The exciting possibilities that come from disrupting industries with digital technologies seem to be limitless. We all live in the shadows of Schumpeter's creative destruction and Darwin's natural selection. In this age of confidence and progress, "software is eating the world," proclaimed Silicon Valley entrepreneur Marc Andreessen. A whole new league of competitors from the online world have revolutionized many industries, including journalism, music, and movies.
Now, technology has its eyes on finance. This seems all too natural as in essence, financial institutions are information intermediaries. Almost three decades ago, the then-CEO of Citibank Walter Wriston stated, "Information about money has become almost as important as money itself." Bitcoin, the most visible example from this nascent development, marks the transition from the "internet of knowledge" to the "internet of value" that could replace financial intermediaries. Online payment mechanisms, such as PayPal and Alipay, and peer-to-peer lending platforms, such as Lending Club and CreditEase, are also capturing increasing segments of the financial value chain.
There is no doubt that the antiquated infrastructure of finance is ripe for a digital transformation. Free of the legacies and structures inherited by the banks, internet firms are poised to facilitate an explosion of financial innovations. Not only will this reduce the cost of financial intermediation, but more crucially, it will lead to the "democratization of finance." Technology will play a role in reaching the 2.5 billion unbanked around the world through mobile payments and microfinancing solutions when traditional banking is inaccessible.
Banks feel threatened, as vividly described by JPMorgan CEO Jamie Dimon: "When I go to Silicon Valley . . . they all want to eat our lunch." The big question is: Will the interplay between the financial and information industries follow a process of Darwinian selection, or one of mutualistic symbiosis? The answer lies in the broader regulatory framework and market realities, which will crucially shape future competition and collaboration. As the anti-Darwinian creationists say, "intelligent design" plays a part.
The Logic of Symbiosis
First, banking is one of the most tightly regulated industries in the world. In the past decade, regulatory scrutiny has heightened with governments' increasing focus on combating terrorism, money laundering, and drug enforcement. Furthermore, as one moves to more complex financial products and bespoke advisory services, costs and expertise are required to comply with regulatory standards. While a "regulatory umbrella" currently exists between established financial institutions and technology companies, regulators will have to catch up as the latter group plays a bigger role in finance. In the United States, a BitLicense framework is proposed to regulate Bitcoin start-ups. In China, the People's Bank of China is also contemplating a regulatory framework for the internet finance sector.
Second, even for simple services, there are strong incentives for disruptors to ride on and improve upon the existing system. Beyond technological capabilities, it takes time and market expertise for a financial network to build up credibility, universal acceptance, and consumer convenience. In the case of payment networks, for instance, this requires the balancing of competing incentives for operators, merchants, and customers, and the development of security and consumer protection measures. The incumbent systems enjoy competitive advantages in the form of significant network effects.
Therefore, there is a strong logic for internet companies to partner with financial institutions. And indeed, the evidence points firmly to a future of mutualistic symbiosis. Apple Pay does not attempt to disrupt the existing payment ecosystem, but rather works with the incumbents to bring balanced cost-benefit economics for consumers, retailers, card issuers, and networks. Ripple Labs, a start-up that enables real-time cross-border payments using cryptocurrency protocols, does not attempt to interfere with a bank's relationship with its regulators and customers. Rather, it is content with providing the technology at the back end.
China's Alibaba is the most visible example of an internet firm venturing into finance. On the basis of its e-commerce business, it moved into small and medium enterprise (SME) lending in 2010. By 2013, it had extended a total of $16 billion in loans. In the same year, it launched the wealth management product Yu'Ee Bao, which attracted over $1 billion in investments from customers in just a few months. Yet for all of its success, partnerships with banks remain important. Above all, the regulatory context is critical. Alibaba is not a bank and is not regulated as such. This allows it to focus on technological innovations while the complexities of financial regulation are still handled by the banks.
Making Partnerships Work
Looking ahead, we should expect more partnerships between finance and technology companies. The more technological capabilities banks can access, and the more financial expertise internet firms can tap into, the better for both. But the challenges of getting this right are considerable. First, there are significant differences in heritage between the two industries. While the internet is open and inclusive, finance can be insulated and conservative. Second, it is not always easy to define the boundaries of the partnership and the respective roles of the partners. One can imagine competing imperatives to occupy the prime position and capture value from financial and information flows.
Then there is the issue of regulation. In such a highly regulated sector as finance, it may not be possible to recreate the internet's permissionless innovation environment. But if regulators start by focusing on risk minimization and consumer protection to the point of discouraging experimentation and innovation, they would be foregoing huge growth opportunities. In this light, a shift away from the traditional prudential regulatory approach and the creation of a level playing field for banks and non-banks will be critical. Recognizing that both established and new players can contribute, government has an important role to play in bringing their strengths together. And as more cross-industry partnerships are formed, regulatory authorities will need to work together in new ways amid the blurring boundaries.
The consequences of getting partnerships right are profound, given the centrality of finance to broad swaths of the economy. For emerging economies in particular, the potential of using technology to achieve developmental goals like financial inclusion, better SME financing, and increased trade flows is also significant. Given an open and innovative mindset on the part of both banks and non-banks alike, and a conducive regulatory framework that enables healthy partnerships to come into existence, technology will eventually modernize the infrastructure of banking.