Oldřich Dědek, CNB Board Member
Balancing Fintech Opportunities and Risks
Oesterreichische Nationalbank
Vienna, 28th – 29th January 2019
When I was preparing for this conference, I asked our Fintech experts for some data characterising the Fintech community in the Czech Republic. The results were not very impressive. The Czech Fintech Association has only 31 members, and some of them are difficult to classify as Fintech firms according to any definition we currently use.
This finding does not mean that the Czech Republic is not part of the process of technological discovery and innovation. This progress, however, takes place mainly in the traditional financial sector – banks, insurance companies and other financial services. For example, the auditing firm Deloitte estimates that domestic banks and insurance companies have already invested over USD 200 million in technological innovation for financial businesses. The CNB, as a regulator, is therefore far from being cornered by the ongoing process of technological improvement. The traditional financial sector is the target of constant supervision to evaluate whether new technological solutions pose a threat to risk management, the safety of savings, cyber security and other traditional functions. From time to time, this constant oversight may result in a red warning light coming on, such as in the case of attempts to use cloud technology for hosting vital information systems. The same cautious approach is applied to harnessing various “cryptos”, such as cryptoassets, cryptocurrencies and cryptoexchanges.
So, one of the main challenges we face is the attitude towards Fintech entities as standing apart from the traditional financial sector. The key issue is to determine what the balanced regulatory approach should be. On the one hand, Fintech firms are expected to generate a permanent stream of innovations and become sound competitors to incumbent institutions, and excessive regulation would stifle this desirable activity. On the other hand, it is also acknowledged that this sector may become a source of instability. So, how do we solve this regulatory dilemma?
Principle of technological neutrality
First of all, the CNB adheres to the principle of technological neutrality. By this, we mean that it should be irrelevant who performs what activities and who uses what technologies. We do not want to make any sort of analogy with active industrial policy and we are not advocates of the policy of picking winners. Such a policy would look like the legacy of a failed planned economy in which winners are picked on a daily basis.
Adherence to the principle of technological neutrality also makes us suspicious of whether, in today’s world of the Fintech revolution, similar schemes are returning under different names. Is the “sandbox”, one of the most commonly used words in the Fintech universe, one such revival? We understand the key idea supporting this arrangement, whose goal is to promote an appropriate regulatory environment which, in turn, supports financial innovation. The small, non-banking Fintech community often refers to this idea. But we believe that sandboxes, incubators and other brand-new initiatives should not breach the principles of equal treatment and technological neutrality. Our attitude here is liberal. We see no reason to create a softer regulatory environment for some entities in the financial market. After all, in reality there is no clear dividing line between a traditional financial institution and a Fintech firm. These entities often work together or compete against each other. As a result, there is no reason for them to be in different regulatory regimes.Let me mention another of the CNB’s reasons for supporting the principle of technological neutrality. We operate integrated supervision of financial markets. Virtually all segments of the financial market are supervised under one roof: banks, credit unions, insurance companies, brokerage firms, investment companies, exchange bureaus, non-banking consumer loan providers and payment institutions. It is clear from this list that the advantage of this all-in-one setup is that it enables us to comprehend the specifics of the individual segments of the financial market while maintaining a broader view over the linkages between them. We therefore have a built-in reservation against any increase in regulatory obligations if we are not convinced of their true necessity.
Fintech and legislation
This panel is here to examine the legislative aspects of Fintech innovations. It is a highly topical issue, since many of today’s laws came into existence at time when nobody had any idea of the impending arrival of some of Fintech’s innovation waves. At present, for example, we are debating whether our Capital Market Act can be applied to initial coin offerings. In other words, can investment tokens be regarded as securities whose issuance is subject to existing regulatory requirements?
The traditional view says that they cannot. The argument is that an unavoidable characteristic of a security is its physical form, which an electronic token obviously does not have. The provision on booked securities, which also do not have physical substance, cannot be applied because they must be kept in a central database, which is another requirement a token does not meet.
On the other hand, an alternative legal opinion considers the above arguments to be a too formalistic interpretation of the law, one which prevents technological development. It maintains that the electronic nature of cryptoassets does not rule them out of being treated as securities.
What is a poor central banker supposed to take from this? We should not put the cart before the horse. The decision of whether or not to regulate is not primarily a legal problem, it is an economic problem. The crucial thing to consider is whether any segments in the Fintech market have reached a size that requires a regulatory response. This notional Rubicon has already been crossed in the area of the abuse of cryptocurrencies for money laundering, to which the AML legislation has responded appropriately. In other areas a wait-and-see approach has been adopted.
Here, I would expect to see the European authorities taking a more active role, since the Fintech agenda is a classic cross-border phenomenon. Progress needs to be made in unifying the currently fragmented national legislation. But it is equally important for legislative proposals to respect the principle of proportionality. It makes a difference if the recipient of a regulation is a big financial institution or a small firm with only two or three employees.
Legitimacy of regulation
The last point I would like to address is the question of what arguments justify regulation. The debate is still evolving. Several years ago, a political demand emerged in the Czech Republic calling for stricter regulation of non-banking consumer loan providers. This market was full of fraudulent and unscrupulous players abusing financial distress and putting many households into an inextricable debt trap.
The CNB resisted regulatory responsibility for this sector based on the argument that its legal mandate lies in safeguarding financial stability. From this point of view, the importance of the non-banking consumer loan providing sector was negligible. However, the debate at the time was dominated by the argument about the need to protect consumers.
So the question is what legitimacy does the central bank have in the regulation of non-banking Fintech companies? Is it the aspect of financial stability? It seems not, because the weight of the non-banking Fintech sector has been negligible so far. What about the principle of protecting consumers? The answer here is not straightforward. For example, is an investor in cryptocurrencies or other cryptoassets a disadvantaged consumer who should be protected as the weaker party to a contract? Aren’t they more like a speculator who likes to take risks, but instead of a casino they prefer to bet on cryptoassets? The CNB does not regulate casinos and lotteries! Moreover, regulation of these areas could create the risk of legalisation and legitimisation of gambling, thereby encouraging consumers to expose themselves to risks which regulatory bodies cannot mitigate.
However, there is yet one more economic argument, which is adverse selection, also known as the lemon market. This means, in effect, that due to information asymmetries, honest players are gradually squeezed out of unregulated markets, which debilitates these markets and lowers their quality. I personally believe that this argument can be used in some cases, for example in the regulation of ICOs. This market has the potential to improve the availability of funds to issuers from the ranks of technological firms and create conditions for their development. On the investors’ side, ICOs may offer interesting returns on funds in supported projects, returns that are different in nature from the investment opportunities on the capital market. These positive aspects fit into the objectives of the capital markets union as one of the priorities for completing the Economic and Monetary Union in Europe.