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Stacks of coins
Op-Ed

The coming “FinTech” revolution

Aaron Klein

Imagine leaving a restaurant having never asked for the check or given your server a credit card. Oh, you paid—you split the bill with your friend, who likewise just stood up and left after the meal. You hail a cab and are driven to your next destination, never thinking about payment. Walking next into a store, you wave your phone over the counter, touching your thumb to verify payment. You put your new purchase in your pocket, which has no wallet or keys, just your phone. Your phone informs you that your paycheck was just deposited and asks if you want to pay your outstanding bills, ordered by those that make the most financial sense to pay first. Your phone tells you that you are $30 further along toward saving for that vacation this winter and are on track to be able to afford it.

You could do much of this today, and shortly, you’ll be able to do all of it.

This new world of financial technology (FinTech) is coming, and it will be revolutionary. Investors are pouring money into FinTech startups, with almost $14 billion invested over the past 12 months, a 45 percent increase in funding since last year. They are investing because they believe it will transform the world. Here’s what FinTech promises to do.

FinTech will allow you to manage and transmit money more easily, cheaply, and smarter. FinTech will help businesses pay their suppliers, and cut down on the costly swipe fees that eat away at profits, especially for small businesses. Removing payment frictions has all sorts of benefits that are not apparent at first glance—those ten minutes that it takes on average to settle your check at a restaurant, if eliminated, can provide for one more seating at the table per night. FinTech will also open up entirely new business models: Uber doesn’t accept cash.

Excitement for FinTech is especially strong among advocates for the middle class, working class, and the poor. The current payment system is highly regressive. You may not think about it every time you use a credit card and rack up your points or miles, but the store that you are buying from is receiving 2 to 4 percent less at the end of the day from you than from a cash-paying customer. Some of that is passed back to you in the form of rewards, while other benefits include having a month to wait before really paying for it. Not so for the person who uses cash, or worse yet, has a high fee, no-rewards subprime credit card. FinTech has the opportunity to change that by offering new forms of payment with their own incentives to reward customers, including those of more moderate means.

More broadly, FinTech has the promise to offer basic financial services far more cheaply to lower-income families who currently pay more for basic financial services than middle-class and wealthy Americans. This is in large part because the technology of smartphones is powerful and ubiquitous. According to the Federal Reserve, more than three out of four Americans have smartphones, and smartphone ownership is far more correlated to age than to income. Smartphone app-based FinTech is one of the few avenues to provide financial services in a format where access is not correlated to income. In fact, minorities were more likely than whites to have used mobile banking over the past year, proof that financial technology can break down the past barriers to access.

Beyond the ability to reach lower-income consumers, FinTech can also offer profoundly different products to solve problems, ones that existing banks haven’t.

Consider payday lending, which consumers in need of small-dollar credit rely on. Payday loans are popular. Twelve million Americans take out payday loans every year. They are also expensive. Loans come at interest rates between 300 and 400 percent, and the average borrower will spend $520 in interest and fees. Contrary to popular belief, payday borrowers are people with bank accounts, as the product requires the consumer to provide a post-dated check from his or her bank account to get a loan. Yet banks, who know their customers are using payday loans, rarely offer similar products. They don’t for a variety of reasons, including the fact that banks cannot make a profit on these products at interest rates that are acceptable to their brand and to regulators.

Can FinTech fill this gap and deliver small-dollar credit on more reasonable terms? The answer may be yes. A hidden truth about payday borrowers is that they typically need the money to meet unforeseen shortages of income, not unforeseen expenses. Income is extremely volatile for lower-wage working Americans; one study found that working-class individuals experienced 40 percent swings in their income on a month-to-month basis, while another found that low-income families had almost three months when their incomes fell by at least 25 percent or more compared to their average income.

The company Even’s plan to fix this problem is simple—employers of hourly workers with volatile income offer Even as a benefit. Even calculates their average week’s pay. When they have a good week, Even keeps the extra funds. When they have a bad week, Even lends them the difference, solving the temporal mismatch between income and expenses without the need for payday loans.

Even is not a traditional bank that would need a charter. But is it a money transmitter that needs a state license in every state in which it operates? Licensing is an expensive and time-consuming process, especially for start-up companies that depend on harnessing the economies of scale that come with technology platforms. Partnering with a bank can avoid some of these concerns but it raises others. Will the FinTech firm be able to satisfy the bank’s know-your-customer and anti-money-laundering (AML) rules? Will a bank want to take a chance on servicing Even given the potential costs of compliance and downside risks?

