The tech industry is often seen as a frontier for innovation and creative destruction, a place where engineers aren’t afraid to break things in the race to develop the next market-moving app. In recent years, tech companies have set their sights on the finance industry (Fintech), engendering a natural tension as the freewheeling ethos of Silicon Valley meets the tightly regulated environment of financial markets and banking institutions. Yet, there is good reason why tech companies have only belatedly begun to explore opportunities in finance. Technological innovation is all about disruption in service of building newer, more efficient ways of doing things – all well and good if the point is to develop an app that makes it easier to order Chipotle. But when it comes to allocating capital, underwriting loans, or facilitating financial transactions, disruption – even the innovative kind – can paralyze and severely damage economies, creating serious loss and hardship for millions of average people.
It is therefore crucial that regulators dial in the right balance when overseeing the development of Fintech, a balance that is tricky to get right. A certain degree of latitude is necessary in the beginning, giving developers and entrepreneurs the room they need to try out new technologies and ideas, while successful ideas eventually reach a critical mass where closer regulatory scrutiny is required. A good example of this is the peer-to-peer lending industry. Small and medium-sized borrowers who lack the collateral or credit record to secure traditional loans form commercial banks are matched with capital from private funders via peer-to-peer lending platforms. On a small scale, this is a clever way of using digital technology to match idle capital with people who can use it for productive purposes, satisfying a need being unmet by the commercial banking system.
However, once the size of the outstanding loans begins to reach into the billions of dollars, closer regulatory scrutiny becomes unavoidable since at that scale, a wave of defaults could have a significant ripple effect through the entire economy. On the flip side, poorly planned or overly aggressive intervention by the government too early in the lifecycle of a Fintech idea can strangle innovation and create economic turbulence. So what is the right balance? There is obviously no single answer to this question but a quick look at three cases – mobile banking in Kenya and India, and peer-to-peer lending in China – can give us a reasonable idea of what a workable regulatory equilibrium might look like.
Cashless payment service M-Pesa in Kenya is a well-known Fintech success story. In 2007, M-Pesa partnered with Kenya’s telecom monopoly, Safaricom, to offer mobile phone customers a cashless payment service. In developing countries like Kenya, the need for such a service is acute, as many people lack bank accounts and rural populations may not have physical access to a bank branch or ATM. This service, which piggybacked on the existing telecom infrastructure and could thus be scaled quickly at low cost, rapidly exploded. In 2009, in the face of some confusion over what exactly M-Pesa was, the Central Bank of Kenya stepped in and ruled that it was a technological service rather than a financial one, and would be subject to less burdensome regulatory requirements than a traditional financial company.
This ruling, which was made during a critical part of the growth phase, clarified the rules of the game and allowed M-Pesa’s growth to confidently accelerate, as market participants now had a degree of regulatory certainty about how they would be treated. The results have been impressive. By 2017, there were over 19 million active users in Kenya alone, clearing on average 10 transactions per month through M-Pesa. We can only speculate, but had the Central Bank stepped in too early with stricter compliance requirements, or waited too long to clarify the regulatory environment, the service probably would not have scaled as quickly.
Indian tech companies are also racing to develop mobile banking and payment platforms for many of the same reasons as Kenya – India has a large unbanked rural population who stand to benefit from conducting routine financial transactions on their cell phones. The regulatory touch in India has been somewhat clumsier than in Kenya. Paytm is India’s leading cashless e-wallet system, having on-boarded 200 million users by early 2017. As Paytm and other cashless Fintech start-ups were expanding their user bases, the Indian government began rolling out a series of policies that, while they may have had the effect of increasing cashless transactions overall, also severely disrupted the economy in the process.
In early 2017, regulators issued new guidelines for e-wallets like Paytm that imposed stricter compliance requirements, capital reserve minimums and caps on transfers to banks. In contrast to M-Pesa, it appears Indian authorities were keen to regulate cashless transactions as financial, rather than telecom, services. The effect of this policy on the growth of cashless transactions is not yet clear and requires further study, but it’s worth noting that the volume of transactions did fall off sharply in the months following the stricter compliance requirements. In tandem with this additional level of regulatory oversight, the Indian government also pushed through a “big bang” demonetization effort at the very end of 2016. The official goal of this effort was to remove small denomination bills from circulation in an effort to reduce off-book financial transactions.
