Fintech and the digital transformation of financial services: implications for market structure and public policy
Economic frictions such as information asymmetries and economic forces such as economies of scale and scope give rise to financial intermediaries.
These frictions and forces also shape market structure. While technological advances are not new to finance, digital innovation has brought major improvements in connectivity of systems, in computing power and cost, and in newly created and usable data. These improvements have alleviated transaction costs and given rise to new business models and new entrants. As technology has increased information exchange and reduced transaction costs, the production of financial services could be disaggregated. Specialized players have unbundled financial services, allowing consumers to find and assemble their preferred suites of products. However, classic economic forces remain relevant even in an age of digital production.
Economic policies
Economies of scale and scope and network effects are present in many aspects of financial services production, including customer acquisition, funding, compliance activities, data and capital (including trust capital). Despite advances in technology, consumer search and assembly costs remain significant. These forces encourage re-bundling, and confer advantages to large multi-product providers, including technology (big tech) firms expanding into financial services from adjacent markets. The digital transformation of financial services gives rise to a set of important policy issues regarding competition, regulatory perimeters and ensuring a level playing field. Potential outcomes regarding competition, concentration and market composition include a “barbell” outcome composed of a few large providers and many niche players.
Authorities must coordinate across financial regulation, competition, and industry regulatory bodies to manage trade-offs between stability and integrity, competition and efficiency, and consumer protection and privacy.
Finance of today? Tomorrow?
Finance is undergoing a profound transformation. Digital technologies are reshaping payments, lending, insurance and wealth management — a process that the COVID-19 pandemic has accelerated. While this is making financial services in many economies more diverse, competitive, efficient, and inclusive, it may also increase concentration in markets. Moreover, new risks may arise to a range of key public policy goals. This paper draws on the underlying economics of financial services and their industrial organization to examine — with recent empirical evidence — the implications of digital innovation for market structure and attendant policies, including financial and competition regulation. The key organizing framework for the discussion is economic frictions such as information asymmetries and economic forces such as economies of scale and scope. These frictions and forces give rise to financial intermediaries and shape market structure.
Effect of technological advancement on finance
We show that while technological advances are not new to finance, digital innovation has brought major improvements in the connectivity of systems and in computing power and cost, which have resulted in large volumes of newly created and usable data. For example, mobile phone usage has surged globally, social and economic activity has shifted online (often to platform-based businesses), and new technologies like cloud computing have become widely adopted. These improvements have led to: 1.Alleviated frictions
2. blurred firm and industry boundaries
3. Rise of new business models.
New, often smaller and specialized financial technology (fintech) players have unbundled services (see definitions below). However, classic economic forces remain relevant. Economies of scale and network effects are strong in digital platforms and cloud computing. These scale effects, alongside economies of scope encourage re-bundling, and allow large technology (big tech) firms and other new players to deepen their inroads into core financial products.
Big tech and finance
Available evidence shows that big tech firms in particular are rapidly expanding their footprint in finance, and can use big data in ways that reduce the need for collateral. Meanwhile, incumbent financial institutions have adapted by adopting new technologies and disaggregating their production of financial services to improve efficiency. Digital innovation could drive a range of industrial organization outcomes. On the one hand, digital technology enables niche providers to reach a target customer base and be economically viable. On the other hand, customer acquisition, funding, “assembly,” and switching costs tend to favour larger providers of digital financial services. One possibility is a “barbell” outcome composed of a few large players and many niche players. The large, multi-product players could include traditional financial institutions, fintechs and big techs — thus both incumbents and new entrants. Small players may include fintechs as well as geographically or sector focused incumbents. While a ‘‘barbell’’ is not the only potential outcome, it is a central case given the economic forces at work. It is a potential steady-state market structure as some participants leverage scale economies and network effects to grow larger, while innovation continues to result in new entrants. There will be a tendency for players to either hyper-focus or to aim for the large, multi-product space. However, continued atomization, stalled re-aggregation, or limits on entry could result in a much much different configuration.
Thank you for reading...