Digitalization has radically transformed many industries in recent years, from the music industry — where the entire business structure has been overturned by digital distribution channels — to sectors like travel and hotel booking. But despite the major hype around fintech, change has been surprisingly slow in the financial sector, falling far short of promises so far.
Since the fintech era began in the 2000s, it has seemed as if global financial services are only a fingertip away. But the response of the financial system, interlinked by a variety of legacy systems, has remained slow. In many countries, the much-anticipated fintech revolution has (so far) been largely limited to the use of novel payment apps by consumers.
A whole new wave of emerging technologies — AI, blockchain, quantum computing and more — has now been hitting the financial industry. But there is still reason to doubt that these technologies will bring the kind of earthshaking change to the financial industry that two decades of other fintech developments have largely failed to deliver. The impact of these technologies, although likely significant, will more likely be a gradual evolution than a radical revolution.
Why have fintechs not delivered radical change in finance? The key reasons are twofold: consumer trust in incumbent institutions over new startups, which has made people hesitant to move from well-established banks to newly launched digital challengers; and the slow pace at which financial regulators have reacted and adapted to new technologies, which has helped protect incumbents.
Revolutionary change in the financial industry requires more than just groundbreaking technology. Global regulatory and governance cooperation is essential to creating the kind of frameworks that will unleash the potential of those technologies, and there are still too many unanswered questions about what that might look like to expect fundamental changes anytime soon.
Accelerating tech
Still, the slow pace of change in the financial sector may be shifting, with new technologies poised to deliver more than just a nice upgrade of the current online banking systems — at least in the long run. There are at least three important reasons for that.
First, regulators across the world have started to introduce more startup-friendly regimes with sandboxes and open-application programming interfaces. Second, digital technologies are not developing linearly but exponentially. The convergence of their development paths leads to ever-more-sophisticated concepts.
For instance, few could have fully imagined the potential of generative AI before OpenAI released its first products to a broader audience, and major advances seem to be looming. Reference problems in AI, a serious reliability issue where models sometimes fabricate information or fail to properly cite data sources, could be addressed through the blockchain by attributing the sources of the data that algorithms use. Quantum computing, meanwhile, will accelerate the use of AI by leapfrogging existing speed limits of conventional computer architectures.
Back in the 1990s and 2000s, a similar convergence of technologies once allowed cable television companies and wired phone network operators to start offering an array of telephone service, broadband internet and hundreds of video channels in a single package — a development referred to as the “triple play” that transformed the media industry.
And finally, customers will embrace services and technologies that meet their needs in the best possible way, opening the door for fintech firms that can truly offer superior products to pry customers away from legacy banks and other financial institutions.
‘Why have fintechs not delivered radical change in finance?’
We have still not seen the full impact of fintech on the broader industry. Much has been made of the possibility to tokenize assets, potentially allowing things like self-directed IPOs, peer-to-peer trading of securities, a broader reorganization of the investment fund industry and a total reworking of how business contracts — which today often remain paper-based — are handled via decentralized finance.
All of business rests on contracts, and DeFi smart contracts can allow them to become digital and also digitally automate the legal enforcement of those contracts. Digital currencies, issued either by private stablecoin providers or central banks, could also fundamentally alter the global financial system.
Those applications, however, remain largely in an early phase of development today. The possible scale of change on the horizon could be more radical than we might predict. For example, the financial system is well-served in lending money to individuals and firms — but who knows what would happen if money starts to be borrowed by machines, in a world where smart contracts communicate automatically with each other. Such a digital ecosystem could develop into a new flow network of automated obligations and enforcement between machines and institutions.
Splinternet or Finternet?
Although these developments could lead to a more homogeneous and unified global financial system, the near-term future doesn’t look as rosy. For example, digital currencies could speed up the transition to alternative reserve configurations induced by central bank digital currencies (CBDCs) and stablecoins — something addressed in the United States by the newly enacted GENIUS Act that aims to create a regulatory framework for stablecoins. In addition, (geo)political developments may lead to an even greater reserve fragmentation in the future. Digital money, and CBDCs, may well accelerate this transition.
One possible outcome is a reinforcement of the existing unipolar global reserve system centered around the US dollar. In this scenario, the perceived safety and trust in the reserve asset would likely persist, but liquidity provision may not significantly expand despite lower transaction costs. Moreover, the greater risk of currency substitution may weaken monetary policy independence in some countries.
An alternative scenario is the emergence of additional new dominant reserve currencies — a multipolar scenario with regional blocs of different CBDCs and stablecoins. These blocs could allow for more efficient risk sharing as well as a greater and more diverse supply of global safe assets. However, this multipolar monetary world could also make the system less stable if some of these blocs are fragmented and marked by weak interoperability.
