The risk of fintech and its regulatory framework

The previous article explained the concept of Fintech as well as the advantages it brings to the development of the socio-economic. Operational practice demonstrates that Fintech has increased convenience in the financial industry since its inception, opening up new development potential for the economy. Entities in need of finance have more options available to them that offer lower costs, easier procedures, and quicker turnaround times. For investors, they will have new investment channels with flexible interest rates. However, the greater the benefit, the greater the risk. Simply put, because Fintech is a new industry, it also entails risks we have never had to deal with. Also, there is currently a dearth of knowledge on the new field, which allows dishonest people to commit fraud. As a result, this article will concentrate on the hazards that come with fintech and also explore the development of a regulatory framework for fintech in several nations worldwide.

Risk of Fintech

As previously discussed in articles, Fintech has a positive impact on society and the economy. Each attractive benefit, however, is always accompanied with potential risks. Especially for a completely new area like Fintech, the dangers might bring exponential harm to the entire financial system and individuals, because it is presently not entirely governed by a comprehensive legislative framework, as well as a lack of public awareness. Many people believe that Fintech is still a young field and that it cannot have a significant impact on the entire global financial system because the volume of Fintech’s financial activities only makes up a relatively small fraction of the financial market. If you share the above viewpoint, let this chapter serve as a reminder of the financial disaster of 2008. To remind you, instruments like the Mortgage Back Securities (MBS), Collateral Mortgage Obligations (CMO), and Collateralized Debt Obligations (CDO) were used to be deemed historically significant financial inventions before the 2008 financial crisis broke out. Afterwards, as we were all aware, those securities led to the US subprime mortgage crisis in 2007, which had a severe impact on the financial system as well as the actual economy.

One thing we must realize is that the financial industry is extremely interconnected; all individuals in the financial system have strong ties and bonds. Only one part of the risk can cause the entire system to fail. This was similar to a fleet of commercial ships made up of dozens of boats linked together by iron chains so that they could travel easily and were not troubled by storms. But, if just one boat caught fire, the entire fleet of commerce ships would be destroyed. It was difficult for any of them to escape because they were chained together. Fintech services are growing rapidly, they are also integrating into the general financial system. As a result, the dangers that Fintech can bring must be carefully analyzed in order to minimize substantial disadvantages in the financial sector. This chapter will try to explain the main risks of Fintech. Because Fintech’s services are so diverse, the article focuses on the risks of Crowdfunding, P2P Lending and Mobile Money. We choose the above three services because they are the most used Fintech products today.

Peer-to-peer Lending

P2P lending has the benefit of providing a rapid and efficient channel for the provision of funds to people or small and medium-sized businesses. It is also a new investment option for investors who wish to put their extra income to work. However, the risks from P2P Lending also appear more, these risks become even more complex and unpredictable when they are deployed in cyberspace. P2P lending may be used by many criminal groups for money laundering, property fraud, theft or invasion of personal information and privacy.

There are many problems with the way the P2P Lending model works today. First, credit risk is one of the major dangers that P2P Lending platforms may bring about (this is the risk that borrowers will not be able to meet their repayment obligations under the terms of the loan agreement). In order to limit this risk, it is necessary to assess the risk of the borrower’s ability to repay. Therefore, it is extremely important to collect customer information to assess creditworthiness. However, the information provided by the borrower is often difficult to verify accuracy by P2P Lending platforms. According to the survey, investors participating in the P2P Lending platform face many difficulties to determine the creditworthiness of the borrower. Governments and financial institutions have always expressed concern with P2P Lending platforms because of this problem (Milne, 2016). P2P Lending platforms get their income from service fees when loans are successfully matched, hence many P2P Lending businesses purposefully produce fictitious loan paperwork with very alluring information for investors.

Second, investors are quite passive and completely dependent on P2P Lending companies. In case if the borrower does not pay their debt, then the investors can only ask for the support from the P2P Lending company to recover the capital, but the company can refuse on the grounds that It is only an intermediary to connect information between the parties. Investors put far too much trust in the platforms’ automated loan selection and risk assessments. The fact that the current regulatory framework does not completely enforce mechanisms to compel P2P Lending platforms to have standards in their risk assessment puts investors at serious risk.

