Prince Michael of Liechtenstein and Thomas Puschmann
The financial system is evolving along multiple dimensions, from new institutions and means of intermediation to novel economic functions and entire infrastructures. The interplay between technology, regulation and nation states will define the financial system of the next decade.
Digitalization has accelerated the transformation of the financial system in recent years, generating a lot of hype. But what can we expect as the relevant and serious lines of development? From a macro perspective, the financial system facilitates the transfer of resources from savers to those who need funds, from payors to payees and from creditors to creditees. In other words, the financial system describes the interaction between the supply of and the demand for the provision of capital and other finance-related services. This perspective distinguishes at least four different sub-perspectives.
First, the institutional perspective focuses on the different financial institutions and utilities, including central banks, commercial banks and non-bank financial institutions, as well as regulatory and supervisory institutions. Second, the intermediation perspective aims to solve the challenges of direct financing between those who need capital and those who provide it, since both parties have different needs and preferences. For these, intermediaries provide term transformation and lot size transformation. Third, from the functional perspective, the financial system fulfills functions to transfer economic resources, payment infrastructures, pool resources, control risk and manage asymmetric information. And fourth, the systemic perspective differentiates a set of complementary and consistent elements. For example, two systems are complementary to each other if the positive effects reinforce each other and the negative effects mitigate each other. The impact of digitalization on these different perspectives is described in more detail below.
The institutional perspective
Startups
Banks, as part of the financial system, are enablers for the real economy of physical goods and services (e.g., real estate, manufacturing plants) by providing services like payments, investments and financing. Banks generate revenues mostly through interest differential business, trading, and fees and commissions. For example, in 2017, the global financial intermediation system had a total volume of $262 trillion, and the revenues associated with financial intermediation were $5 trillion.
However, banks’ position as a financial intermediary is currently challenged by startups and other non-banks from outside the banking sector:
- In sales and advisory, the use of digital channels for expert advice (e.g., by video) and digital self-advisory services (e.g., robo-advisors such as Betterment) are becoming more important.
- In payments, digital currencies of all kinds are penetrating the market. These include privately issued digital currencies such as Bitcoin, stablecoins like USD Coin and central bank digital currencies (CBDCs), which are currently being explored in many countries.
- In investments, new business models in the field of digital assets are emerging, such as the digitalization of non-bankable assets, non-fungible tokens (NFTs) and more.
- In financing, blockchains allow for the tokenization of physical goods like real estate and the financing of property with fewer funds.
- In cross-processes, novel applications in the field of knowledge transfers (as in financial education/literacy) and self-services are emerging (e.g., self-IPOs).
Startups in these areas have emerged everywhere in the world. For example, the Americas is the region with the most fintech startups globally, accounting for 11,651 in total last year, an increase from 5,686 in 2018. In contrast, the EMEA region accounts for 9,681 fintech start-ups (up from 3,581 in 2018), followed by the Asia Pacific region, with 5,061 startups (up from 2,864 in 2018), per a 2023 report. In addition, the non-bank financial intermediation sector’s (which includes hedge funds, insurers and more) relative share of total global financial assets has continuously increased, reaching 48% in 2020, up from 43% in 2004, according to the Financial Stability Board. These trends have led to a situation where banks are challenged from various sides. By the middle of 2023, banks only made up 75% of the entire payment landscape’s market capitalization, with fintech startups at 25%, up from around 10% in 2017
Big Tech
In recent years, large technology firms, the so-called Big Techs in the United States (Alphabet, Amazon, Apple, Meta and Microsoft) as well as their Chinese counterparts, the BAT (Baidu, Alibaba and Tencent), have undertaken major steps to enter the financial services industry. Examples include Facebook’s Diem project, to create its own digital currency, or Alibaba’s Ant Financial, which offers its own core banking system to financial institutions and non-banks. The market capitalization of these companies — combined with their billions of customers — demonstrates their enormous power compared to incumbent financial institutions. These large technology companies may have an especially profound impact on the existing financial system. However, financial services only make up some 11% of Big Tech revenues, while IT (46%) and consumer goods (22%) provide the largest part, according to Bank for International Settlements research. Since most of the revenues are in payments and financing, the Big Tech firms concentrate on these areas and generally do not favor investment services, with exceptions like Apple Savings and Yu’e Bao.
