Asia’s Fintech Revolution

Welcome to Pacific Exchanges, a podcast from the Federal Reserve Bank of San Francisco. I’m Cindy Li. I’m an analyst in the country analysis unit here at the San Francisco Fed. Our job is to monitor banking sector and financial market developments in Asia and to share information with an audience like you. In today’s episode, two of my colleagues in the country analysis unit, Nick Borst and Sean Creehan sat down with me to share their insights on how financial technology, or fintech, is reshaping Asia’s financial system.

Nick and Sean. I read your fintech report with great interest. I also have a lot of questions, but first of all, in your words what is fintech exactly?

Well, there are a lot of different definitions of fintech, but I think one of the simplest is the use of new technology to deliver financial services. And when we’re talking about fintech, we’re really talking about this trend of startups and firms outside of the banking system entering into financial services using new technology, new business models, and accessing new types of markets within the financial sector.

In terms of types of technology, things you may have heard of, of course: blockchain, and the use of mobile phones. You hear a lot about big data, so machine learning algorithms to assist in a credit risk assessment process, for example. I think another interesting way to think about fintech developments is to remember that fintech isn’t necessarily new. We can think of this as a latest phase of development.

Take in the 1980s, you had a fintech disruptor that was coming into the brokerage space and offering low cost alternatives for people that wanted to buy and sell stocks. That brokerage was called Charles Schwab, and today they’re a major player, an incumbent and traditional firm, we could call them.

In the 1990s, there was a cheap payments provider called PayPal, which today is a major incumbent player and maybe easier for us to see them as a fintech player today, but again, that was in the 1990s. This is just the latest phase.

It seems like fintech actually has a longer history than most people realize, but fintech has really become a buzzword these days. As you suggested in your report, Asia’s financial system in particular is undergoing a significant transformation. Why is that?

Fintech in Asia is particularly interesting, I think, because of the speed of development of what we’ve seen there that for a long time Asian financial systems were a little bit underdeveloped. They tended to be on the lower end of the technology curve in terms of adoption of new technologies. But, what we’ve seen over the past couple years is a very rapid development of new financial innovations in Asia. When you combine that with just the scale of some of the markets we’re dealing with there; if you look at the Chinese banking system as a whole it is now bigger than the entire Eurozone banking system. We have a combination of rapid development of new technology on a large scale and that makes Asia uniquely interesting to look at in terms of the development of fintech.

Yes, I think that’s right on. I would just add and connecting to Nick’s point about maybe previously slower developments. If you lack a certain technology in the past it may mean you’re prone to leap frog technologies in the future. If you didn’t have wide spread adoption of credit cards, for example, the use of a smart phone to make payments, that’s a new technology today, but you’re more prone to use it because you didn’t use credit cards before.

The only other thing I’d emphasize, and we can get into this a bit more, is the importance of financial inclusion to Asia. Varying estimates, but at the very least, hundreds of millions, perhaps a billion Asians lack access to basic financial services. FinTech can really help them. Sitting here in the United States, we don’t necessarily have that same challenge.

I want to follow up on this discussion about payment systems. This is an example where non-banks and non-financial firms have long been active participants even before the fintech era. How did fintech change the roles that they play?

Well, let me focus in on China because I think this is where the payment story has been most clear. What you had is very large, slow moving state-owned banks that didn’t necessarily quickly adopt a lot of the new payments technology that came out and that really left an opening for some of these smaller players to jump in and actually gain a market hold. If you’re looking at a company like Alipay, which is part of Ant Financial, they really got started in the e-commerce sector where there was a need to make payments for e-commerce transactions a lot easier. Or if you look at Tencent and payments made through WeChat that’s really a social media app that saw the potential for making payments between people or purchasing things through the app. These are really players that are coming from outside the financial sector that really saw a need in an era of more mobile phones, more e-commerce to make those transactions easier at a time when the incumbent banks really weren’t taking the steps necessary.

I’m glad you mentioned China. It seems like China is a leader of the fintech payment innovation. It also dominates fintech investments in Asia. What’s driving the fintech growth in China?