Third, investors may also face difficulties if P2P Lending platforms go bankrupt. While banks get support from the central bank or government if they can go bankrupt, P2P Lending platforms can only rely on themselves. And so, investors will run the risk of losing all their capital. According to research by the BIS committee on the global financial system, P2P lending platforms are more exposed to operational risks than the banking sector, such as cyber technological vulnerabilities. P2P lending is primarily reliant on modern digital technology to operate. Therefore when there is a technological issue that can result in the loss of the entire database, it has a significant impact on both the user and the platform.

Fourth, the interest rate of P2P Lending is showing signs of usury, when the penalties for overdue debt payment or the unreasonable collection of service fees make the interest rate that borrowers pay may increase up to 20%. In several nations, the P2P lending model is transforming into black credit, with Vietnam being the most prominent example. According to the Monetary Policy Department (2020), the P2P Lending companies listed on the website have lending interest rates that are no higher than 20% annually in accordance with the Civil Code of Vietnam. However, the borrower is actually required to pay a lot of other fees such as consulting fees, early repayment fees. Customers will be required to pay an interest rate of up to 30% per month when all entrance fees are added together.

Crowdfunding

Crowdfunding began to take off in the UK relatively early on, in 1997, and in the US in 2000. The wave of crowdfunding platforms debuted in 2006, and since then, well-known websites like RocketHub, GoFundMe, etc. have emerged. Crowdfunding experiences rapid growth, but it also comes with possible concerns and legal conflicts with numerous nations worldwide. Many experts assessed that this is a model containing high risks, uncertainty and information asymmetry for investors. Crowdfunding has two outstanding characteristics, which are the main risks for this model. First, the majority of the businesses seeking funding are small or recently founded, meaning that their foundations are still weak and their potential risk is very great. Second, crowdsourcing does not require a substantial financial investment from the investor; instead, people can contribute as little as $6. As a result, this strategy mostly draws first-time crowdfunding investors, including housewives, students, and others without prior investing expertise.

When examining the hazards of crowdfunding, the first risk that is always addressed is the risk that comes from the nature of the companies raising capital. Companies that use crowdfunding are typically small-scale and in the early stages of development. As a result, these organizations frequently reveal relatively little information about their company and financial status, and this makes risk assessment difficult for investors. Furthermore, companies that must raise funds through crowdfunding are frequently family businesses or individuals with strong links. This will create distance with shareholders through crowdfunding. In contrast to founders’ holdings, which are typically concentrated, crowdfunded holdings are widely dispersed among many investors. From then, the company’s management lacks transparency and the founders are free to make decisions that are in their best interests. More worse, founders are able to embezzle money from investors in crowdfunding campaigns without even informing them.

The second risk comes from the nature of the securities that crowdfunding companies issue. Investors might exchange the securities they own to the secondary market when they believe the business of the firm is unstable, has no potential for expansion, or they just wish to get out of this investment. However, the securities issued by crowdfunding companies face many legal restrictions, and the attractiveness of these securities is not enough to attract buyers. For instance, before shares can be traded on the market in the United States, they must have been issued for at least 12 months. Investors can then completely face the possibility of losing their money. As was already mentioned, the securities of crowdfunding companies are also impacted by nondisclosure. Value of listed companies is evaluated through market-driven prices. It is more challenging to value crowdfunding enterprises, which can end up costing investors more money than they are worth, due to the lack of information.

The third risk is caused by the misbehavior of crowdfunding platforms. This risk arises from the potential for platforms to commit fraud to steal clients’ money, such as offering virtual investments to deceive investors. Some platforms additionally include options like representing investors at shareholder meetings and voting on their behalf. Nevertheless, this particular interest can lead to a conflict of interest between the platform and the investor, as the platforms may make opposing decisions in order to benefit themselves.

Mobile Money

The deployment of mobile money will be especially helpful in distant locations, where people lack access to financial services and accounts, in the opinion of most experts. This service is crucial for the growth of a cashless economy and the spread of financial inclusion. Apart from these positive aspects, however, there are a lot of possible risks and difficulties associated with the deployment of mobile money.

The first problem is related to the customer’s sim card. A mobile subscriber number is unquestionably required if you want to utilize the Mobile Money service, but in some nations, the administration of phone sims is relatively permissive, which results in a large number of spam sims. While there are still junk sims available, this particular form of mobile money might turn into a channel for criminals to use for illegal activities like stealing property or money laundering. Users must take security precautions to prove their identity when using other non-cash payment methods through intermediaries like banks or e-wallets, such as using passwords, OTP codes, fingerprints, or voice recognition, but when using mobile money services, users only need to provide personal information when registering for a mobile subscription. So, the subject has access to the entire balance of the mobile subscription as long as they steal the customer’s phone. Also, if the issue of junk sim registration is not addressed, criminal organizations can fully exploit Mobile money to launder money by using different pieces of personal information.