The policy was reportedly developed by a small group of insiders and poorly vetted, which became readily apparent as the roll-out created months of chaos in India, a country where hundreds of millions of people don’t have bank accounts and are still reliant on cash. It wiped out much of the accumulated and legitimate wealth held by rural families in small bank notes, and shaved a significant amount off what had been a strong year of GDP growth. In the end, demonetization likely forced more users into cashless e-wallet apps like Paytm (what other choice did they have?) but the cost of doing so was a severe disruption in the economy that arguably failed to offset the benefits. This draws into sharp relief the issue of regulatory overreach in trying to drive people, via coercive and disruptive policies, into adopting Fintech. In their desire to support the Fintech industry with complementary policies, government officials lost sight of what constituted acceptable costs, and millions of people were plunged into chaos because of it.
As mentioned above, peer-to-peer lending is another area where the intersection between Fintech and the regulatory apparatus reflects some interesting tensions. In China, peer-to-peer lending has exploded in the last decade, going from a single app that matched idle capital with under-served borrowers, to over 2,000 by 2017. For the first several years, the Chinese government let peer-to-peer lenders operate with a relatively large degree of freedom. But by 2017, it became clear that the state needed to become more actively involved, with the total value of peer-to-peer loans exceeding $100 billion. At that point, the pool of outstanding debt goes from an innovative tech-driven solution for unmet consumer demands to a potential source of systemic risk.
As the debt generated through peer-to-peer platforms ballooned, Chinese regulators created a tiered system based on asset size: once a platform generated a certain amount of outstanding loans, it was paired with a larger and better capitalized financial institution and forced to submit to stricter compliance requirements. A second round of regulatory crackdowns is expected to further thin the ranks of fraudulent or under-capitalized lenders. Tech entrepreneurs naturally decried this as innovation-killing regulatory overreach, but the fact that peer-to-peer lending continued to grow steadily after the first round of reforms suggests capital is still being allocated to borrowers but with less opportunity for fraud and speculation. While there are signs that growth in the peer-to-peer lending industry is now contracting, this is likely a normal market correction given the tighter regulatory scrutiny. However, given how quickly the industry grew to such a large scale, it is possible that Chinese regulators waited too long before imposing some constraints – time will tell.
The fusion of financial services and technology has great potential for improving lives. There is a well-documented link between expanding access to basic financial services, like credit and online banking, and economic growth. Providing rural populations with access to even rudimentary financial services through mobile phone devices can significantly improve welfare and lower poverty rates. Cashless transaction services like Paytm and M-Pesa, as well as peer-to-peer lending platforms, are important tools for bringing people into the formal economy and increasing financial inclusion in rapidly growing economies like China and India. Clever applications of technology to improve social and economic conditions for millions of people is why the industry is garnering attention and investors.
But for all of Fintech’s upside, there are hazards inherent in the unregulated, or poorly regulated, provision of financial services. Overly activist regulatory authorities can squash the potential of promising services by burdening them with compliance requirements before they have a chance to take-off and scale, or by interfering in natural growth cycles in ways that are economically disruptive, as was the case in India. If regulators wait too long to tighten oversight, then Fintech can scale too quickly and end up posing a systemic threat to the financial system itself, a possibility Chinese authorities are considering at present. Striking the right balance is thus a difficult proposition for regulators, and there is no hard-and-fast rule to follow as conditions unique to each country require different regulatory approaches. But broadly speaking, giving Fintech room to run in the early stages and then tightening oversight once it reaches a critical mass is a sound principle. This was the general path followed by Kenya in response to M-Pesa. As M-Pesa and similar technologies continue to extend financial services to millions of people in sub-Saharan Africa and elsewhere, it is hard to argue against the wisdom of a balanced and flexible approach to regulating Fintech.
 James Guild is a PhD Candidate at the S. Rajaratnam School of International Studies in Singapore. His research interests include regulatory architecture and the political economy of trade and development in Southeast Asia with a focus on Indonesia