The Rise of Fintech: Opportunity or Threat to Traditional Monetary Systems and Policy?

1. The Rise of Fintech: Opportunity or Threat to Traditional Monetary Systems and Policy? Presented at the 2018 ECAMA Annual Conference 22 November 2018, Mangochi Montfort Mlachila Senior Resident Representative in South Africa International Monetary Fund

2. Outline Outline • Defining and Understanding Fintech • The Promise of Distributed Ledger/Blockchain Technology • What are Crypto Assets? • What are Central Bank Digital Currencies? • Implications of Fintech for Monetary Policy • Concluding Remarks

3. Defining and Understanding Fintech

4. What is Fintech? What is Fintech? • Many competing definitions, often focused on the nature of the provider (startup company) rather than the nature of the services or the financial functions performed. • FSB: “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 services.” • Most associate Fintech with delivery of services via the mobile internet.

5. Fintech Development Fintech Development • Fintech is still in its early stages and there exist substantial uncertainties. • However, it is growing rapidly and has the potential to cover all areas of financial service and beyond • e.g., in the U.S., the market size of P2P platforms is projected to be over $150 billion by 2025 (PWC). • Even at the moment, its market share in specific market segments are already significant: • e.g., in 2015, Fintech credit was 14% of equivalent gross bank lending flows to small businesses in the U.K.

6. Fintech: What is new / why now?

7. Main Areas of Fintech Main Areas of Fintech • Payments, clearing and settlement • Borrowing, lending, capital raising • Insurance • Investment Management • Market Support

8. Payments, Clearing and Settlement Payments, Clearing and Settlement • Ability to send and receive payments anywhere, anytime, through digital wallets, e.g., cross-border money transfer • Sending and receiving payments without routing them through the banking system • New forms of settlement media, e.g., virtual currencies (VCs) and non-VC currencies

9. Borrowing, Lending, Capital Raising Borrowing, Lending, Capital Raising • Fintech credit: also known as peer-to-peer (P2P) or marketplace lending is lending facilitated via electronic platform (system) rather than human credit analysts at physical locations. • Crowdfunding and alternative public offering mechanisms.

10. Insurance Insurance • Reach out to potential clients and improve customer experience via social media (cyber insurance) • Design on-demand, short-term insurance products, or personalized and custom-tailored products • Improve risk analysis based on big data, e.g., integrated monitoring systems or social media “fingerprints” • Process claims more efficiently using blockchain and other technologies

11. Investment Management • Electronic trading platforms • Automated investment advising (“robo advisors”) • Automated lending

12. Market Support Market Support • Use of big data, machine learning, and artificial intelligence • Cloud storage for universal access • Software as a service (cloud computing) • Security • Smart contracts

13. Three Positives for Fintech Three Positives for Fintech • Financial services have become more: • Contestable: entry into new markets much cheaper and faster • Decomposable: bundled services (lending) are being separated into their parts or steps (origination, funding, servicing, risk management) • Reconfigurable: service delivery methods can be changed services can be combined in new ways

14. Potential Downsides of Fintech • Anonymity may promote illegal transactions • Inherent instability of most digital assets • Slow speed of transactions under DLT technologies (Bitcoin vs. Visa) • Prone to hacking

15. High Volatility of Bitcoin Price

16. Distributed Ledger Technology (DLT)

17. A Centralized Payment System

18. A Distributed Ledger Payment System

19. Distributed Ledgers: Speed & Efficiency

20. Blockchain • Blockchain is a digital ledger that records every transaction that has ever occurred. • Genesis block of Bitcoin blockchain was established on January 3, 2009 • As of June 27, 2018, bitcoin blockchain contains around 528,000 blocks a new block is generated around every 10 minutes • “Miners” compete to verify the new transaction records within the new block by solving a mathematical puzzle • Once a block is verified and transactions executed, the block will be added to the existing blockchain and will never be changed.

21. How does Blockchain Work?

22. What does Blockchain Look Like?

23. Distributed Ledgers: Security

24. Distributed Ledgers: Applications • DLT has the potential to change the landscape of the financial industry, by reducing costs and allowing for wider financial inclusion. • They can be developed in a fully public system, or fully private system, or a hybrid. • They can be applied independently of a VC, to any area that requires fast, accurate, and secure record keeping: • e.g., land registry, cross-border money transfer, security trading, clearing and settlement, etc.

25. Recent South African Example Project Khokha (collaborative project led by the South African Reserve Bank): • Main objective is to replicate SAMOS (The South African Multiple Gross Operation Settlement System). • Proof of concept designed to simulate a ‘real-world’ trial of a DLT-based wholesale payment system. • Involved seven banks. • Typical daily volume of the South African payments system could be processed in less than two hours. • Transactions were processed within two seconds, across a network of geographically distributed nodes. • Recently received the ‘Best Distributed Ledger Initiative‘ award from the Central Banking Publications.