Another problem is how telecom companies that offer Mobile Money services manage their cash flow. Consider the case of Vietnam, which has around 125 million mobile subscribers. If each of these customers merely spends around $6 per month, there will be $750 million in total transactions per month. Since there is such a significant sum of money involved, the regulator needs to have sanctions in place to make sure the telecommunications firm is using the funds appropriately—waiting for payment, not investing.

Fintech regulatory framework in the world

Fintech’s potential is enormous, and they are developing at a breakneck pace. Not only that, Fintech is being supported and promoted by many countries and international organizations. Sub-Saharan African nations adopted fintech relatively early after quickly seeing its significance. As a result, the region is becoming the global leader in mobile money transfer services; the entire volume of transactions accounts for 20% of GDP, which is more than 7% of Asia and 2% of other regions. The relevance of fintech in reducing poverty was highlighted by United Nations Secretary-General António Guterres in a speech in 2018, and he also addressed the necessity for a proper regulatory framework to oversee fintech.

There are now two perspectives on how to manage Fintech activities: One is requiring Fintech businesses to adhere to the same rules as banks (Fintech companies must have a banking license). This view is popular in France, Germany, the US, China… these countries consider that Fintech’s services are similar to those provided by traditional banks. Therefore, these nations quickly incorporate fintech into their legal systems and safeguard customers. The second view is more flexible when countries adopt the Sandbox regime. Fintech firms are not need to comply with traditional banking rules under the Sandbox regime, and they are free to build their own products. Although this approach enables Fintech companies to cut operating expenses, it also poses a systemic risk if products are not completed. Typical countries that apply this management are the UK and Japan.

Europe

The European banking industry has long struggled with difficult issues such as bank overcapacity and lending problems that have lingered for many years as a result of Europe’s debt crisis. Along with the Covid-19 pandemic outbreak, these long-term challenges had a significant influence on the economic foundation and basic operations of European banks. It was also an opportunity for Fintech to thrive in Europe.

Europe has long been regarded as a leading region for Fintech development since its nations have consistently led the world in the expansion of financial institutions and the Fintech sector. Data also revealed that following the Covid-19 pandemic, Fintech has continued to be the area of technology that receives the highest investment in Europe. European fintech companies make up 17% of the industry’s total worldwide value, and by 2022, it is predicted that more than 30 of these unicorns will reach the $1 billion valuation threshold.

For managing all Fintech services, Europe currently lacks a comprehensive legislative framework. For each different type of Fintech, there are laws corresponding to related industries, for example, Directive 2000/31/EC (e-commerce), Directive 2002/65/EC (distance marketing of consumer financial services), Directive 2009/110/EC (electronic money), Directive (EU) 2015/2366 (payment services), etc. Although there are numerous individual directions that make up the regulatory legislation for the Fintech industry, there are also some general rules that all Fintech businesses must abide by. For instance, the European Commission swiftly repealed the Payment Services Directive (PSD I) in favor of PSD II, which expands on the definition and addresses developments in technology in payment services, after observing the growth of Fintech. Additionally, the General Data Protection Regulation (EU) 2016/679 (GDPR), which went into effect on August 25, 2018, mandates that Fintech firms have personal data protection procedures in place. The GDPR filled in the holes in the current data protection laws while also defining “big data” more precisely.

The European Commission nominated the European supervisory authorities (ESA) – including the European Banking Authority (EBA), the European Securities and Markets Authority (ESMA) and the European Insurance and Occupational Pensions Authority (EIOPA) – to be the route supervisor as well as support for financial technology in 2018. In addition to monitoring compliance with financial regulations as discussed above, ESAs also design various soft policies or rules to encourage the growth of the Fintech sector. The EU Fintech Lab was first established by EBA to foster knowledge sharing and capacity building among member agencies and regulators. EU Fintech Lab functions as a forum where European Fintech companies can present their services, seek advice from experts, and interact with policymakers and inspectors in person to better align legislation with their business operations. Additionally, the ESA’s mandate calls for close coordination between the financial regulators of its member nations. The paper claims that European financial regulators are at odds on how to govern Fintech in their respective nations, and that this lack of cooperation may impede the growth of Fintech.

