China and America both need new fintech regulation

In a recent episode of Professor Scott Galloway’s podcast, he talked with one of my favourite writers: the eminent historian and Hoover Institution senior fellow Niall Ferguson. The subject of the conversation was the relationship between the United States and China. Their fascinating and informative discussion ranged across many fields, including financial services and fintech. Ferguson touched on a particular aspect of what he calls “Cold War 2” in context of finance, saying that American regulators “have allowed the fintech revolution to happen everywhere else” by which I think he meant that the nature of financial regulation in America has been to preserve the status quo and allow the promulgation of entrenched interests while the costs of financial intermediation have not be reduced by competition. He went on to say that “China has established an important lead in, for example, payments”, clearly referring to the dominance of mobile payments in China and the role of (in particular) Alipay in bringing financial services. He made this comment around the same time that the Chinese government pulled the plug on the Alipay IPO, what would have been the biggest IPO in history.

Weareno1

with kind permission of TheOfficeMuse (CC-BY-ND 4.0)

As an aside, if you want to understand some of the big picture around the coronavirus, currency (and what I call “The Currency Cold War” in my book of the same name), then you might want listen to this Coindesk podcast with Ferguson and the journalist and author Michael Casey. They talk about the current state of the world and what it could mean for money. As the author of one of the best books on the history of finance, The Ascent of Money, Ferguson has a very wide and well-informed perspective on the issues and, indeed I quote him more than once in my book!

At a time when America is finally beginning to at least think about opening up financial services to allow real competition, China is heading in the opposite direction by clamping down on fintechs. Click To Tweet

Ferguson’s point about payments is particularly interesting to me. One way to provide more fintech competition to the incumbents would be to provide a more relaxed environment for payments. America lacks a regulatory construct equivalent to the EU’s “Payment Institution” and it really needs one if it is to move forward. The EU regulatory framework has just been battle-tested with the collapse of Wirecard following massive fraud. No customer funds were lost in the collapse of the badly-regulated non-bank because the customer funds were ring fenced in well-regulated bank and, as I will suggest later, this might be the right regulatory balance for new US regulation.

One place to look for this new regulation might be the OCC, which has developed the concept of the Special Purpose National Bank (SPNB) charter. I don’t want to sidetrack into the controversy around these charters, except to note that the OCC expects a fintech company with such a charter to comply with capital and other requirements that seem unlikely to generate the innovation and competition that America wants. This was obvious from the comments on the original proposals, when fintechs made it clear they would be reluctant to invest in such an OCC license unless such a licence would require the Federal Reserve to give them access to the payments system (so they will not have to depend on banks to intermediate and route money for them). The fees associated with such intermediation are significant (ie, top five) operating cost for many fintechs.

I agree wholehearted with Prof. Dan Lawry of Cornell Law School, Lev Menard of Columbia Law School and James McAndrews of Wharton Financial Institutions Center who in their response to the OCC’s proposal labelled it “fundamentally flawed” and called for the organisation to instead look at strengthening the regime for non-bank financial institutions. The focus on banking regulation, though, seems entrenched. I notice that Congresswoman Rashida Tlaib (MI-13), along with Congressmen Jesús “Chuy” García (IL-04) and Chairman of Task Force on Financial Technology Rep. Stephen Lynch (MA-08), have just introduced the Stablecoin Tethering and Bank Licensing Enforcement (STABLE) Act, which similarly propagates this outdated (and inappropriate) regulatory perspective by requiring any prospective issuer of a “stablecoin” (let’s not even get into what is or is not a stablecoin) to obtain a banking charter.

There is an alternative. The idea of another kind of federal charter that would allow regulated institutions access to payment systems, but would not allow them to provide credit, seems much more appealing for not only stablecoin issuers but almost all other fintechs as well. Such a charter would separate the systemically risky provision of credit from the less risky provision of payment services, a very different concept to the SPNB charter. The economist George Selgin, Senior Fellow and Director of the Cato Institute’s Center for Monetary and Financial Alternatives, recently posted a similar point on Twitter, arguing for the Federal Reserve to give fintechs direct access to payment systems (instead of having to go through banks). This was the approach taken in the UK when the Bank of England decided to give settlement accounts to fintechs, where examples of fintechs who took advantage of this opportunity to deliver a better and cheaper service to customers range from the $5 billion+ Transferwise money transfer business to the open banking startup Modulr (which just recieved a $9 million investment from PayPal Ventures). Interestingly, Singapore has just announced that it will go this way as well, so that non-banks that are licenced as payment institutions will be allowed access to the instant payment infrastructure from February 2021.