Financing data shows that in 2018, credit volumes increased to $397 billion for Big Tech companies and $297 billion for fintech startups (for a total of $694 billion for both sectors), up from $10.6 billion and $9.9 billion in 2013. In 2019, Big Tech credit volumes were estimated at $572 billion, with fintech credit volumes at $223 billion — amounting to a total of $795 billion, an increase of over 14% compared to 2018.
Despite Big Techs’ efficiency advantages in modern IT systems and their large amounts of available data, these companies also pose risks and can lead to monopolies in certain areas. Regulation of tech giants therefore means both simplifications (like India’s Unified Payments License (UPL)) and tightening (like India’s E-Commerce Law) at the same time. In addition, regulation requires not only financial policy but also the involvement of other regulators (competition authorities, data protection authorities, etc.), which makes Big Tech regulation a very complex field.
Digital ecosystems and embedded finance
While the first phase of the early ecosystem approaches saw startups mostly dominate the landscape, more and more incumbents are now entering the market. Together with the Big Techs that also extend their reach across various industries, this leads to a blurring of the lines between established industry sectors, and it may redefine well-established industries. New, cross-industry digital financial services include on-demand insurance for the sharing economy and payment services for cross-mobility services. Just as the internet evolved from an internet of information to an internet of services in the last few decades, the internet of value will allow clients and organizations to exchange money and other value (e.g., digital assets and loyalty points) across different ecosystems in which these services are embedded.
The financial system is engaging in these novel digital ecosystems through digital finance platforms, embedded finance and open banking — as well as models beyond finance that allow financial institutions, startups and Big Techs to extend their value creation in non-financial services domains. This is enabled by digital forms of money such as central bank digital currencies (CBDCs) and private forms of digital money such as stablecoins, which give citizens and consumers payment instruments for economic transactions. However, of the many CBDC projects in Europe, the UK, China and beyond, most are still in the early phases of development and are not yet live.
Digital ecosystems are global by definition and thus are difficult to coordinate within national borders[YW1] . Consequently, policy development must be coordinated on an international level across different industry sectors. An example is the case of global stablecoins. Because of their potential worldwide reach, they demand a discussion of what form “money” can have, who can issue it, and how payments can be recorded and settled. As the scale and scope of such new digital ecosystems grow, so too do the benefits of network transactions in a more dynamic way (“network externalities”). A global stablecoin network may pose challenges to banks’ business models as the migration to one or more stablecoin networks may disintermediate the role of banks in payments, and could have implications for the role of central banks and monetary policy. This may finally lead to the digital analog of “dollarization.” As central banks respond to this development, the introduction of various CBDCs could potentially lead to a more fragmented financial and business world, due to a kind of “splinternet” — although it also holds huge potential to develop toward a more open, integrated and accessible “finternet.”
The intermediation perspective
Decentralized finance (DeFi)
The role of banks in financial intermediation is not only tested by startups and Big Tech companies from outside banking. The field of decentralized finance (DeFi) has evolved as another challenge. In DeFi, financial transactions are facilitated in peer-to-peer networks without intermediaries, but rather via direct interactions of individuals and organizations. This can lead to reduced transaction costs by reducing monopoly costs, while at the same time creating network effects from which all participants can benefit. Total Value Locked (TVL), a metric used to measure the total value of digital assets that are locked or staked on a particular DeFi platform, increased across the ecosystem from zero in 2018 to around $250 billion by December 2021, decreasing thereafter to around $93 billion as of May 2024.
As a recent analysis shows, most DeFi applications are built on Ethereum (58.7%), followed by Tron and Binance (8.8% each) as well as Avalanche (3.4%). The same study revealed that most applications can be found in decentralized exchanges (28% of use cases) and lending (9% of use cases).
The functional perspective
Digital money
The current financial system, which is often termed “Bretton Woods II,” emerged after World War II and maintains a clear U.S. dollar dominance. But with slower and reduced global trade, this system seems more vulnerable than ever. As money evolved in many regions and countries of the world independently from each other, a very heterogeneous world of “money” exists today, even as some regions have seen consolidation (as within the European Union). In parallel, a new financial system with digital, privately issued currencies (such as stablecoins) emerged, which is mostly not connected to the incumbent system that primarily consists of central bank-issued fiat money. Yet, the future effects might be even bigger than we can foresee today.