Anecdotal evidence is growing that banks have reservations about partnering with FinTech companies due to questions of AML compliance. After all, plenty of apps can be used by bad actors for nefarious purposes without the FinTech firm having any idea. The horrific San Bernardino shooters had recently taken out a loan through Prosper, a peer-to-peer FinTech lender that uses WebBank, a FinTech-focused bank to move the funds. Both companies were heavily discussed in the media for making these loans shortly before the terrorist attacks. Sure, the same couple could have racked up their credit card debt or taken out other loans with no intention of paying them back, but that does not change the risk of bad headlines.

In 2000, moving the more than 40 billion paper checks to regional centers across the country in order to be cleared cost $1 billion.

For instance, Ripple, a FinTech company trying to transform the payment system, was fined $700,000 for AML violations, making it the first virtual currency exchanger to be fined under the Bank Secrecy Act. Today, for two people or businesses to pay each other, they have to send and receive money on the same payment system, or “track”—credit cards to card processors, PayPal account to PayPal account, check from one bank to another. Ripple would allow consumers and businesses to “cross tracks” between payment systems, my credit card to your bank or my PayPal to my babysitter’s Venmo. But Ripple, in its early days, failed to register as a money transmitter and implement and maintain adequate AML procedures.

As the cases of Ripple and Even show, a myriad of laws and regulations govern finance and banking. Government policy can encourage FinTech innovation or it can shut it down. The reason that you can deposit a check with your phone from anywhere at any time is a law that you have probably never heard of: Check 21, which was passed as a result of the tragic events of 9/11. The story of Check 21 suggests a future path by which forward-thinking governments can make FinTech a reality.

Since the dawn of paper checks, banks had to produce the physical, paper checks in order to clear them. Paper checks were thus flown all over the country to a network of more than 30 check-processing centers run by the Fed as well as other private check-clearing houses. The system worked around the clock, with most processing centers humming during the graveyard shift. Moving the more than 40 billion checks written in 2000 cost over $1 billion. While it used 1960s-era technology and was horridly inefficient, it worked.

In the aftermath of 9/11, planes were grounded for a full week. While the media focused on stranded passengers all over the country, the Fed and the country’s banks were thinking about stranded checks. Led by Federal Reserve Vice Chairman Roger Ferguson, regulators wisely suspended and bent certain rules to allow for the buildup of tens of billions of dollars of float in the financial system as outstanding checks literally piled up on tarmacs across the country. It was clear that we needed a better way forward.

The Federal Reserve sent Congress a legislative proposal that would effectively allow banks to take a picture of a check and email the digital image for clearing. Consumers would have access to the digital image, and a variety of other rights were updated to account for the fact that the paper check was going to disappear. Vice Chairman Ferguson summarized the benefits before Congress, stating, “The [Fed] Board believes that, over the long run, the concepts embodied in the proposed Check Truncation Act will spur the use of new technologies to improve the efficiency and reduce the cost of the nation’s check collection system and provide better services to bank customers.” Congress agreed and passed Check 21. While those of us who worked on it at the time dreamed of ATMs that captured checks and printed the image on your receipt, none of us appreciated that in only a few years consumers would be able to deposit their checks from anywhere at any time through their cellphones.

Government also made wise choices in dealing with the FinTech of the 1970s: ATMs and magnetic stripes. The advent of ATMs and cards with magnetic-stripe payment technology helped the dream of ready access to your full bank account from anywhere become a reality. But there was one major problem: What happened if customers lost their card? Consumers were afraid to adopt technology that would put their entire bank account at risk if they lost their wallet or had their card stolen. Banks were afraid to create a system where they would be liable for their entire deposits in cases of fraud or theft that the bank could not control. Without a legal framework, no one knew what the rules of the road were.

The Electronic Fund Transfer Act of 1978 (EFTA) solved these problems, and it did so using the fundamental logic of the Nobel Prize-winning economist Ronald Coase. The Coase Theorem, one of the most cited theorems in economics and law, basically says that the government’s role is to assign clear property rights and make those rights broadly tradable. In a world where there is perfect information and no transaction costs, the market will reach the right outcome. While one can be skeptical of how broadly these conditions apply in the real world, the application of Coase’s logic to debit cards through EFTA was a home run in public policy.

