Herbert Poenisch, Member of IMI International Committee and former Senior Economist BIS.

Big Techs such as Amazon, Facebook, Microsoft in the West and Fin Techs such as Ant Finance and Tencent in China are some of the biggest companies in the world, much bigger than banks and they increasingly venture out into financial activities or leverage off individual products such as payments. The recent example is Facebook which is planning to launch its own cross border digital currency, Diem (before Libra). There are also dedicated FinTech companies, such as Ant Finance which offer a variety of financial services, such as interwoven activities which lead to complex structures which are not easy to regulate and supervise.

The current organisation of regulation and supervision of financial players is based on the old structure. There are dedicated organisations for banks, insurances, securities etc. There have been cross business activities for a while, such as banks offering insurance products. This led to the creation of financial services authorities as regulators and supervisors of entities dealing across financial sectors, such as the Financial Conduct Authority in the UK. Regulation has also covered non financial holding companies offering financial services.

However, regulating and supervising entities which are big in non finance, such as social networks which venture out into finance are a new challenge. Their forte is DNA, Data collection, operating Networks and interwoven Activities. Equally, dedicated FinTech companies like Antoffercross business financial products, thus crossing regulatory lines. In this article two case studies will demonstrate the regulatory dilemma and efforts by authorities to come to terms with them. The first one will be Facebook with its Libra (now Diem) digital currency project. The second one will be Ant Finance with its complex palette of financial services.

This article will not cover the other main concerns about Big Tech such as financial stability risk, operational risk, cyber risk, competition concerns as well as data governance which are addressed by previous contributors. It concentrates on how to capture the financial activities of Big Tech with existing regulatory and supervisory approaches.

1. Principles of financial regulation and supervision

As Governor Yi Gang recently stressed in recent speeches that there should be no unregulated financial services on offer, regardless of whether it is an established bank or a non-bank entity providing it. Similarly, payments instruments should not be linked with other financial services. While is a commendable stance, regulation can be light or tight depending on the systemic importance of agents. For example treating telephone companies offering payment services like a bank is an overkill and decoupling payments from other financial services might stifle necessary innovation. After all, the advantage of a smartphone is that it leverages off the technology to offer a myriad of functions.

Another principle is same business, same risks, same rules. However, rigidly enforcing such a principle would stifle innovation, by subjecting providers of stablecoin to the same regulations as issuers of e-money, such as banks. However, heeding the creation of a level playing field is commendable as it would be less rigid in application.

All current financial services can be divided into the following six categories according to the FSB. Only one regulatory and supervisory authority is charge of each product. (i) Issuing digital currency is put firmly in the court of the central banks as they have the monopoly of providing legal tender and are charged with monetary stability. (ii) Regulating payment services is also responsibility of central banks who are in charge of overseeing the functioning of the payments system. (iii) Extending credit such as through P2P platforms is the responsibility of the banking regulator. (iv) Crowd sourcing is a collective investment vehicle and is responsibility of securities supervisors. (v) Wealth management is also an investment activity and thus responsibility of the securities supervisors. (vi) Provision of internet insurance is certainly responsibility of the insurance regulator and supervisor. Like this, all possible financial activities are assigned to specific authorities for so called activities based regulation (AB). However, as the first case study, Diem will show, even clear responsibilities are not easy in application. Secondly, cross financial sector links makes the assignment to one regulator more difficult as the second case study, Ant will show. In this case regulation is moving towards entity based regulation (EB).

2. Issuing a stablecoin by Facebook

The world of central banks has been shaken by the Facebook project to issue a stablecoin, not a cryptocurrency, accessible to its 2.7 billion subscribers.

The project caught the attention not only of these subscribers but of common people all round the world as well. Facebook planned to issue this digital currency by its Libra Association, which counts other organisations as members, such as blockchain companies. The Libra (now Diem) would be linked to a basket of major currencies, with daily value calculations like the SDR. The Diem would readily be convertible back into the underlying currencies, calculated on a daily basis.