Touching on what we discussed before I think the key difference with China is just the scale. If you look at both in terms of fintech funding, largest size of fintech startups, China has actually passed both Europe and the United States. One of the reasons is that the Chinese market for some of the key fintech industries like payments and peer-to-peer lending has grown so large that it’s attracted that attention and that investment.

Yeah, I mean I think there’s also a distinction at least in the marketplace lending sector, which we get into in the paper a bit. Historically, deposit rates in China were capped. A saver may have found that the money they were putting into a traditional bank account wasn’t earning an attractive rate of interest. Particularly, when you account for inflation, so maybe a negative real rate.

You two are much more of an expert on shadow banking in China than I am. We’ve talked about this before, but that certainly led to savers seeking alternative products. As I looked at this more closely it does seem like some of the growth of marketplace lending, at least from the demand side of an investor may be is explained by a search for yield in that Chinese low rate environment. I think that has also encouraged this sector, this fintech sector in China, vis a vis other countries.

I would just add in the case of China we maybe traditionally think of the Chinese financial system as fairly closed and conservative, but I actually think, in terms of fintech, Chinese regulators have been pretty progressive. There’s been a willingness to do things like license third party payment providers to allow sort of a peer-to-peer lending market to grow. Now, of course, they’ve taken steps to limit risk and the potential impact on the traditional banking sector, but I think in general Chinese authorities have been pretty open to seeing this fintech sector grow for some of the reasons that Sean mentions, that basically there’s a need for some underserved parts of the Chinese economy to get access to financing. Fintech is potentially one of the ways to do that.

There is a lot of talk regarding China’s P2P platforms these days. Not only about their success, but also about potential risks. What are some of the risks associated with P2P lending and are these risks unique to China?

There could be a variety of risks. On a relative basis, marketplace or peer-to-peer lending in China is still a relatively small slice of overall credit and lending. Depending on how you estimate it, maybe one to three percent of total lending. Maybe not yet there in terms of financial stability risk, although further growth might lead to that. But, from the perspective of an investor or a borrower, some questions you might have: Are there protections in place to prevent fraud? Do consumers have the right to control their own financial data? So, if you’re using alternative data and an algorithm to make a credit decision, does the consumer have a right to that data if they take it to a new provider? Do they have a right to understand more transparently, how is this decision being made? These are all questions that people are confronting around the world. Are these platforms using regulated banks as custodians for the funds? This is particularly an issue if you’re concerned about fraud. Is there excess leverage being built up through these platforms?

We can talk maybe a little bit more later about some of the specific responses, but you’ve seen areas where maybe someone that wants to buy a house, they normally would have to put say eighty percent. Or, sorry. Twenty percent of a down payment. Maybe they’re actually using a marketplace lending platform to borrow that down payment. That would make it a purely leveraged investment, which is problematic. These are some of the things that you might think about. In terms of your question, is this relevant in other parts of the world? I think for sure.

Yes, I think you’re right. I think many regulators in Asia are probably facing similar challenges and regulators in Asia have implemented policies that are supportive of the fintech industry, but they are also mindful of balancing out risks and opportunities. Can you update the audience on some of the recent public policy and regulatory developments in the rest of Asia?

Yeah, just to maybe touch on the payments part of this. I think you’ve seen a real balanced approach by some of the regulators where if you look at countries like Singapore or Thailand, they’ve sort of adopted a roadmap approach of setting clear and defined rules that really set out space for non-banks to come in and participate in the payment system. Very forward looking, which I think is positive.

At the same time there have been some concerns, probably legitimate, about whether some of these payment methods can be used for money laundering or terrorist financing. Things like that. That’s since we’ve seen many different regulators put out stricter requirements requiring some of these payment companies to be subject to supervision, regular examinations, that sort of thing.

A real balanced approach of, let’s bring these companies into the payment system, provide equal rules so that they can compete fairly, but at the same time make sure they’re not becoming conduits for some of these illegal activities.

