Digital innovation is transforming financial services. Innovations in financial technology such as mobile money, peer-to-peer (P2P) or marketplace lending, roboadvice, insurance technology (insurtech) and crypto-assets have emerged around the world.
In the past decade, fintech has already driven greater access to and convenience of financial services for retail users. Meanwhile, artificial intelligence (AI), cloud services, and distributed ledger technology (DLT) are transforming wholesale markets in areas as diverse as financial market trading and regulatory and supervisory technology (regtech and suptech).
A host of new firms have sprung up to apply new technologies to meet customer demand and most incumbents indicate that digital transformation is a strategic priority (Feyen et al 2021). Indeed, leading banks are rapidly closing gaps in digitization of internal processes and customer offerings, to compete with fintechs and the large technology (big tech) firms that have also entered the fray (BIS 2019; Frost et al 2019).
The COVID-19 pandemic has accelerated the digital transformation. In particular, the need for digital connectivity to replace physical interactions between consumers and providers, and in the processes that produce financial services, will be even more important as economies, financial services providers, businesses and individuals navigate the pandemic and the eventual post-COVID-19 world.
For instance, the pandemic has already accelerated the shift to digital payments (Auer et al 2020a). It has also intensified e-commerce (BIS 2020; Alfonso et al 2021), which may benefit big tech firms and their activities in finance. Countries with more stringent COVID-19 policies and lower community mobility experienced a larger increase in financial app downloads in the wake of the outbreak (Didier et al 2021). Finally, it may be speeding up work on central bank digital currencies (CBDCs) (Auer et al 2020b).
The Impact of digital innovation on key economic frictions
The adoption of technology is not new in the financial sector, but a number of constraints had defined the operating environment until recently. In the late 20th century, the industry was already characterized by a relatively high degree of computerization since most financial services were dematerialized.
Only payments frequently required physical cash or a check, and onboarding for new products and services often required in-person or paper-based processes. Still, reaching and connecting to customers routinely required physical infrastructure such as branches and automated teller machines (ATMs).
Customers wishing to transact with counterparties using other banks had to use expensive and sometimes slow or risky processes such as wire transfers. Even after the advent of digital payment systems and the dematerialization of securities, connectivity remained a barrier to entry – an institution typically had to be licensed and part of the consortium of banks or brokerage houses to participate in a transactional network. Furthermore, data processing and storage were expensive, requiring the operation of bespoke mainframes and data centres. This limited the volume of information that could be gathered, stored, analysed, and exchanged to improve efficiency, better price risk, and tailor products to customer needs.
Technology advances in connectivity, data processing, and storage
Significant technology advances have taken place in two key areas that have contributed to the current wave of technology-based finance:
• Increased connectivity. Internet and mobile technology have rapidly increased the ability to transfer information and interact remotely, both between businesses and directly to the consumer. Through mobile and smartphones, which are near-ubiquitous, technology has increased access to, and the efficiency of, direct delivery channels and promises lower-cost, tailored financial services.
This included data centres, front and back-office connectivity to core banking systems, branch automation, and interoperable payments networks connecting financial firms, including wire services, automated clearing houses (ACH), and ATM networks.
In principle, most financial services can be now delivered directly and digitally, vastly increasing access to finance. An emerging class of services and assets could in principle even be delivered
without the need for an intermediary. At the same time, the rapid increase in connectivity has enabled large network effects and strengthened the position of established intermediaries offering mobile networks and subscriptions, such as telecom companies, particularly in some emerging market and developing economies (EMDEs). Furthermore, the development of widely used applications and services like social media, search and social communication have enabled more peer-to-peer casual interactions. These are increasingly being tapped for economic interactions, as well. This has strengthened the position of the companies providing these services.
