The Challenges and Opportunities of Financial Innovation in the Digital Age: A Path to Institutional Innovation in Global Governance

The Challenges and Opportunities of Financial Innovation in the Digital Age: A Path to Institutional Innovation in Global GovernanceFinancial innovation has never ceased, but historically, most innovations served primarily commercial institutions, with minimal relevance to the general public. Until the first decade of the 21st century, ordinary people's interaction with the financial system was largely limited to traditional services like bank deposits and mortgages

The Challenges and Opportunities of Financial Innovation in the Digital Age: A Path to Institutional Innovation in Global Governance

• Financial innovation has never ceased, but historically, most innovations served primarily commercial institutions, with minimal relevance to the general public. Until the first decade of the 21st century, ordinary people's interaction with the financial system was largely limited to traditional services like bank deposits and mortgages. Stock investment remained the domain of a select few. However, financial innovation subsequently permeated daily life. Mobile payments and online wealth management flourished in China, becoming prime examples of fintech. In countries with relatively lax regulations, the volatile yet persistent cryptocurrency market emerged. More significantly, the concept of Central Bank Digital Currency (CBDC) has received considerable attention from major global economies over the past decade, with many actively conducting research and pilot programs; China, among others, has already implemented CBDCs, integrating digital currency into people's lives. These fintech innovations and their societal impact require careful consideration by policymakers and citizens alike. Eswar Prasad's book, The Future of Money: How the Digital Revolution Is Transforming Currencies and Finance, delves into these innovations and their potential benefits and drawbacks.

I. The Evolution and Impact of Fintech

The definition of "Fintech" is not static. To narrowly define it as financial business models arising from the proliferation of the internet and digital devices in the last decade is overly restrictive. In the latter half of the 20th century, the replacement of paper ledgers with computer-stored account data in banking represented a significant fintech milestone, albeit one largely imperceptible to average customers. The introduction of Automated Teller Machines (ATMs) was more readily apparent in daily life. However, neither revolutionized people's lives dramatically.

The true transformation stemmed from credit cards and the underlying payment networks. For citizens in developed countries of the 20th century, the convenience and security of domestic and international payments offered by credit cards were unprecedented and remain unparalleled by subsequent payment methods. However, access to credit card services remained limited in low- and middle-income countries due to stringent credit checks by banks to mitigate risk, a hurdle insurmountable for most in developing nations. Many lacked even debit cards, relying solely on cash.

The convergence of mobile internet and smartphones provided an opportunity to change this. Alipay, initially based on online shopping payments via computers, rapidly transitioned into a mobile payment tool, quickly followed by WeChat Pay, which swiftly dominated the market. China's leading payment platforms not only handle massive concurrent transactions but also feature efficient risk management systems, keeping fraud rates extremely low, making China the country with the highest mobile payment adoption rate. The US has seen the rise of Apple Pay, Venmo, and enterprise-level payment backend providers like Stripe. India, through government initiatives, has established a biometric-based public digital infrastructure, providing a unified payment interface for service providers, thus enabling broader financial inclusion.

Importantly, mobile payments are not entirely dependent on mobile internet and smartphones. In 2007, Kenya's M-PESA mobile banking service leveraged feature phones and SMS to enable mobile payments, allowing users to open accounts and deposit funds at partner locations and transfer money via text messages, without internet access, successfully popularizing cashless payments. Even a decade after M-PESA's launch, with less than 20% of Kenyans having internet access, M-PESA reached almost every household, increasing financial service coverage from 27% to 83%.

Cross-border payments pose a significant challenge to payment providers. Traditional remittances are costly and time-consuming due to multiple countries' regulatory requirements, involvement of numerous financial institutions, complex procedures, and stringent scrutiny. To address exchange rate volatility risk, institutions must charge high fees. Some workers from developing countries working overseas face remittance fees as high as 8%. To address this, new institutions have emerged, some establishing standardized payment protocols and network platforms, others holding diverse foreign currencies and acting as market makers, and still others focusing on niche markets, such as student tuition payments.