One particular area where I think there has been a lot of concern and focus has been on bitcoin. I would say in general, Asian regulators tend to be a bit more skeptical regarding bitcoin, but that doesn’t mean that virtual and digital currencies are completely out of the question. I think they’ve been open to seeing a lot of Asian banks start their own blockchain and virtual currency experiments and then some of the regulators, the PBOC, People’s Bank of China, for example, has actually talked about issuing their own virtual currency and has actually taken some steps to move forward to that.

I think, in general, Asian regulators are very open to promoting these things, but also very cognizant of controlling risk before they get too large.

In terms of the lending side, marketplace lending, in the piece and here we’re focusing a lot on China, and certainly on the marketplace lending side that’s true. From the data that we’ve seen almost all of the growth in this space, in Asia, has been in China. Perhaps naturally you’re seeing more of a formal regulatory response from the Chinese authorities. They have more to work with.

As I was alluding to earlier, the China banking regulatory commission and the State C, over the past six months essentially, a little more than that, have come out with a series of new regulations to protect consumers, make sure that customer funds are held in custody at traditional financial institutions to place limits on exposure to investors and borrowers for these platforms, to eliminate guarantees. Some of these platforms have been guaranteeing a performance of their funds to investors, which is an unscrupulous marketing tactic and certainly something that they can’t back up at the end of the day, so a lot of that sort of more robust rule making regulations.

Now, the question, of course, is in terms of supervision of these platforms. It’s still a pretty fragmented market, so the data shows that there maybe isn’t even one firm that has ten percent of the market in China for marketplace lending. By comparison, as of 2015 the leader here, Lending Club, had roughly half of the market, according to the data that we have. The lack of a dominant firm and the highly fragmented nature of this space makes it a little bit harder for regulators. Especially, when they themselves are still developing a framework for this new sector.

One of the really interesting things we saw, even over the course of writing this paper, the list of Asian countries doing this continue to grow and grow and grow, is the proliferation of what we call “fintech sandboxes,” which is basically a space where fintech companies or fintech companies in partnerships with banks can actually try out some of these new ideas and technologies with basically a blessing from the regulator that they’re not going to face overly harsh penalties if they trample on some existing regulations. It’s sort of a defined area or scope of activity that fintech companies can really experiment with new ideas without having to engage in the full weight of regulation for really achieving scale.

As we were writing this paper, it seemed like one after another an Asian country was announcing a sandbox. Some of them tend to be a little farther along than others. I think the Singaporeans and Hong Kong have been kind of at the forefront of developing sandboxes and actually participating as a regulator directly in some of these sandbox experiments. But, I think the list is now maybe eight, nine, ten different countries in Asia now have a regulatory sandbox.

Yeah, we were debating whether it’d be easier to have a list of those countries that actually don’t have a sandbox at this point. But, just to piggyback on that, another couple of interesting points there. Australia and Singapore have an agreement in place to allow their fintech firms to move between their two sandboxes to encourage some collaboration between the two financial systems, which are two of the most developed financial systems in all of Asia.

I think another open question as we look at how this evolves is how do you regulate? Do you regulate based on formal type of institution? So, is this a chartered bank? Is it a telecom or commerce company that might ordinarily be regulated by a different authority? Because if you do it by type, then maybe there would be different regulators. Or do you regulate it based on function? Like, what are they actually doing? What kind of activity? They may be an e-commerce company at the holding company level, but they’re lending. Should they be treated the same way as a bank? These are all questions that regulators are grappling with and I would expect, as sandboxes develop, they’ll have a more concrete idea of how to handle this question.

I find the sandbox concept really interesting. It seems like mirroring the financial technology innovation, there are also some regulatory innovations, as well. It seems that some country’s governments are using public policies not only to level the playing field, but also to nudge more use of financial technology especially for the underbanked population. What do you think are the potential social and economic benefits that fintech can bring?