Consumer interfaces are changing from physical branches to convenient digital access from anywhere. Digital consumer interfaces (eg web, mobile) enable new players to directly reach consumers both near and far. By using apps from different competitors, consumers can build their own complete bank and gain more personalized services. This has likely reduced the value of legacy physical networks and the incumbent’s grip on the customer, who can easily shift funds to different providers to access preferred services (Shevlin 2019). For example, the innovation of mobile money was a network-based account ledger provided by non-bank players and mobile network operators, leveraging already-ubiquitous mobile network connectivity infrastructure. This was combined with a new ecosystem of low-cost agents for the customer interface, and a high degree of automation to eliminate most back-office processes.
Mobile money ecosystems deliver low value/high volume transactions cost effectively, making this a viable offering for low income inclusive finance segments. Similarly, fintech payment aggregators (eg Square and Stripe) offer convenient payment services to merchants without the need for them to set up a merchant account with a processing bank. The aggregators act as the ‘merchant of record’ taking responsibility for compliance vis-à-vis network and bank requirements.
A related development is that the customer interface could be with institutions outside the jurisdictional boundaries of the customer. On the internet, it does not matter to the consumer if the provider is in Kansas or Kathmandu (although it may matter to the regulator!) Services have adapted accordingly.
Non-financial companies can also leverage customer connectivity and data to offer financial services, altering the competitive landscape and blurring industry boundaries. As mobile applications and the internet have become a dominant way through which consumers live their lives and businesses operate, e-commerce, telecom, online search, logistics/transportation, and social media platforms have become the new gatekeepers to the customer.
Digital platforms and big techs in particular are well placed to directly tap into their vast customer networks and data (BIS 2019). They are able to offer contextually relevant financial services to their user bases to enhance the customer’s experience or increase sales of their core product.
For example, e-commerce, ride-hailing, and social media platforms have integrated seamless payment services to strengthen the value proposition in their core markets. Micro-insurance has been embedded into mobile money and the sale of consumer products. Users do not desire most financial services in and of themselves, but see them as a means to another activity (eg pay a driver to reach a destination, take out a working capital loan to obtain inventory). As such, embedding the financial service directly into that core activity can be attractive to the customer. It can even make the customer more aware of services about which they otherwise might not have known, or to which they might not have had access.
Banks have used customer relationships to cross-sell financial services since the beginning of banking; now an increasing range of non-bank actors are doing the same thing. The back and middle office are being revamped – or eliminated entirely.
Technology has reduced the costs of, and need for, much of the traditional backoffice infrastructure, from paper processing to data centres. The back office is being revamped to lower costs and improve communication.
Process automation and upgrades to software and IT systems are causing a restructuring of financial institutions and a reduction of full-time employees. Middle-office functions such as
reconciliations are increasingly unnecessary. Entire processes, and many of the skills that previously had to be hired, can be replaced with automation or expert systems.
This has also given room for third parties to step in, such as cloud service providers and fintechs with specialized capabilities that sell their software-as-a-service (SaaS) to banks (eg data processing, credit scoring, electronic know-your-customer (e-KYC)).
For example, a bank can work with a credit-scoring company that leverages unique data and scoring expertise to provide a seamless customer experience.
Unencumbered by legacy systems, some new entrants have built new software platforms to handle their core banking activities, while others rent. Cloud-based infrastructure and BaaS providers allow smaller banks to outsource technology operations and leverage the latest systems to compete alongside larger banks. They enable small start-ups to purchase not only data processing and storage capacity, but also entry points into regulated infrastructure and regulatory compliance. Thus, smaller players can grow capacity in tandem with their customer base, without the initial setup costs and step function cost curves previously required.
CONCLUSION
Digital innovation is bringing about economically meaningful changes in the production of financial services, with implications for the industrial structure of finance. Improvements in connectivity and computing can help to enhance efficiency and competition. In many cases, financial services have seen an un-bundling of different products and services. At the same time, financial frictions and forces that drove the need for financial intermediators in the first place have reasserted themselves. The financial sector may be tending toward a barbell outcome in market structure, in which large multi-product institutions exist alongside more
specialized niche institutions.
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