My good friend Chris Skinner was right to say that many US fintechs will follow the likes of Varo, apply for new licenses and become more and more like traditional banks, but that’s because the traditional bank licence is all that is on offer to them. But this is an accident of history that jumbles together money creation, deposit taking and payments. It’s time to disentangle them and to stop, as Jack Ma (the billionaire behind Alibaba and Ant Group) recently said, regulating airports the way we regulate train stations. He said this was shortly before Chinese regulators halted Mr. Ma’s IPO, following his comments  questioning financial regulation, clearly signalling that their relaxed attitude toward the growth of China’s financial giants is coming to an end.

The Chinese regulatory environment is changing. Whereas China was happy to see its techfins grow in order to help them scale while American enterprises were kept at bay, it is now beginning to rein them in. The new players are now having to build up capital and review business structures as those regulators focus on issues such as data privacy, banking partnerships and lending. With respect to that latter point, note that the concerns around the Alipay IPO were related to lending and leverage, not payments. Although heading towards half of Ant’s revenues came from the lending, facilitated by their vast quantities of data, but they only came up with 2% themselves (if they were were a bank, they would be required to provide something like a third) passing the rest of the exposure onto banks.

Meanwhile, in September, the European Commission (EC) adopted an expansive new “Digital Finance Package” to improve the competitiveness of the fintech sector while ensuring financial stability. The proposed framework includes a legislative approach to the general issue of crypto-assets, called Markets in Crypto-assets (MiCA). I’ll spare you the whole 168 pages, but note that it introduces the concept of crypto-asset service providers (CASPs) and defines stablecoins as being either “asset-referenced tokens” that refer to money, commodities or crypto-assets (although how this can be called “stable”, I am not at all clear) or “e-money tokens” that refer to one single fiat currency only.  E-money tokens (eg, Diem) are a good way to bring innovation to financial services because they are a way to bring genuine competition.

I think the EU may be charting a reasonable course here. China needs to regulate lending more, the US needs to regulate payments less. America needs more competition in the core of financial services and now is a good time to start. With the Biden administration on the way, they can tackle this core issue that, as The Hill says, the U.S. government has “ignored and neglected” the need for a regulatory framework that will support American technological innovation around cryptocurrency, setting aside an embarrassing and “outdated regulatory approach to fintech”. Prof. Lawry suggest a simple and practical response for the US regulators, which is to amend the state-level regulatory frameworks around money services businesses (MSBs), which they say “are the product of a bygone age”, and learn from M-PESA and Alipay where a 100% reserve requirement seems to have proved very successful. There is no evidence that such a requirement stifles growth. Congress need only introduce a uniform requirement that MSB hold a 100% in insured deposits at a bank that holds account balances at the Federal Reserve, which is in essence the same as an EU Electronic Money License and therefore ought to lead to mutual acceptance.

In short, China needs tighter regulation of non-bank credit, America needs lighter regulation of non-bank payments. The way forward is to separate the regulation of payments from the regulation of credit from the regulation of investments. This is the way to get competition and innovation in financial services.

Fed-PESA or Fed-Pal or Fed-Coin?

I am not an expert on American politics and I’ve forgotten all the cartoons about how a bill becomes a law and that sort of thing, but I was absolutely fascinated to read in a draft the Democratic Party stimulus proposal for the United States (the ‘Take Responsibility for Workers and Families Act’’, all 1100 pages of which are here) about the use of electronic wallets to make direct stimulus payments. The proposal says that a “digital dollar wallet” shall mean a digital wallet or account, maintained by a Federal reserve bank on behalf of any person, that represents holdings in an electronic device or service that is used to store digital dollars that may be tied to a digital [identity] or physical identity” (my emphasis).

Wow. That’s a pretty interesting vision. None of the components exist, of course, and the digital dollar didn’t make it through to the final 1,400 page version of the proposal. It did, however, reappear in a bill from Senator Sherrod Brown (D-OH), ranking member of the Senate Committee on “Banking, Housing, and Urban Affairs” that again confuses what banks, bank accounts and bank money are by calling on the U.S. Government to

    1. Allow everyone to set up a digital dollar wallet, called a “FedAccount,” a free bank account that can be used to receive money, make payments, and take out cash.

      It wouldn’t really be like a typical bank account of course, it would be more like an M-PESA account because all users would have an account in the same centralised system. Since there are millions of Americans without bank accounts (not because there is a shortage of banks, by the way) but with smartphones, something like this is long over due.

    2. FedAccounts would be available at local banks and Post Offices.

      This must mean account opening would be available in these locations because they have the facilities for rudimentary identity verification. The U.S. has no digital identity infrastructure, so these have to be co-opted. With instant digital onboarding though, the vast majority of the population ought to be able to enroll on in a couple of minutes, download the Fed-PESA app and get to work. There should be instant downloading of the associated debit card to Apple Pay or Google Pay as well.

    3. FedAccounts would have no account fees or minimum balance requirements.

      You could, of course, simply tell commercial banks to provide this service as a public service and as a condition of holding a bank licence. The problem though is two-fold: the banks don’t want to provide such as service and people without bank accounts (for a variety of reasons) don’t want to use. But if the U.S. had electronic money regulations in place, then these accounts could be provided by Walmart or someone else who understands customer service.