With the digitalization of money, the typical functions of money as a unit of account, a medium of exchange, a store of value and a legal tender are increasingly becoming unbundled . For example, Bitcoin serves as a medium of exchange in some countries (like El Salvador)as well as or better than existing fiat currencies, which have higher transaction costs. This is why central banks around the world have recently started to explore CBDCs. On the other hand, digital platforms may also lead to a re-bundling of monetary functions.Here, payment services are bundled with other services (such as data services). Ultimately, we might not only differentiate between private and public forms of (digital) money but also between private and public forms of individual functions of money, which would ultimately lead to very high complexity that is impossible to manage without digital management and oversight.
Payment infrastructure
Payment infrastructure is another important pillar of financial systems, as it provides basic functions to support an economy with basic services for the exchange of goods and services. This is currently also discussed in the context of so-called digital public infrastructure (DPI), which will one day complement the existing physical infrastructure of roads, railways and so forth. In the financial system, the payments sector is one of the most important pillars of DPI and was also one of the first areas to see innovations early on. In 1871, Western Union launched the wire transfer over its telegraph network; in 1958, American Express launched the first credit card. Currently, the payment value chain is increasingly being unbundled by fintech startups such as Chime, Digit, Varo and Aspiration in the U.S. and Monzo and Revolut in the United Kingdom, as well as large technology firms like Alipay and WeChat in China and NU Bank in Brazil. These companies challenge the major revenue sources of payments for interchange fees, credits, cross-border payments and additional fees. For example, the cost of an international payment transaction today is approximately $25-35 but could in the future decrease to $1-2. On the other hand, public initiatives like UPI in India or Pix in Brazil, which focus on financial inclusion, complement this development.
The systemic perspective
Future financial market infrastructure
In addition to banks, financial utilities — including central securities depositories, clearinghouses, credit rating agencies, information and data providers, payment processors, credit card processors and exchanges — are another important element of the financial system. Some of these players are often bundled in so-called financial market infrastructures (FMIs), such as when capital markets substitute lending and savings functions offered by banks. In the traditional financial system with traditional assets, reserve balances (such as Fedwire and the Depository Trust and Clearing Corporation) are used for this. However, in a fully digitalized world, stablecoins and wholesale CBDCs might be used. In Switzerland, for example, the digital exchange SDX deposits money in its account at the Swiss National Bank and then issues a token on the platform that can be used by institutions linked to SDX. Future financial market infrastructures like the one in Switzerland will have a higher degree of specialization, combined with more standards-based integration capabilities.
Sustainable digital finance
Sustainability has become another major factor for the development of the future financial system. The potential of promoting digital finance for sustainability includes (1) the availability of more, cheaper and more trustworthy data, which enables greater transparency about firms and value chains; (2) cost reduction within financial intermediation through the unbundling of financial services, which are provided by specialized firms; and (3) innovative products, services and business models. With this, digitalization is estimated to help reduce global carbon emissions by as much as 15% with innovation in energy, agriculture and transportation.
While only some large corporations have just begun to align the Sustainable Development Goals (SDGs) with their existing profit-driven business models, an increasing number of SDG-focused startups have emerged that effectively incorporate these objectives in their initial business models. They consider an SDG approach as a competitive advantage, enabling the pursuit of both business and sustainability through the use of innovative technologies. Cases include novel, token-based financing platforms for startups in developing countries (which have only limited access to bank credits in their countries), new payment infrastructures based on digital currencies, digital wallets to improve financial inclusion, waste management in smart cities, peer-to-peer trading platforms for renewable energy production and consumption, and decentralized autonomous organizations (DAOs) based on blockchain technologies to govern and finance large (public) projects and prevent fraud and corruption.
A global analysis [LINK COMING] of 531 sustainable fintech startups revealed that most of those identified are based in the U.S. (19%), followed by the UK (16%), Germany (12%) and Switzerland (11%) — collectively representing 58% of all startups in this field. Such startups not only provide services to the financial sector but also to other industries, such as energy, technology, government/NGOs, agriculture and supply chains. Among the companies reviewed, 50% focus on supply chains, offering solutions such as ESG data provision, carbon emission analysis and reduction, blockchain platforms for green supply chains and data for responsible consumption. Another 35% of the firms concentrate on the financial services industry, offering impact assessment, financing solutions for sustainability projects and risk management solutions.
