Fed takes fintech head on

Recent statements by a Federal Reserve governor make clear that this century-plus-old institution is geared to take on the prospect of revolutionary technological changes.

Financial technology in general, and blockchain in particular, present significant potential for transforming financial services, as well as introducing significant risks that must be addressed, said Federal Reserve Governor Lael Brainard recently.

“While financial innovation holds promise, it is crucial that financial firms, customers, regulators, and other stakeholders understand and mitigate associated risks,” she said in a recent issue of Consumer Compliance Outlook, a Fed publication. “There is a tension between the lightning pace of development of new products and services being brought to market—sometimes by firms that are new or have not historically specialized in consumer finance—and the duty to ensure that important risks around financial services and payments are addressed.”

Continuing commentary on fintech

The recent Fed article was the latest commentary from the governor on pending fintech issues. In October, Brainard addressed the Institute of International Finance in Washington, D.C., about distributed ledger technology (generally termed blockchain) and its implications for payments, clearing, and settlement.

“The genuinely innovative aspect of distributed ledger technology combines a number of core elements that can be used to support the transfer process and distributed recordkeeping for digital assets and digital representations of assets,” she said. “These elements include peer-to-peer networking and distributed data records, which provide broadly shared access to a single ledger across participants in the system, so that all participants maintain a shared, accurate history of all transactions in the system. In addition, cryptography provides a secure way to initiate a valid transaction as well as to securely transmit and store data. And consensus algorithms provide a process for transactions to be confirmed and added to the single ledger.”

Brainard outlined several specific use cases in which blockchain might be applied:

• Cross border payments—“Reducing intermediation steps in cross-border payments may help decrease time, costs, and counterparty risks and may materially diminish opacity, for instance by enabling small businesses or households remitting payments across borders to see the associated transfer costs and processing times up front.”

• Trade finance—“Where document-intensive processes are not fully automated, distributed ledger technology may be able to reduce significant costs and speed up processing associated with issuing and tracking letters of credit and associated documents.”

• Securities markets—“The industry is exploring activities ranging from the issuance of securities on a distribute ledger, to the clearing and settlement of trades, to tracking and administering corporate actions.”

• Commodities and derivatives—“There are projects to streamline some of the more antiquated corners of the markets … Distributed ledger technology could potentially be leveraged to provide coordination that facilitates exchange, clearing, and settlement of obligations.”

• Smart contracts—“To take a familiar example, for a corporate bond with a specified par value, tenor, and coupon payment stream, a smart contract would automatically execute payments on the specified schedule to the assigned owner over the life of the bond.”

Currently, though, Brainard noted that all of these potential applications “are in their infancy.”

“The initial relatively simple proofs of concept must be followed by much more complex demonstrations in real-world situations before these technologies can be safely deployed in today’s highly interconnected, synchronized, and far-reaching financial markets,” she said.

It’s got to be secure

To that point, Brainard emphasized that all parties, private and public, must strive to develop robust security in any future blockchain-related system.

“What matters to us as policymakers and regulators is not only whether the migration to a new technological platform increases or reduces risks, but also whether risks are rendered more or less opaque, and how they are distributed among and between financial intermediaries and end users,” she said. “In the payments, clearing, and settlement arena, some important risk areas for consideration include settlement, operations, and cybersecurity, as well as money laundering and terrorist financing.”

Prevention of adverse actions remains the preferred approach, she noted, but, realistically, resiliency and recovery will also need to be high priorities.

“Indeed, many firms have suggested that the distributed data storage concept has the potential to increase the level of resiliency and data integrity,” she pointed out. “The basic idea is it should be harder to corrupt multiple copies of the same data simultaneously such that digital ledgers could reduce the vulnerability associated with a single point of failure. We must press firms and experts to identify the strengths and vulnerabilities of this concept, even as we all look for ways to make databases more secure and resilient.”

Speaking more generally, in a question-and-answer format in the Fed’s Consumer Compliance Outlook publication, Brainard said: “Just as smartphones revolutionized the way in which we interact with one another to communicate and share information, fintech may impact nearly every aspect of how we interact with each other financially, from payments and credit to savings and financial planning.”

She provided these examples:

• P2P—“Once broad adoption is achieved, it is technologically quite simple to conduct cashless person-to-person fund transfers, enabling, among other things, the splitting of a check after a meal out with friends or the sending of remittances quickly and cheaply to friends or family in other countries.”

• Financial management—“Financial management tools are automating savings decisions based on what consumers can afford, and they are helping consumers set financial goals and providing feedback on expenditures that are inconsistent with those goals.”

• Savings—“In some cases, fintech applications are automatically transferring spare account balances into savings, based on monthly spending and income patterns, effectively making savings the default choice.”

• Real-time access—“Other applications are providing consumers with more real-time access to earnings as they are accrued rather than waiting for their regular payday.”

• Access to credit—“By reducing loan processing and underwriting costs, online origination platforms may enable financial services providers to more cost effectively offer smaller-balance loans to households and small business than had previously been feasible.”

Again, though, she pointed out that both those in the industry as well as regulators and supervisors must be responsible for safe and sound practices and the management and mitigation of risks.

“Fundamentally, financial institutions themselves are responsible for providing innovative financial services safely,” Brainard said. “Financial services firms must pair technological know-how and innovative services with a strong compliance culture and a thorough knowledge of the important legal and compliance guardrails. While ʻrun fast and break things’ may be a popular mantra in the technology space, it is ill-suited to an arena that depends on trust and confidence.”

On the other side, she said, “regulators’ approach to fintech should be no different than for conventional financial products or services. The same basic principles regarding fairness and transparency should apply regardless of whether a consumer obtains a product through a brick-and-mortar branch or an online portal using a smartphone.”

Fed’s internal task force advances

To address the effects of fintech on financial services and its regulation, Brainard said, the Federal Reserve has established a multidisciplinary working group that is engaged in a 360-degree analysis of fintech innovation:

“We are bringing together the best thinking across the Federal Reserve system, spanning key areas of responsibility—from supervision to community development, from financial stability to payments—to assess the impact of technological development on the Federal Reserve’s responsibilities.”