The impact of technology on finance: a new eBook
The financial system performs many important functions, including the provision of payment systems for the exchange of goods and services, the production of information, and the methods of sharing risk and allocating capital efficiently (Merton 1995). The financial system and banking institutions have faced several challenges over the past decade, including a new regulatory environment, the consequences of the Covid-19 outbreak, and the transformation of their business models towards a net zero carbon economy. These issues have been discussed in previous reports in the Future of Banking series (Bolton et al. 2019, Carletti et al. 2020, Bolton et al. 2021). Another major challenge is technological change. Agents, institutions and markets performing financial functions have historically been quick adopters of new technologies, particularly computer and information technologies. It is therefore not surprising that the financial sector is one of the most disrupted by digitization and new techniques for processing massive amounts of data. Witness, for example, the proliferation of fintech offering new payment or intermediation services (Figure 1 shows the growth of fintech investment).
Figure 1 Growth of investments in FinTech
Remarks: Based on a sample of 78 countries from Q1 2010 to Q2 2021. Data for 2021 has been extrapolated based on observed data up to Q2 2021. 2 Herfindahl-Hirschman Index (HHI) calculated for all countries in the sample.
Sources: PitchBook Data Inc; authors’ calculations. BIS Quarterly Review, September 2021
The fourth report in the Future of Banking series (Duffie et al. 2022) contains three overarching messages. A first idea of the report is that it is possible and desirable to develop a modern, interoperable and efficient payment system based on bank deposits. The development of central bank digital currency (CBDC) technology should primarily aim to overcome market failures and should not be rushed without careful consideration. A second idea is that the growing use of consumer data allows for efficiency gains, but also involves potential risks in terms of privacy issues, reduced competition, and potential increase in income inequality. A third idea is that the electronicization of stock securities has political and economic consequences that must be taken into account.
To download Technology and financethe 4th Future of Banking report, here.
Payment system interruption
With the primary goals of improving the efficiency and inclusiveness of their payment systems, most central banks are currently exploring the development of CBDCs. Many are also struggling with other FinTech payment approaches such as stablecoins, neo-banks, and “quick payout systems,” which are based on real-time gross settlement of bank payments. CBDCs have several potential benefits, such as improving the efficiency and competitiveness of payment systems and promoting financial inclusion. However, the report argues that in many countries, particularly the United States, it is premature to commit to deploying a CBDC. The costs and benefits are significant and will remain uncertain until revealed by technological and political exploration. The biggest challenge for designing a CBDC is how to protect privacy while controlling money laundering and illegal activities.
At the same time, policymakers should explore the appropriate role and regulation of new payment methods, increase the reach and interoperability of rapid payment systems, and regulate to foster greater competition in the banking payment system. Digital currencies can have disruptive effects for regulated banking institutions, particularly as they affect funding costs and, potentially, undermine the supply of credit. However, it is early to jump to conclusions here. The design of CBDCs is not regulated. In addition, the establishment of a CBDC has an international dimension that can disrupt national monetary systems. It has been argued that with widespread use of CBDCs, any national currency will be as easy to use in cross-border payments as any other, and that this could erode the dominance of the US dollar and reduce transaction costs. Yet, if CBDCs are not directly interoperable, multi-CBDC bridge arrangements would be required (Auer et al. 2021).
Data measurement and data valuation
Data is another important policy issue for the provision of technology-enabled financial services that requires specific assessments and policy recommendations. The growth in the amount and diversity of data, coupled with advances in artificial intelligence (e.g., machine and deep learning), is dramatically reducing the cost of acquiring information (Goldfarb and Tucker 2019). The report analyzes how data-driven decision-making and new data technologies offer the promise of extraordinary efficiency gains, but also threaten our economic and social order. Data can mitigate mismatch issues that lead to channeling funding to the wrong ideas, storing resources where they are not needed, and selling goods to consumers who would value other products more. Addressing these mismatches can trigger a powerful increase in productivity. However, companies’ use of data also risks compromising consumer privacy, leaving them vulnerable to manipulation; it risks fueling monopoly power, which erodes consumer surplus; and it further exacerbates income inequality, which can undermine support for liberal democracy.
There are no easy answers to resolve these trade-offs. However, any thoughtful approach must be based on measurement. Data measurement is not an easy task. We offer a variety of data measurement approaches that can be employed to assess the quantity, private values, and social costs and benefits of data use by modern businesses.
Technology, data and stock market trading
The evolution of information technology has changed the form in which security markets share risk and discover the value of assets. In particular, securities trading is increasingly taking place on electronic platforms run by for-profit companies which, like other FinTech companies, use algorithms to match buyers and sellers, develop pricing systems innovative and monetize the massive amount of data generated by trading activity on their platforms. Overall, this development has intensified competition between trading platforms and between securities brokers, which has led to lower trading costs for investors. The report identifies four areas that deserve the attention of policy makers.
First, to address market fragmentation, investors need quick access to market data and a consolidated view of market data across trading venues (a “consolidated band”). However, the cost of market data has increased in recent years, raising concerns about the market power of trading platforms over their data. Also, unlike the US, there is not yet a consolidated band in the EU capital markets, despite provisions in recent regulations. A second related concern is “latency arbitrage”. Due to high frequency trading, investors can exploit information before it is reflected in prices, making adverse selection worse for slower traders. Reducing this negative externality is not easy because quick access to market data also allows latent arbitrageurs to provide liquidity when needed. Third, increasing volumes of dark trading can harm liquidity and price discovery in lit markets. To address this issue, EU regulators capped dark trading volume in dark pools. However, this cap does not take into account the growth of internalisation (off-exchange trading between brokers and investors, which is subject to less strict transparency rules than those that take place on the exchange). This calls for greater regulatory attention to internalization. Finally, electronisation poses new risks to financial stability, as evidenced by extreme price variations over very short periods (“flash crash”). The report analyzes the factors behind these phenomena and proposes a safeguard: better coordination of circuit breaker mechanisms between markets.
Auer, R, P Haene and H Holden (2021), “Multi-CBDC Agreements and the Future of Cross-Border Payments”, BIS Papers No. 115, Bank for International Settlements.
Bolton, P, S Cecchetti, JP Danthine and X Vives (2019), The sound finally? Review of a decade of financial regulationThe Future of Banking 1, CEPR Press.
Bolton, P, H Hong, M Kacperczyk and X Vives (2021), Resilience of the financial system to natural disastersThe Future of Banking 3, CEPR Press.
Carletti, E, S Claessens, A Fatas and X Vives (2020), The banking business model in the post-Covid-19 worldThe Future of Banking 2, CEPR Press.
Duffie, D, T Foucault, L Veldkamp and X Vives (2022), Technology and financeThe Future of Banking 4, CEPR Press.
Goldfarb, A and C Tucker (2019), “Digital Economy”, Economic Literature Review 57(1): 3-43.
Merton, RC (1995), “A functional perspective of financial intermediation”, Financial direction 24: 23-41.