Japan

Japan is one of the leading nations promoting the growth of fintech, especially given that they appear to be huge fans of cryptocurrencies. The proof that, thanks to a favorable legal framework, Japan was rapidly developing into a key market for Bitcoin, with 29 bitcoin exchanges still in operation, and the nation’s tax authorities collecting taxes on the cryptocurrency. Furthermore, because the Japanese government actively discourages the usage of cash, electronic payment systems are being rapidly extended. According to the research in 2021, the rate of cash in circulation in Japan is little over 20%.

Japan’s Fintech legal framework, like that of many other nations, was not complete, and rules were dispersed among a number of distinct legislation. Additionally, Fintech activities’ administration is not uniform. While the Japan Financial Services Agency (JFSA) oversaw and issued licenses for Fintech companies (including cryptoasset exchanges, crowdfunding platforms, and electronic settlement agents), the Ministry of Economy, Trade and Industry was in charge of the credit card issuers or payment service providers. When rules conflicted, it was challenging for managers and Fintech companies alike.

Fintech regulatory framework in Vietnam

In comparison to the rest of the world, the Vietnam Fintech market emerged relatively later. Although Fintech began to exist in Vietnam in 2017, it may not really take off until 2021 in terms of both quality and quantity. In the research by Vu Thi Anh Tuyet and Vu Thi Thanh Thuy (2021), the Vietnamese Fintech market’s transaction value increased 77% in just three years, from $4.4 billion in 2017 to $7.8 billion in 2020. State Bank of Vietnam (SBV) figures show that by the end of 2021, there will be more than 154 Fintech businesses, a four-fold growth from the 39 companies in 2015. The above examples also show us that Vietnam’s Fintech market is also developing as rapidly as the international market.

However, fundamentally speaking, Vietnam has not yet created a seamless and comprehensive legislative framework for the Fintech industry. The laws governing fintech are dispersed among several legislative instruments, including the Law on E-transactions 2005; Law on Information Technology 2006; Decree on E-transactions in Financial Activities 2007… However, current regulations still only focus on Fintech activities related to banks such as electronic payments, while other services, like crowdfunding, peer-to-peer lending, or cryptocurrency, are still not covered by any specific regulations. Additionally, criteria for consumer protection or the protection of personal data have not been standardized to be incorporated in specialized Fintech legislation, creating challenges for both government agencies and private companies. The current growth goals for Vietnam simply aim to increase public knowledge of and comprehension of Fintech, for example: Decision Approving the Scheme for Development of Non-Cash Payments in Vietnam during 2016-2020… The SBV has finalized a draft Decree on a controlled trial mechanism for financial technology activities in the banking sector, focusing mainly on services such as Blockchain Technology/Distributed Ledger (DLT); peer-to-peer lending (P2P Lending); open application programming interface (Open API); electronic identification and identification technology (e-KYC).

From November 2017, after understanding the instability in its legal structure, The JFSA and the Ministry of Economy, Trade, and Industry met with a number of research groups to discuss changing the legal framework governing the financial system to accommodate the rise of Fintech. Japan used to differentiate its financial system according to the “type of business,” but later moved toward an interdisciplinary legal framework and began to differentiate according to “function”. Japanese regulators have detailed plans to develop Fintech with four basic objectives. In which, creating a strong foundational legal framework, facilitating the growth of a cashless economy, and sharing data were the first objectives. The second goal was to revise several laws to introduce new cross-sectional financial intermediary services. The Financial Services Intermediary Act, which replaced the Financial Instruments Sales Act and allowed for the establishment of financial services intermediary enterprises, was proposed in 2020. Additionally, the Payment Services Act was amended to allow for the development of new categories of fund transfer services. The third objective is to boost automation and digitization, enabling businesses to access Fintech to increase business efficiency. In addition to supporting Fintech startups, Japan also encourages Fintech firms operating in the “insurance” or “banking” sectors to be owned as subsidiaries by these institutions. Finally, Japan made the decision to utilize the Regulatory Sandbox to test the management and supervision of new Fintech services, analyzing the results and identifying areas for improvement.

© 2023 Nguyen Tran Viet. All rights reserved

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