I think this is one of the biggest areas that fintech can help and we didn’t talk about it so far, but India is a real leader in terms of recent financial inclusion efforts and trying to bring together a lot of different public policies to both increase financial inclusion, but also encourage say, digitization of payments. We released some research on this last year, but India has been modernizing its payment system, making it easier to have non cash transactions using new, universal ID cards that have been implemented by the government for a number of other reasons, but using those to make it easier for a consumer to authenticate herself to a financial institution. Making it also easier for that financial institution to authenticate that customer. What we call know your customer compliance, which is important for anti-money laundering, counter terrorist finance, et cetera. Trying to create synergies there.

Another interesting program that they’re doing is what they call the “direct benefits transfer.” They’ve been delivering hundreds of millions of new bank accounts to the poor and now they’re sending welfare payments for, say fuel subsidy or food subsidy or education, would traditionally been sent through cash payments via an intermediary. Now, they’re sending them directly, digitally into those bank accounts. These are all efforts to give people that were previously unbanked access to the financial system. Also, to encourage them to use non cash payments. There’s all sorts benefits. I mean, increasing national savings, so instead of having cash under a mattress, you now have it at a bank. That helps the government. That helps private sector borrowers.

The underbanked issue is huge. If you look at Asia, the estimates vary quite a bit, but roughly a third to twenty-five percent of the population is underbanked or unbanked, yet at the same time other estimates say that in excess of ninety percent of people in Asia have access to a cell phone. There’s a very clear vehicle there to get people access to financial services and I think fintech has immense potential to do that.

One of the things we cover in the paper is remittances are very, very important to a lot of Asian countries, bigger than external development assistance in many cases. Yet, Asia has very high fee rates on remittances and some of the new fintech technologies that are coming could potentially slash those fees immensely. That’s, I think, a very concrete example of how fintech can benefit people’s lives.

We’ve talked about this before, but it seems that we can get a lot of mileage from existing infrastructure and technology in terms of fintech.

Yeah, and we talk about this, too. This may merit further research, but fintech doesn’t have to be high tech.

It can just be as basic as a prepaid card, which previously wasn’t usable by someone, say an Indian in a rural area because there wasn’t an electronic payment reader, but now there might be. Yeah. It doesn’t always have to be super high tech.

One other point I was going to make, getting back to something we were talking about why maybe China was particularly receptive to this. I know in China there is, India has a lot of smart phone adoption as well, but I believe, I don’t have the exact numbers in front of me, but China has a higher level of smart phone adoption, right? You have a more sophisticated piece of technology in your pocket. If you open up an app like WeChat, I don’t know if our listeners are familiar with it, but it’s a very sophisticated messaging app in China. I don’t know, how would you describe it? It’s like a combination of Facebook and …

Everything.

Everything. Okay. Anyway, they have a very interesting payments app and you can do all sorts of payments activity in that app. Something well beyond what a typical app here in the US can do.

Then, maybe one final point on this is small businesses are critically important in Asia. They represent a huge part of GDP and an even larger portion of employment in Asia, but they’re critically underserved by existing banks and so they get a much smaller share of loans relative to their contribution to the economy. That’s really where fintech can make a difference. It can make the process of providing loans much cheaper so that suddenly it becomes profitable for companies to actually make small scale loans to SMEs. It also can use alternative sources of data so that a new entrepreneur who doesn’t have an existing credit record or, as is the case in many Asian countries where personal credit histories are very limited or nonexistent, that you can use those alternative data sources to actually evaluate someone’s creditworthiness and make them a loan.

I think that’s a really interesting area in general for fintech around the world because the SME credit gap is pretty much existent in every country. For understandable reasons, right? A bank has a harder time assessing the credit risk of a new, small business. Maybe they don’t have, like Nick said, they don’t have a credit history or they just have volatile payments or what have you.

A classic example would be an e-commerce company that maybe has actually really good granular data about small businesses transactions online. That can be pretty powerful and maybe in the past the bank didn’t have that sort of information at its disposal.

We talked about payment system. We talked about marketplace lending and I guess fintech firms are also gaining some market share in terms of asset management. Looking at all this, I guess, one key trend in the fintech world seems to be non-banks and non-financial firms basically disrupting the banking sector and bringing innovative business models. How did all this effect the banking industry?

