Digitization of money and finance: Challenges and opportunities

Introduction

I would like to express my appreciation to the Federal Reserve Bank of Atlanta for the invitation to speak on the issues facing central banks and regulatory authorities in this era of technological advances in the field of finance.

The global economy is experiencing a non-stop digital revolution. Consider this one number: a recent study estimates that by 2025, what is called the “global data-sphere” will grow to 163 trillion gigabytes from 16.1 trillion gigabytes in 2016. That ten-fold increase will encompass data held everywhere from the cloud to our handheld devices.

This represents an almost unimaginable combination of technological benefits—and potential dislocations. We have virtually infinite information at our fingertips, and we face the possibility that our jobs will be obsolete before we retire.

The macroeconomic implications of this digital revolution are also breathtaking. For example, it may alter the path that low-income countries have followed over the past half century. The latest IMF World Economic Outlook contains a study suggesting that automation may replace a lot of labor-intensive manufacturing that these countries have used to climb the development ladder. Instead, jobs in these countries may migrate to the service sector.

With all of that in mind, in my remarks today, I would like to focus on one frontier of technology that is certain to have a major impact on our economy: the digitization of money and finance.

First, I will discuss how financial services may be transformed by the adoption of financial technology;

Second, I will examine how crypto-assets rise may pose challenges to financial integrity and stability;

Third, how central banks and regulators can mitigate potential stability risks without impeding innovation;

And finally, I will highlight the work the IMF is doing to help its 189 member countries address these challenges.

Implications for Finance

The digitization of finance has been spurred by the innovations encompassed in the term fintech. Put simply, fintech is the collection of technologies whose applications may affect financial services. This includes artificial intelligence, big data, biometrics, and distributed ledger technologies such as blockchains.

Fintech offers the promise of faster, cheaper, more transparent and user-friendly financial services. It raises the prospect of expanding financial inclusion, especially in developing countries. The possibilities are exciting.

Companies working with artificial intelligence are exploring credit scoring based on payment data. Fintech startups in Latin America, Africa, and Asia are moving toward the use of peer-to-peer lending data, and information from mobile phone payments to build reliable credit databases.

Another area under development is “smart contracts” that could allow the more secure and faster settlement of financial market transactions. These contracts use software to enable automatic triggers that allow transactions without human intervention.

In the realm of lending, small- and medium-sized enterprises could gain greater access to financing and investment opportunities as costs and other barriers to entry are lowered. One example is a Fintech Challenge in Sierra Leone. The central bank of that African country and the UN are encouraging local and regional efforts to develop fintech-based apps to facilitate credit to farmers in remote areas.

But there inevitably will be risks. Financial stability could be affected—through disruptions to existing service providers and business models. Unregulated sectors could create additional operational risks related to cybercrime and outsourcing.

The 2016 cyber-attack on the central bank of Bangladesh is a case in point: hackers gained access to the bank’s SWIFT codes and transferred millions of dollars from its account at the Federal Reserve Bank of New York.

New technologies and new forms of intermediation may upset the balance between transparency and privacy. The recent Facebook-Cambridge Analytica case underlined the need for clear rules governing privacy and data ownership. Ethical concerns are just as important as legal guidelines when it comes to individual users.

Enter Crypto-assets

Crypto-assets also have entered the financial landscape. There has been a notable expansion of such assets in recent years. Our latest Global Financial Stability Report estimates an increase in the market capitalization of all crypto-assets to about $600 billion this past December. That’s an increase from about $25 billion only one year before! And that does not take account of the more transactions taking place outside of the exchanges.

In truth, there are both opportunities and risks associated with crypto-assets. As an asset class, crypto-assets have not been correlated with other assets, and could provide diversification benefits to investors.

Some useful technology is being developed to improve market efficiency. For example, services have slashed from days to minutes the time it takes for cross-border payments to reach destinations. These include relatively small firms like BitPesa in Africa and BitOasis in the Middle East and such well-known companies as Western Union and Moneygram.

As with other forms of fintech, crypto-assets also have the potential for criminal activities. They can mask identities, which makes them attractive for money laundering, terrorist financing, tax evasion and fraud. Last year’s law enforcement operation against the AlphaBay criminal marketplace was a prime example of the crypto-underworld.

What of the legitimate market? Last year’s skyrocketing prices of crypto-assets invited comparisons with past speculative bubbles. For example, the increase in the price of bitcoins in 2017 was roughly analogous to the South Sea Bubble of the 18^th century.