26. Virtual Assets

27. Virtual “Currencies” (VCs) • What is virtual "currency"? • “A type of unregulated, digital money, which is issued and usually controlled by its developers, and used and accepted among the members of a specific virtual community.” (ECB 2012) • VC schemes comprise two key elements: • Digital representation of value that can be transferred between parties • The underlying payment and settlement mechanisms.

28. Virtual Currencies (VCs) • VCs have a variety of different features. For instance: • Convertibility: non-convertible versus convertible • Operate through a centralized (e.g., WebMoney, E-gold, or de-centralized (e.g., Bitcoin) model • The issuance and redeemability of the VC • Mechanisms to implement and enforce internal rules on the use and circulation of the VC • Payment and settlement process. • Examples of VCs: • Ethereum, Ripple, Bitcoin Cash, Litecoin, and EOS. • Wikipedia currently lists about 40

29. Are VCs Money? Q: Do they fulfill all the economic roles of money (store of value, medium of exchange, and unit of account)? A: At the moment, VCs do not completely fulfill the three economic roles associated with money. • High price volatility of VCs limits their ability to serve as a reliable store of value • The current small size and limited acceptance network of VCs significantly restricts their use as a medium of exchange • There is little evidence that VCs are used as an independent unit of account

30. Cryptocurrencies • Decentralized VCs rely on cryptography for their operations, thus “cryptocurrencies”: • There is no central party (e.g., a central bank) • The systems may allow for the issuance of a limited, or unlimited number of currency units • Most users are “pseudo-anonymous”: their VC “addresses” are public information among users, but their real-world identity is unrevealed • They derive value solely from the expectation that others would also value and use them.

31. An Example: Bitcoin • There is no central repository or administrator Instead, the Bitcoin system utilizes “blockchain,” a type of “distributed ledger” technology (DLT). • A peer-to-peer (P2P) payment system first introduced in a 2008 research paper published under the name Satoshi Nakamoto • Transactions stored in a public ledger, using its own unit of account “bitcoin”

32. An Example: Bitcoin • Bitcoins are created as a reward for payment processing work: • Users offer computing power to verify and record payments into a public ledger in a “mining” exercise, in exchange for newly created bitcoins or transaction fees • Bitcoins can then serve as a medium of exchange among users, using “wallet” software on their computers, mobile devices, or a web app. • Fixed total supply: max. 21 million to be reached around 2140 • Every four years or so, the amount of new bitcoin created and earned by miners with each new block of transactions is cut in half • So far 80 percent of all bitcoins have been “mined” • Current “mining” speed: 12.5 bitcoins around every 10 minutes, or 1,800 bitcoins each day • Current market value: around $6,200 each coin (as of 31 October 2018). Total market cap: approximately $115 billion • Daily transactions: around 150,000-500,000 bitcoins.

33. Central Bank Digital Currency

34. Central Bank Digital Currencies (CBDCs) • An electronic form of central bank money • be exchanged in a decentralized manner known as peer-to-peer • convertible at par with the central bank’s other liabilities such as cash or reserves. • Potential benefits • Entail savings on the costs of maintaining and replacing notes and coins in circulation • e.g., it costs the U.S. Mint 5.2 cents to produce a $1 note, which is expected to last 70 months 33 cents to produce a $1 coin which may last 30 years • Reduce transaction costs for individuals and businesses, in particular those with limited access to banking services. • Boost the adoption and efficiency of the new, decentralized, service economy.

35. Possible Features of CBDCs • Account-based versus token-based: • Option 1: Individuals or firms hold electronic funds in CBDC accounts at the central bank or designated accounts at supervised depository institutions Or, • Option 2: CBDC tokens to be issued, which would circulate electronically among private individuals and firms, and might only rarely be redeposited back at the central bank. • These two schemes differ in: • identification requirements (counterparty vs object) • verification mechanism (centralized vs decentralized).

36. Possible Features of CBDCs • Wholesale versus retail: • A restricted-access, digital settlement token for wholesale payment applications • Alternatively, a widely available, consumer-facing payment instrument targeted at retail transactions.

37. Possible Features of CBDCs • Interest bearing or not? • Alternative types of accounts or nodes? • Level of anonymity and privacy: • CBDC transactions become traceable, unlike cash? To what extent should anonymity be maintained and privacy be protected? • Permissionless DLT networks are generally “pseudo-anonymous,” and permissioned networks have a higher degree of freedom to choose • New technologies are allowing a greater level of control in the design of DLT networks • Ultimately it depends on the preferences of the general public.

