OTTAWA: In July 2017, the Bank of Canada released a discussion paper outlining a framework for the assessment of risks and opportunities for central banks in connection with Fintech. This paper also more generally explores potential implications of Fintech for central banks, given their mandate over monetary policy, the design and distribution of currency and/or financial stability. One of the reasons that Fintech is being keenly watched by central banks is in connection with its potential implications on monetary policy and the design and distribution of currency. Cryptocurrencies and distributed ledger technology more generally have revived interest in the idea of electronic currency, potentially leveraging such distributed ledger technology. Such concept could have significant implications on a central bank’s ability to manage monetary supply.
The Bank of Canada has begun experimenting with distributed ledger technology in the payments system (although not in respect of currency directly) by running a pilot called Project Jasper (please see our blog post on the subject). The conclusion of the first stage of the pilot project was that such technology was not yet ready for live use in wholesale large value settlement systems, and the pilot is continuing and has progressed to a later stage. This seems to suggest that electronic currency may still be some time away for central banks. The paper also discusses entity-based regulation vs. functional regulation, and their applicability in the regulation of Fintech. Entity-based regulation is based on type of entity (banks, credit unions, securities dealer, etc.). Functional regulation is based on type of activity (payments, lending, etc.). The reality is that financial regulation will always involve aspects of both entity-based regulation and functional regulation. However this blend is constantly evolving and it is important for regulators to strike the right balance. Overemphasizing entity-based regulation can be risky because it presumes that there are well-defined institutions to regulate. Fintech is shifting the traditional definitions of what is a bank, a wealth manager, a broker dealer, etc. Entity-based regulation could consequently result in entities in key parts of the financial sector falling outside the scope of the regulatory scheme. This could expose the entire system to additional risk.
Fintech is also resulting in changes to existing players and an increased shifting and blurring of organizational boundaries. If the size of large banks becomes a hindrance to their ability to keep pace with innovation, these institutions may begin to spin off business units in a process known as “unbundling”. Banks and other established players may also choose to partner with and acquire Fintechs. The major consequence will be that the line between bank and non-bank entities will become less defined, making entity-based regulation more challenging. There are also challenges with functional regulation. If regulators do not clearly define the specific function they are targeting, there is a risk of market confusion which acts as a deterrent to innovation. Functional regulation can also be too prescriptive. Overly prescriptive regulation risks being outpaced by technological developments and thus becoming ineffective. This is a particular challenge given the rapid pace of advances in Fintech.