This underscores the need for cooperation across such blocs and would require supranational coordination to prevent the world from a splintered instead of a finternet, a term recently coined by the Bank for International Settlements. All these developments call for more cooperation, more multilateralism and less fragmentation. And it requires a comprehensive policy framework with policy principles that span multiple jurisdictions. Yet current international tensions — with even close allies feuding over trade restrictions, and several conflicts hardening relations in key parts of the global economy — make the prospects for such global collaboration appear uncertain at best.
A potential solution to the risk of a splintered global financial world involves the creation of problem-solving collaborative networks, knowledge-sharing and co-production strategies, shared governance structures and standards as well as the promotion of transparency, legitimacy and accountability. One example is continuous linked settlement (CLS), a system that helps banks efficiently by synchronizing both sides of the transaction. It enables both investment managers and broker/dealers to populate their foreign exchange instructions and publish them to their respective counterparties. New currencies, however, usually take a long time to be integrated; for example, the Chilean peso took around three years to be onboarded to CLS.
Overestimating the speed of change
The chances of a rapid transformation of the financial system are slim, since so many of those essential questions remain unanswered. Until solutions are found, the future financial system will look more like an evolution of the current one, despite the clear power of new technologies, regulatory shifts and national policies to drive change.
For example, early adventures in crypto and DeFi demonstrated the enormous potential to reorganize the financial system. But they also demonstrated the accompanying risks, sometimes in dramatic fashion. Additionally, the current financial system was first developed in the industrialized world with banks, stock exchanges and other financial institutions, connected with traditional utilities as the major intermediaries. Yet this has led to a digital infrastructure that is tremendously challenged, with aging tech getting leapfrogged in areas like AI and blockchain.
While incumbent institutions still spend most of their budget maintaining systems that are often quite old and outdated, fintech startups and the big tech behemoths have been able to build their systems from scratch. In parallel, entirely new infrastructures based on both consortiums and public blockchains have emerged. Countries in the developing world have a potential advantage here, as they frequently do not have to develop complex, heterogeneous IT environments from scratch and can jump straight to applying these novel technologies to introduce new financial infrastructures. The Mojaloop project to develop interoperable open-source payments systems in various countries in Africa is one good example, although there are many other instances where regions in Asia and Africa have skipped over building the kinds of infrastructure still prevalent in wealthy countries and instead developed new systems that are mobile and novel by design.
‘One possible outcome is a reinforcement of the existing unipolar global reserve system centered around the US dollar.’
IT promotes a new financial system that is made from digital money, digital assets and a new digital financial market infrastructure that connects both old and new players. The first fintech developments are only the forerunners of this overall redesign. But the development of basic infrastructure driven by new IT developments, standards and services requires time and will not happen overnight. Regulators need to adapt to this new world, which requires that the digital services themselves — and not institutions — are the central focus of regulatory oversight.
We tend to overestimate the speed of development, but a closer look into the open questions discussed above shows a very clear gap between the new world of the future and the existing one. The development of standards, for example, remains at a very early stage. ISO launched its new working group on blockchain in 2016, and experiences from past developments suggest that several more years are required before a real impact can be seen.
On the other hand, many technical questions remain unsolved. Performance limitations of many blockchain solutions, for example, have not been fully addressed. The same applies to consensus mechanisms that do not view proof-of-work as an acceptable solution for many application areas. Many Web3 technologies are still at a very early stage, while AI is also confronting serious challenges, including that regulators are very unlikely to accept that data sources are not traceable to their original source. The developments ahead, therefore, will more likely be an evolution than a revolution.
Further developments looming
While tokenization and AI are still developing their full potential, there is already another wave of interesting trends in fintech. First, embedded finance, the seamless integration of financial services into non-financial platforms (such as bringing lending services into e-commerce, mobility and social media), continuously blurs the line between banks and tech companies, reducing the visibility of traditional financial institutions.
Second, hyper-personalization enables companies to develop digital representations of their clients and offer custom-tailored products and services. Third, immersive analytics allows the use of technologies such as virtual reality, augmented reality, mixed reality and large interactive displays to help people analyze and interpret complex data in a more natural, engaging and intuitive way. As the financial sector is mostly virtual, there might be possibilities in various application areas like investment management decision-making, workplace environments and virtual bank branches.
‘All these developments call for more cooperation, more multilateralism and less fragmentation.’
Another field of innovation is digital twins, a concept for digital models of real-world products and systems that originated in engineering and manufacturing. Digital twins are increasingly being adapted for financial modeling, risk management, compliance and policy testing as a virtual representation of the financial system and a connection to the real economy. They can be used to simulate, analyze and optimize financial decision-making in real time. For this, the digital twin integrates various data sources and can then be used for application areas like the assessment of the performance of a certain company in a certain value chain and industry sector under different circumstances.
Other applications are macroprudential simulations, such as modeling the impact of economic shocks on a certain economy; real-time risk management, such as simulating the fallout from possible market events; credit models that can predict default risk under different macroeconomic conditions; and regulatory compliance testing, which could do things like simulate and test compliance with regulatory frameworks like Basel III, MiFID II or sustainable taxonomies.
