In the years since the financial crisis of 2008, the landscape of banking has changed dramatically. The Occupy Wall Street movement galvanized popular outrage over perceived Wall Street abuses. The Dodd-Frank Act ushered in the greatest changes to financial regulation since the Great Depression. And “too big to fail” became a collective bogeyman, as journalists, scholars, and politicians bemoaned the ever-greater concentration of wealth and power within a few elite Wall Street firms.

But an even greater change is afoot in finance, one that is being driven less by Wall Street than by that other great bastion of prosperity: Silicon Valley. As large financial institutions in Manhattan have hunkered down in the wake of the financial crisis, a set of new players have sprung up in their place, offering new and innovative financial services to fill the gaps left by the retreat of traditional players. These financial technology, or “fintech,” firms promise to disrupt the financial world in fundamental ways.

Fintech is an expansive term, but it generally refers to a new breed of financial institution that provides traditional financial services in new ways, utilizing innovative online platforms and algorithmic decision-making. Fintech’s innovations are shaking up broad swathes of the financial sector. In the asset management industry, new “robo-advisor” firms offer to optimize investment portfolios through risk-assessment algorithms that constantly monitor market developments. In the debt market, peer-to-peer lending platforms connect borrowers, such as students and small businesses, looking for loans to willing lenders around the country. In the equity market, crowdfunding sites create ways for new companies to raise money through online campaigns, often using viral marketing and social media sources to connect with potential backers.

In perhaps its boldest innovation yet, fintech is pioneering the use of virtual currencies that aim to replace traditional forms of money entirely. These currencies, such as bitcoin and ethereum, rely on online digital ledgers maintained by users to keep track of transactions as they occur.  The currencies can be used to buy and sell goods much in the same way that normal currencies can, and they have steadily grown in popularity and acceptance.

Silicon Valley is coming

“Silicon Valley is coming.”  That is the stark warning that Jamie Dimon, the CEO of J.P. Morgan Chase, issued to investors about the threat posed by fintech to his bank. The statement has received near-mythic status in fintech circles, but it also raises an important question: How precisely will fintech change the world of finance?

It will do so in three ways. Fintech will dramatically reduce the cost of financial services. It will broaden access to financial services to a much greater slice of the population. And it will decentralize the locus of power in finance, creating disaggregated financial markets filled with small specialist actors.

These changes will force traditional players to reconsider their business models as they grapple with new expectations and greater competition.

First, fintech will reduce the cost of providing and receiving financial services. One of fintech’s great discoveries is that the world of finance is filled with inefficiencies: financial products are complex, overpriced, and bloated with fees; and consumers have paid the price. Fintech overturns that model.

It is now possible for an investor to receive cutting-edge, data-driven investment advice from a robo-advisor firm at a fourth or a fifth of the price that traditional asset management firms charge. Small businesses that used to struggle to find banks willing to give them loans now have access to loans at much lower interest rates through online peer-to-peer lending platforms. Savers looking for a place to invest their money can similarly receive better yields through peer-to-peer platforms than they could through regular bank accounts.

Second, fintech will broaden access to financial services. This is partially due to the lower cost of fintech. When high quality financial services such as loans and investment advice are available for cheap, we should expect that more people will use them. But low cost is not the only reason why people are migrating to fintech. Fintech also appeals to a new generation of internet-savvy consumers who are comfortable using their smartphones and laptops to interact with each other. Many of these consumers have an abiding distrust of large banks, whom they view with suspicion after the rash of scandals in recent years. Fintech also allows groups that been excluded from financial services (because they do not have sufficient savings or a proven track record, or they do not meet the traditional profiles expected by financial institutions) to gain access to the financial sector.

Finally, fintech is decentralizing and disaggregating financial markets. While finance was once dominated by a few large institutions, that is no longer the case, as a plethora of new fintech firms have entered the market. In doing so, they have injected a dose of competition and disruption into once staid industries. The typical fintech firm is a small start-up with only a few employees. It focuses on a small slice of the market, such as student loans or small business funding. This is the opposite of the “too big to fail” phenomenon that played such a central role in the financial crisis.

In sum, fintech is showing that finance can be done in a different way, one that is more convenient, more open to outsiders and more cooperative.

New concerns

But as with any industry that is founded on innovation and disruption, fintech comes with its own challenges and concerns. While fintech promises to make financial services cheaper, more widely available, and more competitive, it also presents questions about the proper role of finance in a modern economy and in society more generally.

Fintech’s promise to broaden access to financial services, while potentially transformative and immensely important, will place pressure on consumer protection laws. If individuals can invest large amounts of their money in startups and risky loans, all at the press of a button, they may be more likely to enter into transactions that they do not fully understand. If homebuyers can take out mortgages in a matter of minutes and entirely on their smartphones, they may reflect less about the potential risks of such loans. Regulation will need to take into account these situations, which will only become more prevalent as fintech expands into new areas.

Regulators will also need to ensure that fintech is not being used to evade national laws.  Bitcoin, for example, was used as the currency of choice for the Silk Road, the darknet website that trafficked in drug sales. Even more troubling is the potential for terrorists and organized crime to use virtual currencies to fund their illicit activities. Some commentators worry that peer-to-peer lenders and crowdfunding sites will encourage sham companies and Ponzi schemes. These are worrisome developments, and regulators must act to stamp them out. It would be a shame if fintech were tarred as the playground of criminals and fraudsters.
All of this suggests that regulators have a role to play in fintech. Financial regulators will need to keep a watchful eye on fintech innovation as it emerges as a growing force in the financial world. This is easier said than done, of course. Algorithmic decision-making and crowdsourced financial ledgers are not simple concepts, and they may have vulnerabilities that we cannot fully understand. It is therefore paramount that all parties – firms, consumers, and government – have adequate information about how fintech products work and what their risks and rewards are. The only way for this to happen is for fintech and government to work together on a cooperative basis. But if they do, fintech might well prove to be as revolutionary as its backers claim.