How Regulation Works in FinTech

“How do you regulate something that’s never existed?” This is the challenge governments face in its efforts to regulate the FinTech industry.  

In this video, Lauren Cohen and Christopher Malloy, Course Conveners in the Harvard VPAL FinTech online short course, discuss the battle between incumbents and start-ups, and consider which companies may be at a disadvantage when further industry regulation comes into effect.

With this in mind, they also reflect on who will lead the future growth of the FinTech industry – will start-ups continue to drive innovation in this sector, or will traditional financial institutions be at the forefront?

Transcript

How do you regulate something that’s never existed? That’s a classic question that technology industries have faced for many years, and now this war between government regulators, incumbents, and start-ups is forefront in the future of FinTech. What’s the right path for government regulation, and how should these FinTech start-ups and incumbents respond to this situation?

So, on this issue of government regulation, the question is, “When is the government going to crack down and when is it not?” And obviously in China, there’s been lots of crackdowns recently. Another case that’s been quite interesting here in the US, is this Madden versus Midland case. Where the government is coming in and potentially regulating FinTech lenders, and saying that they can’t charge above a certain interest rate.

The stated goal of that is, of course, to get rid of what’s called predatory lending, and help consumers from getting ripped off. And the question is, is FinTech ripping off these consumers or not? I mean you could make an argument that FinTech is coming in and helping the exact consumers that the government claims to be worried about.

Whenever you get into this government regulation issue too, then FinTech, are they going to be able to find a way around this? And if they can’t find a way around this, then do you have, Tech on FinTech, like FinTech squared, that’s going to come in, and be able to figure out a way to do it? However much the government wants to regulate these things, it seems like there’s always ways around these.

And so, it’s going to be tough for the government to regulate things like bilateral transactions. If you and I agree that: Okay, I’m going to lend you ten dollars at the beginning of the week, and you want to pay twenty at the end of the week, then of course that’s a massive interest rate. And yet, we might be happy to do that, right? One of us may really need the money until the other is happy to do that, and we’re both better off by making that transaction. So to the extent that the government comes in and tries to tamp down on these – could be not so great for their citizens.

Exactly, and one argument that FinTech companies will make is that these markets don’t exist, but they could exist at some price, and we’re making consumers better off, and – by creating this enormous market – society’s better off.

And so, then the question becomes, “Okay, who is most hurt by this regulation?”

Exactly. So are they going to come after the big established players? Or are they going to crack down the new incumbents?

If history has told us anything, it’s that these government regulators – they have jobs too, and so they want to prove that they’re really doing a great job, and it’s much more newsworthy to take down the big fish. It’s much more newsworthy, if you can take down that firm that everyone’s heard of. And so, in that sense, incumbents almost have more innovative risk in this space, than a new small innovator.

They have large established brands and client bases, and to the extent that they don’t want to put that at risk, they may be less willing to dive into some of these markets, and perhaps that’s why some of these FinTech companies have gotten market share in certain areas where the incumbents have been slow to enter, particularly in developed countries like the US.

But, then, you have this double-edged sword – if I’m late to enter into this market, there’s some kind of brand equity that can be built up from a LendingClub, or a Prosper, or one of these other people, then by the time I want to get into it, it’s too late.

There’s a big first-mover advantage. I can either try, and then compete late, or I try to partner with them. So this partnership angle is something that we’ve seen growing of late. The extent to which FinTech companies always want to build their own brand, and go public, and build a huge business, but now, realizing that maybe it’s in their best interest to partner, and of course, on the incumbent side, perhaps the same way. Like, building all this expertise in-house is quite costly and difficult. It might just be easier to establish a partnership.

You’ve seen this in other industries too, right? We’ve seen this in the biotech-farmer relationship, and how that’s evolved over time. And that, now, much of the innovation in that – in drugs, is been pushed down to biotech, and now large pharma companies – like a Merck or AstraZeneca – simply buy the biotechs later.

And have a marketing role.

Yeah, you can imagine something similar being true here. So, in that sense, what does government regulation do? And what do we need to worry most about in the FinTech space with government regulation? Well, it might not be that it’s going to massively impact the rate of innovation, and the technology that’s developed, but it impacts who does the innovation.

So the most valuable capital that you have, it turns out, is your human capital. So we want you to answer that big question: Where do you want to bet your career? Do you bet your career on that innovative new FinTech start-up that’s going to change the world, or with the incumbent firm that’s trying to get into this Fintech space?