For now, crypto-assets are still relatively insignificant compared with conventional assets, and, so far, they do not pose a threat to macro-financial stability. However, this could change.

When asset prices go up quickly, risks can accumulate, especially if market participants borrow to buy them. So, when leverage rises because of crypto-assets, vulnerabilities may emerge.

The growth of crypto-asset-related investment funds and futures contracts increases the opportunities for mainstream investors. However, this broadening of the investor base could result in increased correlation between crypto-assets and traditional assets. That would increase the potential for the transmission of shocks, especially during episodes of risk aversion.

The expansion of the investor base, and the lack of transparency in the crypto-markets, could combine with rapid growth to produce market disruptions. These could be amplified by two other factors: the borderless nature of the underlying transaction mechanism and different national regulatory approaches.

The Regulatory Response

How should regulators and central banks respond?

To maximize the full potential of new financial technologies, policymakers must strike a sensible balance. This involves creating a supportive space for innovation, while maintaining a robust regulatory framework. Trust in an evolving financial system needs to be maintained. Allow me to suggest four key points:

• First, regulators need to complement their focus on entities with increasing attention to activities. This responds to the reality that an increasingly diverse group of firms and market platforms are providing financial services.
• Second, governance needs to be strengthened. Rules and standards will need to be developed to ensure the integrity of data, algorithms, and platforms—in other words, to ensure that they operate in a manner that does not expose consumers or the financial system to undue risk.
• Third, policy options could be considered to support open networks, and licensing policies could be adjusted to help foster competition.
• Fourth, legal principles need to be modernized. Maintaining trust in financial services may also require the development of new legal frameworks to clarify rights and obligations within the new financial landscape.

Regulators have begun to address these challenges with a variety of approaches across countries. That is important because the responses already vary. Some of them include:

• clarifying the applicability of existing legislation to crypto-assets;
• issuing warnings to consumers;
• imposing licensing requirements on certain market participants;
• prohibiting financial institutions from dealing in crypto-assets;
• completely banning the use of crypto-assets;
• and prosecuting violators.

The development of effective regulations is still at an early stage. Countries are exploring new technologies and creating controlled environments to test them. And they are working with fintech companies in innovation hubs and regulatory sandboxes.

But crypto-assets exemplify the difficulties that regulators face in the fast-changing realm of Fintech. They are difficult to regulate because they cut across the responsibilities of different national agencies, and operate on a global scale. Many are opaque and outside of the conventional financial system, making it difficult to monitor their operations.

The bottom line is that policymaking will need to be nimble, innovative, and cooperative.

The Role of the IMF

It will take a coordinated effort among multilateral organizations, the private sector and governments. This includes the IMF. With our near-universal membership and our financial-sector expertise, we are uniquely situated to help develop policy responses.

The IMF can help advance the agenda on Fintech regulation by offering advice and by serving as a forum for collaboration. We can work with governments and international standards setters on a consistent regulatory approach.

Immediate action is needed in three key areas:

• to close data gaps that are inhibiting effective monitoring of potential risks and their links to the core financial system;
• to support systemic risk assessment and timely policy responses;
• and to protect consumers, investors, and market integrity.

It is essential that regulations have common elements. This will go a long way toward facilitating consistent international cooperation. Such common elements could include:

• good practices;
• requirements to promote the transparency and the integrity of Initial Coin Offerings;
• the strengthening of risk management;
• and the assurance of strong internal controls at crypto-asset exchanges.

At the same time, central banks can forestall the competitive pressures that crypto-assets may exert on fiat currencies by continuing to run effective monetary policy. They also can improve the convenience, efficiency and stability of payment and settlement systems.

Some central banks have started to explore a new form of central bank money called central bank digital currencies. Approaches vary by institution, and a single definition is lacking. But broadly speaking, a CBDC is a digital form of central bank money that can be exchanged, peer-to-peer, in a decentralized manner. If designed properly, CBDCs could make central bank money more attractive in the digital age, while maintaining support for the stability of the banking system.

In fact, a group of central banks is actively experimenting with the use of digital currencies and distributed ledger technology with the aim of making cross-border payments more efficient.

Conclusion

To conclude, it is important to get the balance right. National regulatory authorities and central banks will need to calibrate the regulation of fintech in a manner that appropriately addresses the risks without stifling innovation. During the process efficient and stable payment and settlement systems, and financial stability need to be continuously and constantly protected.

In other words, if we adopt the right policy responses, something good can come out of this wave of technological innovations—more efficient and accessible financial services, and better money and monetary policy.