In EFTA, the government created and assigned the liability rights and responsibilities for cases in which consumers had their card stolen, hacked, or simply lost. Assuming the consumer reported the loss to the bank within a reasonable time (60 days), the consumer’s liability was capped at $500. Importantly, EFTA allowed banks to voluntarily provide greater coverage and also gave consumers legal recourse with a private right of action if institutions failed to uphold the law or provide the necessary disclosures.

This allowed the market to flourish. Consumers had incentive not to lose their cards, but also knowledge that their nest egg could not be wiped out. Banks were incentivized to develop robust fraud detection, but also knew that consumers were on the hook. Recall that in 1978, $500 was equivalent to more than $1,800 in today’s dollars. That is real money for most people. Everyone knew the rules of the road. EFTA worked, and debit card usage skyrocketed. As banks’ security systems improved, they competed with one another to offer greater levels of protection for trusted customers, to the point that today many consumers have zero liability for losses or fraud.

However, EFTA, like many 1970s creations, has its limits. It only applies to certain types of accounts and transactions. Originally, it exempted remittances and wire transfers. This allowed for a giant loophole that led to the exploitation of millions of hardworking immigrants who wired money back to their loved ones but were tricked by hidden fees, inadequate disclosures, and no legal liability to resolve errors. While that problem was solved when EFTA was expanded to include remittances under the Dodd-Frank Act of 2010, new FinTech providers are largely exempt from EFTA if their customers do not use a debit or credit card. For example, if you use PayPal to send money through your debit card (i.e. linked to your bank account), then you are covered by EFTA if something goes wrong, although the coverage is through the bank issuing the card. But if you use your own balance to send funds, EFTA does not apply. Did you even know about that difference the last time you used PayPal?

What are the FinTech equivalents of Check 21 and EFTA that government can enact today to unleash these new innovations? Beyond modernizing specific outdated laws to enable FinTech, governments can set ground rules and assign rights and responsibilities that allow technology to flourish. There are several simple steps policymakers can take so that we can harness FinTech to improve our economy and our lives. First, government needs to modernize EFTA to provide consumer protections, as well as a consistent legal framework applied to FinTech companies and products that move funds. Second, regulators like the Federal Reserve need to make sure that the benefits of FinTech flow through to customers and modernize their existing regulations. Even though Check 21 has revolutionized check processing, the Fed still allows banks to hold checks for five days. This is particularly problematic for Americans living paycheck-to-paycheck, as uncertainty over whether their money is there or not can cause them to overdraft their account, resulting in hefty fees.

Federal regulators need to go through existing regulations and modernize times and speeds to match today’s world. Finally, bank regulators and anti-money laundering officials need to work cooperatively and productively to embrace FinTech, instead of fearing it. Rather than pressure banks or increase costs of compliance for common-sense applications that involve moving money, AML regulation should attempt to harness FinTech. Let’s have IBM’s Watson, the famous computer that dominated “Jeopardy!,” catching patterns of terrorist financing, instead of banks filing outdated paperwork on apps used to help parents pay child support.

FinTech is on its way, and as Uber, Airbnb, and Pokémon Go have shown, when it arrives, it can arrive at lightning speed. Smartphones possess all of the technology necessary to replace credit and debit cards, checks, loyalty cards, and, increasingly, credit underwriting. The ubiquity of technology, coupled with human ingenuity and amplified with investment capital, is likely to produce rapid changes in finance, reordering daily aspects of life and business.

FinTech has the capacity to improve the speed, efficiency, and experience of a wide range of aspects of daily life—from eating out to hailing a cab to simply making ends meet. An improved payment system, a faster velocity of currency, and a reduced number of frictions can save time and money. Eliminating paper receipts, moving through stores without waiting in line at the register, and sending and receiving funds in real time will improve the quality of life and reduce costs. Businesses will operate better both at the cash register and in the backroom, with sped-up payment and order flows, and more information for managers to make decisions. How firms adapt to FinTech may make the difference between winners and losers in the twenty-first century. Advances in financial technology could be the next wave we need to restart our cycle of productivity and growth.

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