(De)regulation
A digitalized financial system would benefit from such a scenario. However, financial regulation has been challenged through technological innovations by the “innovation trilemma,” which forces regulators to provide clear rules, maintain market integrity, and encourage financial innovation. At best, as scholars ChrisBrummer and Yesha Yadav have argued, only two out of these three goals can be very often achieved. Four major areas must be considered as relevant when designing regulation for the future financial system:
Comprehensive regulation: Many fintech-related regulations have been incrementally developed based on their emergence. While early approaches focused on mobile payments and robo-advisors, discussions today often concentrate on blockchain, initial coin offerings, etc. But as fintech moves towards a complete digitalization of money — even embracing the monetization of data— the regulatory framework will need to be entirely reanalyzed. The emergence of a completely new financial system that is complementary to the existing one raises questions across all areas, not only single banking activities such as the Revised Payment Services Directive (PSD2) or the Markets in Crypto-Assets Regulation (MiCA). Although a comprehensive framework requires a holistic approach, more fine-grained exploration and regulation is needed. An example was the discussion about “too small to care” and “too big to fail” institutions after the great financial crisis. Such a multi-layered, modular approach is also needed for fintech, as the novel technologies, actors, banking processes and business models will often require different methods and fields of regulation.
Appropriate (de)regulation: Countries have followed different approaches to regulation. While some followed a “laissez-faire approach” (like China in the early days of peer-to-peer lending),others have tried to regulate every single element of the new evolving financial system (like the European Union). But appropriate regulation will only be possible if risk and innovation are balanced.This requires a more in-depth understanding by the regulators of technical developments and a more in-depth understanding of regulatory objectives by technology entrepreneurs. In general, regulation follows the maxim that similar activities should be regulated in similar ways, without including technological discussions and avoiding regulatory arbitrage. The move of financial services activities to unregulated areas, in combination with the credulity that financial institutions’ risk management systems would effectively signal eventual problems, were two of the major causes of the 2008 financial crisis.
Harmonized regulation: The harmonization of global regulation has a long history. As the economy and the financial system became global, the first institutions and regulations were introduced at a global level. But, in many areas, regulations are still stuck at a national level and integration challenges remain.
Organizations are often faced with a lot of regulatory requirements across various jurisdictions.
The integration of financial monitoring systems on a global scale could thus be very beneficial. Novel financial market infrastructures based on new technologies like blockchain might even strengthen the need for a harmonized approach. This harmonization applies also to new digital platforms that provide financial services, like those of the big techs. Current regulatory approaches primarily focus on financial institutions, i.e., the incumbent players. But digital platforms follow an entirely different approach (although they have often become dominant financial services providers, as in the case of China). For example, traditional regulation focuses on those institutions that hold client balances, which in many cases is not true for digital platforms.
Digitized regulation: IT-driven innovations require novel ways of regulation that can dynamically adapt to new technologies and changing environments — moving from an “ex post facto” regulatory approach to “ex ante,” outcomes-based regime. But today’s legal structures and regulations were written decades or even centuries ago, and they were written on paper. To meet future requirements, regulations must follow a “digital by default” approach. With each new regulatory page, complexity and implementation requirements increase.
Just as companies started to develop open APIs and newinfrastructures, regulators should also rethink their existing (analog)regulation approaches (e.g., the Financial Conduct Authority’s approachto expanding regulatory reporting in the UK). To be sure, the maxim“Code is Law” should not be interpreted literally. But new rightsstandards could in the future be implemented as algorithms for many(but not all) areas. These algorithms would require a new field of(technical) expertise by regulators. For example, pricing algorithmsoften automatically coordinate prices among different companies, andwithout oversight could lead to market manipulation and price rigging.
These four defining elements and developments have a huge effect on the financial system of the future, which can be described by the“Vaduz Architecture of the Financial System” (see figure above). IT enables automation and innovation, but also disintermediation, where efficiency gains outweigh additional risks. Regulation can enable innovation and protection at the same time, if designed properly, and nation states can foster financial inclusion and sustainability by promoting technology. All three areas have an impact on the financial system, which has “digital money,” (financial) institutions and digital ecosystems as core components.