The advantage would be online payments and transfers, as well as store of value including for those who do not have a bank account. Thus financial inclusion would be a main beneficiary. The underlying central bank assets would be invested in low risk securities, thus similar to the forex management of central banks. Using existing major currencies, Diem would be importing the trust in central bank issued money. However it is uncertain whether the underlying forex assets have the same credit risk as those underlying present day central bank currencies.

Facebook also promised to respect all present supervisory parameters such as AML-ATF-KYC verification to avoid having Diem misused for illegal activities. Originally the Libra Association applied for approval with FinMa, the financial market regulatory authority of Switzerland. In 2021 it changed location to the USA together with the change of name to Diem. The application is still pending and the approval process is handled by the FED, the US Treasury and the SEC.

The Financial Stability Board (FSB), at the request of the Group of 20 has produced guidelines for the issue of stablecoins, which would also apply to Diem.

The report includes 10 recommendations, characteristics, risks and vulnerabilities of stablecoins as well as regulatory and supervisory issues connected with the issue of such coins.

Regarding the characteristics, stablecoins would fulfil all three basic functions of money, denomination, transfer as well as store of value. The core issue of balancing the supply and demand would be either through asset management of the underlying portfolio or by algorithm. The challenge will be stabilising the value of the stablecoin by either creating or destroying coins. The transfer of coins without a central authority would require a mechanism for validation. The best technology would be distributed ledger technology with blockchain. This would allow permissioned transfers at the beginning as well as permissionless transfers later on. There could also be a division into small permissionless amounts and big permissioned amounts. The cross border use would require cooperation and coordination between national authorities. The FSB and its sub groups would be the right forum to investigate such issues.

The risks and vulnerabilities mentioned in the FSB report address both, the transfer function as well as the store of value function. The value of the stablecoin would fluctuate, just like the SDR, causing a wealth effect on coin holders. Used for payments, would the system be robust enough to function under stress, such as a large volume of transactions, to ensure the smooth functioning without having access to a lender of last resort.

Some countries which issue weak currencies might be worried about currency substitution and capital flight, as its citizens might prefer holding stablecoins rather than the national currency. The issue of monetary sovereignty, which looms large has not be addressed by the report.

In a survey various regulatory authorities responded that some legal provisions for stablecoins exist such as on e-money, collective investment vehicles, or just plain deposits. There is legal uncertainty of whether Diem would be a claim on the Diem Association or the underlying assets. As there are no capital or liquidity requirements planned for Diem, the banks, the issuers of e-money would claim unfair competition, thus violating the principle of same business, same risks, same rules.

Bearing in mind these uncertainties, the approval of the first stablecoin, the Diem is still a while off, possibly not before CBDCs with a cross border application are launched. Ever since the challenge from stablecoins appeared, central banks have intensified their research, trials as well as pilot projects, such as the PBOC and the eCNY.

3. Complex financial institutions such as Ant Finance

China is unique in that it allowed a top of the art FinTech institution to emerge and grow organically without stifling its development. The regulatory regime was rather permissive until 2015. This experiment has created useful innovations but also had downsides as many researchers predicted. This has prompted the authorities to step in, by initially curbing some of the excesses and more recently by starting to disentangle the complex structure and unbundle individual products.

What started by Alibaba as an e-commerce platform, TaoBao spun off a financial subsidiary called Ant Finance. It established it own payments platform called Alipay. This system uses commercial bank money but operates its own payments infrastructure, which is not interoperable with other platforms such as by Tencent or banks and it does not have access to a lender of last resort. The researchers called this the lock-in effect for a captive clientele. Using the float of the payment system, the largest money market fund, Yu’ebao emerged. The big data collected in the course of operating the payment system has given Ant an advantage over established banks. This allowed it to establish a credit rating system, called Zhima which had a lower default rate than traditional bank operated credit scoring systems. Ant used its exclusion power to put pressure on borrowers to service their debts.

The superior information on borrowers allowed Ant Finance to operate a P2P platform, called Zhao Cai Bao where, in the true adherence to information transformation, it managed to put borrowers and lenders together. The lenders were mostly small and medium sized banks which were restricted in their lending due to geographic limitations imposed by the major banks. They provided the funds which were pooled by the platform and channelled to trustworthy borrowers. In case of default, Ant could enforce its exclusion power. Thus the financial transformation was in the hand of banks, with Ant Finance adding a small share of its own funds.