It’s definitely a mix of both a competitive threat, but also an opportunity. It’s a competitive threat in the sense that in some cases they very much are displacing banks, where they’re directly competing with banks on various services. Even if they’re not a huge market share, I think in the paper we show that even though peer-to-peer lending is growing very quickly and payments are growing very quickly, they’re still not dominant in terms of market share, but they can still exert a lot of pressure on bank fees. That can put pressure on overall bank profitability.

At the same time, not only in Asia, but around the world I think both fintech companies and banks are realizing that sometimes partnership rather than competition is the way to go forward and that a lot of, for example, in the case of peer-to-peer lending, lenders are beginning to realize that a lot of times it makes sense to partner with an organization that has a branch network and that there’s benefits to having a physical presence. Banks, at the same time, are realizing that rather than trying to invent the wheel by ourselves and create all this new technology, maybe we can partner with a fintech and use their existing technology and that’ll actually be much cheaper than trying to develop it on our own.

Yeah, and we touched upon this in earlier conversations with us and Sopnendu Mohanty at the MAS. Anju Patwardhan who was previously at Standard Charter in Singapore. The amount of money that banks, traditional banks, spend on technology each year is probably in excess of the current new venture capital that’s floating into fintech firms. They are themselves very involved in this.

Specifically, on what we’re looking at in the paper, for example, in the marketplace lending sector in China, traditional banks are actually involved. The second largest marketplace lender is Lufax and that is a subsidiary of Pingan Financial Group, which is a major financial group in China. The largest insurer. There you have a traditional firm that’s just funding one of the most successful marketplace lenders. I think that’s evidence they see that, “Yeah, it’s maybe a threat, but it’s also an opportunity. It’s something we can be involved in.”

One way that this may evolve though is if you look at some of these new players that come into the market, again coming back to the example of Alibaba and ANT Financial. They start with one vector of we’re going to offer payments, then it slowly expands to where now we’re going to be a broker for different financial products via our app if you want to purchase wealth management products or different insurance policies. They’ve also gone to the extent of starting their own private sector bank in China. They have an affiliated bank now called My Bank where they’re going to focus on SME lending, so you see the potential for if banks don’t adapt that this space will be filled by these new entrants into the market and they’ll grow and begin to offer new services. Eventually, begin to look much more like full service financial institutions.

As you said, competitive threat, but also an opportunity for collaboration and I guess new models for collaboration are also emerging. What do you see as the greatest opportunities for fintech in Asia in the next few years and do you foresee regulatory challenges?

Yeah, I think we’ve talked about it. We’ve already touched on a lot of this, but again, reaching the unbanked or the underbanked, for sure. Whether it’s on the consumer side or the small medium size enterprise side.

One topic we didn’t get to yet, but I thought was interesting, we touched briefly upon this earlier. I can’t remember if it’s in this paper or an earlier blog post, but trade finance. If you look at the world of trade finance it seems somewhat archaic. It’s very paper based. There’s a lot of lags between an international buyer and some other country sending a payment and that eventually being received by the manufacturer, or whoever, the good provider or the service provider. There’s a lot of ways that this might be improved by fintech. Again, it doesn’t have to be really high tech fintech, but it could be blockchain-based trade contracts. That sort of thing.

For me, I see two big trends over the next couple years. One, will be that these non-bank entrants that are coming into the financial sector will begin offering a wider variety of financial services and become more full spectrum players within the financial sector. Number two, I fully expect to see that some of these innovations we’re seeing in Asia are not only going to spread within the region, but also start to spread internationally. That’s very exciting from one aspect that the potential to catalyze change in other parts of the world, but also from a regulatory aspect, that’s going to raise a lot of new questions of sometimes these technologies can move much faster than regulators and especially when you’re dealing with different jurisdictions. That makes things potentially very complicated. I think that will be an emerging issue that regulators will need to keep an eye on.

Well, I want to thank both of you for a great conversation on a very interesting topic. Sean and Nick’s most recent report, “Asia’s FinTech Revolution” is available for download on our Asia Program website.

Thanks, Cindy.

Thanks, Cindy.

Thank you.