over $200$ members. Experienced setbacks when Goldman Sachs, Morgan Stanley, and Santander left in $2016-2017$ .
- Hyperledger: Launched in $2015$ ; also saw membership lapses as firms became more selective.
Smart Contracts: Self-executing applications written in code (crypto-code) that run exactly as programmed on a blockchain without third-party interference.

ARTIFICIAL INTELLIGENCE, MACHINE LEARNING, AND BIG DATA

Definitions:
- Artificial Intelligence (AI): Machines responding to stimulation with contemplation, judgment, and intention (John McCarthy's term).
- Machine Learning: Algorithms that optimize automatically through experience to find patterns in big data.
Usage Scenarios:
- Back-office: Robotic Process Automation (RPA) can save banks $20-25\%$ in IT operations.
- Legal: JPMorgan's "Contract Intelligence" platform reviews $12,000$ credit agreements in seconds (previously $360,000$ human hours).
- Compliance: HSBC uses AI to detect money laundering and terrorist funding.
Major Deals: S&P Global acquired fintech Kensho for $550\,million$ .

INTERNET-OF-THINGS (IOT) IN FINANCE

Concept: Millions of physical devices connected to the internet sharing real-time data.
Applications:
- Wearables: Apple Watch, FitPay, and Barclays' bPay.
- Beacons: Battery-powered Bluetooth radio transmitters (BLE). Chase tests beacons to pre-announce customers to tellers; Barclays uses them for disabled navigation.
- Trade Finance: Commonwealth Bank of Australia and Wells Fargo executed the first global trade (cotton from Texas to China) using blockchain, smart contracts, and IoT for physical supply chain triggers.

CREDIT, DEPOSIT, AND CAPITAL-RAISING SERVICES

Crowdfunding: Raising money through collective online efforts (social fundraising).
- Kickstarter ($2009$): Focuses on creative arts/music.
- Crowdcube: Equity crowdfunding and mini-bonds.
- Indiegogo: Over $800,000$ campaigns across $235$ countries since $2008$ .
- GoFundMe ($2010$): Personal causes (celebrations, illnesses).
Lending Marketplaces (P2P Lending): Nonbank online platforms using algorithms to determine creditworthiness for unsecured loans (LendingClub, OnDeck, SoFi).

INVESTMENT MANAGEMENT SERVICES AND ROBO-ADVICE

High-Frequency Trading (HFT):
- Market share peaked at $61\%$ in $2009$ with $7.2\,billion$ revenue.
- Receded to just over $50\%$ volume in $2018$ with revenue below $1\,billion$ .
Copy Trading: Social FX trading platforms (eToro, Trade360) allowing users to mimic successful traders. eToro grew from $3\,million$ users ( $2013$ ) to $8\,million$ ( $2017$ ).
Robo-Advice: Online algorithms for investment tasks (Wealthfront, Betterment).
- Cost Efficiency: robo-advisors charge $0.15\%$ to $0.35\%$ vs. traditional wealth management fees of $1\%$ or more.

REGULATORY APPROACHES AND FINTECH CHARTERS

Regulatory Sandboxes: Controlled environments for startups to test products under supervision.
- UK (FCA): Pioneer of the sandbox model in $2015$ .
- Lithuania: Offers e-money licenses in $3-4$ months; issued licenses to Revolut and Google Payment Lithuania.
- Arizona ( $2018$ ): First US state to launch a sandbox ( $2-year$ testing period).
OCC Fintech Charter (US): A special-purpose national bank charter for nonbanks to pay checks or lend money (but not take deposits or use FDIC insurance).
- Status: Facing lawsuits from the NY State Department of Financial Services (DFS). A federal judge ruled in October $2019$ that the OCC lacked authority to issue these charters.

INTERNATIONAL REGULATIONS: GDPR AND PSD2

General Data Protection Regulation (GDPR): EU law (enforced May 25, $2018$ ) giving citizens rights to control their personal data. It uses a transparent opt-in model.
Payment Services Directive 2 (PSD2): EU regulation requiring banks to share consumer data with third parties (if authorized) to increase competition.
Open Banking Standards: Forced the UK's biggest banks to release data in standardized forms. Fintechs register as Account Information Service Providers (AISP) or Payment Initiation Service Providers (PISP) for direct API access.
Utilities: Companies like Yapily and Tink provide financial APIs to help banks comply with PSD2/Open Banking regulations.