II. Fintech and Financial Inclusion

Beyond payments, fintech assists micro, small, and medium-sized enterprises (MSMEs) and individuals unable to access credit from commercial banks. Strict regulations and operational models limit banks' ability to perform cost-effective risk assessment and post-loan management for high-risk borrowers, often requiring collateral or guarantees. Many lacking collateral and with poor credit histories are excluded.

Emerging financial institutions target this gap. They often operate online, reducing operational costs, and leverage big data and machine learning algorithms to assess borrowers' default risk, thus improving approval efficiency. In China, MYbank exemplifies this, leveraging Alibaba's e-commerce and payment data to provide loans to millions of MSMEs with significantly faster approval times than traditional banks. Ant Group's "Huabei" consumer finance product similarly utilizes big data and algorithms to provide small personal credit loans, achieving high market penetration and low non-performing loan rates.

The insurance industry also benefits from big data and AI. Beyond improving actuarial accuracy using new data types from payments and other sources and automating underwriting and claims processing, some companies allow customers to exchange more personal information for lower premiums, effectively mitigating information asymmetry.

III. The Rise and Challenges of Cryptocurrencies

Bitcoin's emergence marked the beginning of the cryptocurrency era, with its future prospects remaining highly debated. While Bitcoin's price is extremely volatile, its resilience has convinced some supporters of its potential as a future world currency. However, a sober analysis suggests this is highly unlikely.

First, Bitcoin's transaction speed is slow, with limited transactions per second and enormous energy consumption. Second, its price volatility lacks stability. Third, its decentralized nature, considered an advantage by some, may introduce significant security risks, such as permanent loss due to lost keys and irrevocability of transactions leading to irresolvable disputes. Fourth, Bitcoin's anonymity is not absolute; regulatory agencies can still trace transactions by linking transaction information with identities.

To address Bitcoin's shortcomings, many new cryptocurrency solutions have emerged, such as using "proof-of-stake" mechanisms instead of "proof-of-work" to improve efficiency. However, these solutions haven't achieved widespread success and often introduce new problems. Stablecoins, pegged to fiat currencies to reduce price volatility, have gained popularity recently, but their adequate reserves remain questionable. Smart contracts, a blockchain application automatically executing predefined conditions without third-party intervention, have limited applicability due to blockchain's inability to directly interact with the real world.

The biggest challenge for cryptocurrencies is government regulation, particularly the conflict between anonymity and regulations against money laundering and terrorism financing. Many countries have implemented varying degrees of control, some even prohibiting cryptocurrency trading. Facebook's Libra project ultimately failed due to the potential for circumventing cross-border capital flow regulations.

IV. The Opportunities and Challenges of Central Bank Digital Currencies (CBDCs)

Currency is closely linked to national power, and CBDCs are a strategic response by central banks to the cryptocurrency challenge. Retail CBDCs can be considered digital cash, offering greater convenience and security than physical currency. CBDCs can promote financial inclusion and serve as a backup payment system to safeguard economic operations.

The economics community has explored CBDC applications in macroeconomic policy, such as implementing negative interest rate policies, although these may be politically challenging. However, CBDC accounts could be used for direct subsidy disbursement to citizens, reducing administrative costs and minimizing corruption and fraud.

Despite CBDCs' benefits, central banks are proceeding cautiously, primarily due to concerns about disintermediationCBDCs replacing bank deposits as the primary savings method, disrupting the existing financial order.

Wholesale CBDCs offer greater potential in cross-border payments. Using blockchain technology, CBDCs can improve efficiency and reduce costs. The "multiple CBDC bridge" project jointly developed by the Hong Kong Monetary Authority and the Bank of Thailand, along with the participation of the People's Bank of China and the Central Bank of the UAE, highlights CBDCs' potential in cross-border payments.

V. Inequality and Global Governance in Financial Innovation

Financial innovation offers both financial inclusion and efficiency gains but also presents new challenges. Traditional financial institutions face competition from new entrants, and regulators must balance innovation promotion with financial stability. Large economies' fintech innovations rapidly spread globally via the internet, with some smaller countries observing their citizens utilizing overseas financial services to bypass domestic regulations. For poorly governed nations, this might be an avenue for economic self-help; however, it presents a challenge for small countries committed to financial regulation. The inequality created by financial innovation between early and late adopters requires institutional innovation in future global governance to address.