38. Central Banking in a New Era • Numerous possibilities of central banking in the future • Algorithmic central banking? • CBDCs with stable real value? • Central banking based on a “smart rule”? • Programmable money and smart contracts?

39. Implications of Fintech for Monetary Policy

40. Implications of CBDCs • Implications on monetary policy framework • Issuing the CBDCs can help maintain the demand for central bank money, so central banks may continue to enjoy • Base money, narrow money and broad money could become much less distinguishable • More difficult to forecast the velocity of money, or money demand in general need to re-examine monetary policy transmission mechanism. • Role of financial intermediation in a decentralized financial world? • Traditional sources of bank revenues could be severely eroded • Financial infrastructure could be revolutionized • The overall financial landscape might change substantially.

41. Implications of CBDCs • Implications for financial stability • Accelerated speed and volume of financial transactions may not necessarily lead to greater financial risks • Heavier reliance on automated transactions may increase market volatility, although it depends on the specificity of the underlying algorithms • Wider adoption of certain algorithms and technological solutions may increase vulnerabilities to cyber attack, in particular with an increased concentration on key nodes • Eventually depend on how financial landscape and relevant technologies would likely evolve in the future. • Implications for financial regulation • May need to complement the focus on financial entities with increasing attention on financial activities • Governance of data and algorithms need to be strengthened • Licensing regimes need to be re-designed to bring new types of service provides into regulatory perimeter • Emerging technologies could facilitate regulatory compliance (“Regtech”).

42. Other Challenges Going Forward • Technological challenges: • scalability, interoperability, cyber security, among others. • Legal principles need to be modernized • International dimensions: • Need to establish international standards and best practices and strengthen cross-border cooperation • Network effects associated with currency internationalization? • First-mover advantages?

43. Concluding Remarks

44. Concluding Remarks • Fintech is here to stay • Countries need to take advantage of opportunities and mitigate the risks • Regulatory sandboxes may be the way to do it • The Bali Fintech Agenda shows the way

45. Bali Fintech Agenda 12 policy elements aimed at helping member countries to harness the benefits and opportunities of Fintech while at the same time managing the inherent risks. • I. Embrace the promise of fintech. • II. Enable new technologies to enhance financial service provision. • III. Reinforce competition and commitment to open, free, and contestable markets. • IV. Foster Fintech to promote financial inclusion and develop financial markets. • V. Monitor developments closely to deepen understanding of evolving financial systems. • VI. Adapt regulatory framework and supervisory practices for orderly development and stability of the financial system. • VII. Safeguard the integrity of financial systems. • VIII. Modernize legal frameworks to provide an enabling legal landscape. • IX. Ensure the stability of domestic monetary and financial systems. • X. Develop robust financial and data infrastructure to sustain Fintech benefits. • XI. Encourage international cooperation and information-sharing. • XII. Enhance collective surveillance of the international monetary and financial system.

46. Extra Slides

47. Future? Current New networks and means of payments Evolving landscape for cross-border payments Account-based Ledger A Country A Country B Ledger Central Bank Central Bank Ledger Domestic Payment System Domestic Payment System Ledger Ledger Ledger Bank Bank Bank Bank Ledger Ledger Nonbank Nonbank Nonbank Nonbank Ledger Payee Payor B Route 1: Correspondent Banking Route 2: Payment System Link • Choice of account-based and token-based systems • Less reliance on correspondent banks

50. Selected References • Bibliography Financial Stability Board, 2017, “Fintech Credit: Market Structure, Business Models and Financial Stability Implications.” Financial Stability Board, 2017, “Financial Stability Implications from Fintech.” International Finance Corporation, 2017, “Blockchain in Financial Services in Emerging Markets, Part 1: Current Trends,” EMCompass, Note 43. International Finance Corporation, 2017, “Blockchain in Financial Services in Emerging Markets, Part 2: Selected Regional Developments,” EMCompass, Note 44. International Finance Corporation, 2017, “Digital Financial Services: Challenges and Opportunities for Emerging Market Banks,” EMCompass, Note 42. International Monetary Fund and World Bank, 2018, “The Bali Fintech Agenda: A Blueprint for Successfully Harnessing Fintech’s Opportunities.” International Monetary Fund, 2017, “Fintech and Financial Services: First Considerations,” IMF Staff Discussion Note 17/05. Jenik, Ivo, and Kate Lauer, 2017, “Regulatory Sandboxes and Financial Inclusion.” Working Paper. Washington, D.C.: CGAP. World Economic Forum, 2017, Beyond Fintech: A Pragmatic Assessment Of Disruptive Potential In Financial Services. FDFI