Leveraged on the big data of more than 500 million clients, Ant Finance also established its own digital bank, MYbank, took deposits and lent to consumers and small businesses, called Jiebei without geographic restrictions. MYbank had lower costs as it did not have to run a branch network. At some stage, MYbank provided 20% of consumer loans, with lower costs and a lower default rate than banks. It also issued its own virtual credit card, called Huabei.

Later on it leveraged on its technological prowess, such as facial recognition. It added wealth management within Ant Fortune, financed green investment in Ant Forest. It also sold its own insurance products as well as mutual health insurance, called Xianghubao. It also started a cooperation with the PBoC on the introduction of the digital renminbi eCNY.

In late 2020 Ant Finance planned its IPO in Shanghai and Hong Kong, the largest one ever. However, the authorities stopped the IPO, citing cyber security and data protection. In 2019 the authorities also clamped down on the money market fund by subjecting the payment float to a 100% reserve requirement. On the reverse side they were not allowed access to the liquidity window of the PBoC. Instead a special institution for clearing and settlement between payments platforms HyUnion Clearing was set up under the PBOC. As from beginning of 2021 all customer funds of payment platforms need to go through PBOC accounts. This cuts the ability of these platforms to leverage other financial products off customer deposits.

Governor Yi Gang praised the achievements of FinTech companies in providing financial products to those neglected by major banks, such as micro and small and medium enterprises (MSME) at lower costs, less collateral and lower default rates.

However, on the downside he expressed concern about the collection of vast data, the cross sectoral risk, as customer funds were invested in other financial products. The monopoly position has led to a winner takes it all uncompetitive behaviour. The privacy of data and information security is at risk. Its lending posed serious challenges to established big banks. It was the small and medium sized banks which benefitted from additional business through platforms.

In its regulatory response since 2016 the PBOC tries to fill regulatory gaps, create transparency and a level playing field. The main pillars are that all financial businesses should be licensed and that there should be firewalls between financial products. The monopoly on credit information has to be broken and subjected to guidelines by the PBOC, increase competition of payments providers, remove the algorithm bias and ensure personal privacy though the cybersecurity law.

China has passed an updated regime for regulating financial holding companies to submit all financial service providers under one umbrella as well as to compile consolidated balance sheets. Since early 2021 Ant Financial has been registered as a financial holding company (FHC). The State Administration of Market Regulation (SAMR)is drafting regulation, covering financial regulation, competition regulation as well as data governance. In future, the dynamic FinTech sector will be subjected to tighter regulation and supervision of a mixture of both types, activity based as well as entity based. This casts a shadow over this dynamic experiment which has dramatically changed the financial landscape in China, which was truly unique in disrupting an established structure.

Conclusion

As recent forays of Big Tech and the advanced experience of China in FinTech have shown, national regulators have been caught off guard and are getting organised to address the challenges to financial regulation, competition regulation and data governance. The landscape is still dominated by silos of different authorities, without an established exchange of views and centralised decision making. This is a classical case of recognition lag and reaction lag to evolving technology. To be on the safe side, financial regulators have resorted to what they have been doing, regulating certain financial products.

However, the unique experience of China with the rapid growth of an integrated financial service provider in the form of FinTech, enabled by a permissive regulatory regime can provide society with advanced financial products more efficiently at the expense of creating a monpoloy and exercising monopolistic powers harming social harmony. The reaction by the authorities has been an entity based regulation of FHC as well as unbundling of highly intervowen financial services. What seems a regulatory storm not only in finance, but also in other digital products should not turn into a stifling of innovation and returning to past unchallenged positions once the dust settles.

While national regulators struggle to meet the challenges of Big Tech on a national scale, many of these Big Techs are global providers straddling countries and products. There is yet no coordinated international effort to meet these challenges, as several fora address various aspects, such as competition and data protection. In the area of finance, the Financial Stability Board would be the right forum to address the gaps in regulating digital finance. AUN type of world organisation such as a World Digital Organisation WDO is still a while off while Big Techs use their global freedom to advance their digital products, including digital finance.

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