citizens’ benefits come with increased risks.
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 “UNDP’s Human Development Report 2019 points to convergence of ‘basic’ capabilities, whereas ‘enhanced’ capabilities underpin a ‘new generation of inequalities’, focused on two seismic changes – technology and climate change“
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Digitalization offers growing potential benefits to citizens who can access and make valuable use of improved, customized, cheaper financial services. Individual saving and investments should become easier and more rewarding, with more choice, portability and transparency. Growing numbers of people working as independent traders and contractors or running small businesses will have cheaper and faster access to borrowing. Such benefits will however come with risks.
Digitalization puts people at risk of privacy violations and data security breaches, fraud, irresponsible lending, and discrimination based on profiling. This might be through, for example, cryptocurrency exchanges, fake transactions on ecommerce sites or peer-to-peer marketplaces or online gaming, and fraudulent crowdfunding campaigns.
Traditional consumer protection risks such as lack of transparency, unfair or discriminatory treatment, disproportionate, improper or unauthorized use of data by financial service providers, deceptive sales and marketing techniques can also be amplified through digital channels. New types of financial service providers, such as mobile operators and digital platforms, may be operating outside of traditional financial regulations leading to lack of consumer or investor protection.
Data gaps, biases and ownership limit finance’s alignment to the SDGs. To be useful economic, social, environmental and governance data must be able to be aggregated, analysed and used across multiple platforms. Many factors mobilize against this. Data from the informal sector is harder to gather, let alone aggregate, all the more so if individuals and companies lack the capabilities and tools to produce such data, or are anxious not be observed by their respective governments. Lack of disaggregation by critical factors, such as sex, makes useful analysis more difficult. When such data is available, fragmented, non-interoperable systems restrict useful data aggregation and analysis. Too often data quality and integrity remain a challenge.
Digitalization of finance creates a possibility that product design, artificial intelligence and algorithmic decision will replicate gender and other biases and discrimination. Small developing economies which have not yet harvested large pools of data are particularly vulnerable to biases since lending algorithms will be trained on foreign data, in particular when virtual banks are established by global banking groups or BigTech firms. Automation and machine learning based on incomplete or bias-saturated data may also further marginalize sections of the population already facing disadvantages.
Privacy and security of personal data has become a critical issue, especially with digital platforms and mobile operators gathering so much data about users. Encouraging access and use of data that supports innovations aligned with citizens’ needs may take precedence in the short-term in countries looking to establish the bases for digital financing ecosystems. However, securing adequate protection of citizens’ personal data and privacy is increasingly viewed to be paramount for lasting, sustainable citizen benefit. Different countries are adopting different approaches to use, ownership, and protection of data, European Union has introduced General Data Protection Regulation (GDPR) to secure people’s rights over their data, but the impact of this legislation is too early to judge despite moves by several jurisdictions to emulate it. In the main, consumer consent remains a challenging construct.
Cybersecurity is becoming the most important systemic risk in digital financial services. Just as citizens become more vulnerable, so do businesses, governments and the financial system as a whole. Cyberattacks affected over 4 billion records, in the first half of 2019 alone, representing a 54 percent increase from the same period in 2018. Over the past two years, cyber insurance premiums have tripled as the costs associated with cybercrime continue to grow. Financial institutions increasingly rely on a handful of cloud infrastructure providers, with similar IT features and systems. Such data concentration increases the risk of it being targeted and compromised and creates the potential for cascading effects from breached entities. Global standards such as Financial Action Task Force (FATF), CPMI-IOSCO guidance on cyber resilience and CMPI strategy against wholesale payment fraud related to endpoint security provide a first barrier against these risks.
Digital disruption drives innovation but is likely to be followed by growing market concentration. New entrants offer financial services through product and enterprise innovation, operating on the edges or outside of existing financial regulatory regimes. Digitalization supports steeply increasing returns to scale, with near-zero marginal costs of service, and dramatic synergies in the application and value of data. As enterprises grow, they can further enhance service offerings in broader areas. Grab and Uber are leveraging payments data to offer credit lines and insurance products to drivers, and M-KOPA is using M-Pesa payments data to supply ‘pay-as-you-go’ access to clean energy and consumer debt.
Digital platforms succeed when they can harness network effects and associated increasing returns to scale. The associated benefits may also have costs resulting from increasing market concentration and the use and privacy of data. Macroeconomic impacts and systemic risks also need to be considered, arising from this increased market concentration, and associated risks such as algorithmic pro-cyclicality and contagion, and potential dilution of full control over monetary outcomes.
Rent taking by financial intermediaries remains a major risk of digitalization to the extent that it contributes to increasing levels of complexity and opaqueness in well-developed financial and capital markets and poses a regulatory challenge of tracking rapid evolution of digital finance. A landmark study highlighted that the margin taken by the financial sector for intermediation of investment in the US has remained constant at about 2 percent for more than a century despite increased volumes and technological developments, suggesting that intermediaries have absorbed the financial benefits from the associated cost reduction effects.
The recent promulgation by the European Union of a revised Payment Systems Directive (PSD2) illustrates a context specific regulatory approach to securing a level playing field for new players, which could support partial disintermediation. For incumbent financial institutions, cost reduction opportunities from digital represent both an opportunity and threat to their bottom line as their market is opened up to radically cheaper competition. Many incumbents are racing to invest in emerging technologies to improve service to customers and enhance operations. Some, however, may resist increased transparency of their activities and rewards.
For public financing, similarly, realizing the digital dividend is largely dependent on both sound investment in functional digitalization, and the willingness of governments to underpin the ‘trust ecosystem’ with enhanced transparency, targeting and assessment of public spending.
Financial Conduct Authority: Quantifying the High-Frequency Trading “Arms Race” (2020)
Brookings: Finance, Productivity and Distribution (2016)