    4. Account holders would receive debit cards, online account access, automatic bill-pay, mobile banking, and ATM access at Post Offices.

      All of which cost money, of course, and I’m not sure that debit interchange and interest foregone would be sufficient to pay for these accounts since most of them will be empty most of the time.

    5. FedAccounts can be used to make sure that everyone who is entitled to COVID-19-related relief receives it quickly and inexpensively. That means that people will not have to rely on costly check cashers or other alternative financial services.

      Nor will they need commercial banks (why would I keep an account at a commercial bank when I can get a free account from the government). What’s more, assuming that people can transfer money from one FedAccount to another as easily as people transfer money to each other by WeChat or M-PESA (with a vanishingly small marginal cost) then why wouldn’t merchants accept it?

That last point is, of course, the proximate cause of the interest in the Uncle Sam Account (USA, as I call it) and it did lead me to think that what if the corona crisis does indeed turn out to be a trigger for a digital dollar and universal digital wallets? I’m with Senator Brown in trying to find a 21st century solution at a time of national crisis. That would be amazing. But is this right architecture? Setting aside what might be meant by a “digital identity” for the moment, let us just focus on the digital dollar.

How would it work? Would people really have accounts with or devices from a central bank?

Fed-PESA or Fed-Pal or Fed-Coin?

There are obviously a number of different ways that the digital currency could be implemented by central bank as part of strategy to move to a cashless society (by which of course I’m in a society where cash is irrelevant not where it is illegal). Way back in the 1990s the model that was chosen for the Mondex experiment that began in the UK was to have the central bank control the creation of digital currency but have it distributed by the commercial banks through their existing channels

As I set out in my forthcoming book “The Currency Cold War“, this is only one of the ways of implementing a digital currency. The obvious, and potentially much cheaper, alternative is the Sherrod Brown plan: simply have the central bank create accounts for all citizens, businesses and other organisations. You could imagine something like amperes but on population scale, Bank of England pairs are if you like, in the UK example. This will be cheaper because it will be completely centralised and the marginal cost of transferring value from the control of one personal organisation to another through such a system would be absolutely negligible.

Central banks don’t really want to do this, however, because it would mean having to manage millions of accounts and they would prefer somebody else to do this and deal with everything else that goes with interacting with the general public. The commercial banks and plenty of other non-bank players (think Alipay in China for example) already have the apps, the infrastructure and the innovative approach that would not only bring the digital currency to the mass market but would also open up the potential for the digital currency as a platform for innovation and development.

This is what the Chinese refer to as the “two tier” approach (personally, I insist on calling it the Mondex approach) and I don’t doubt that it will be the approach adopted by commercial banks around the world where that time comes because the problems attendant on the disintermediation of the commercial banks are great. In the Bank of England’s March 2020 discussion paper on “Central Bank Digital Currency” (which is an excellent report by the way), they call this neither the two-tier nor the Mondex approach but the “platform approach” and quite rightly note that one of the key advantages of it is that it will help innovation throughout the “stack”.

Now imagine a merging of something like India’s UPI, M-PESA, social media and the “lifestyle apps” coming from the Far East and you can begin to develop a picture of just how powerful such an implementation might be in all markets. The Bank of England uses some specific terminology which I think makes sense and will allow for constructive discussions between regulators, businesses and innovators in the payments space. In the Bank of England’s platform model it is assumed that the central bank runs the platform (will come back to what the platform means in a moment) and provides what the Bank of England call “API access” to this platform. The people are allowed to access the platform are labelled Payment Interface Providers (“PIPs”) and it is these providers (banks among them course) who interact with users.

This seems to make a lot of sense to me. If anyone can pass on Mr. Brown’s address, I will cheerfully send the Senator a copy of my book hot from the press.

The Real Innovation

The Bank of England are clear that they do not envisage this platform as a cryptocurrency platform (although I can see reasons why this might be appropriate, the Libra-style architecture goes in this direction for example) but they do say that the technologies of a shared ledgers might be the best way to implement the reason it out in my book. Were such a system to come into existence its resilience and availability would become matters of vital national interest Therefore it will make complete sense to take advantage of the new technologies and construct a decentralised and robust solution. It’s quite easy to imagine what this might be. Each bank would have the option of maintaining its own or accessing somebody else’s, all banks above a certain size would be mandated to keep a copy of the ledger and the payment interface providers gateways would simply talk to each other (through the normal protocols of consensus chosen for the particular architecture) but there will be no central system in the middle that could either because of management failings princess usually the case), unforeseen technical problems or subversion by foreign powers.

The paper, which I urge you and Senator Brown to read, goes into a lot of detail about the design of such a viable national system and notes, as I do, that one of the most game changing aspects of such implementation would be what they call “programmable money”, what I called “smart money” in my previous book “Before Babylon, Beyond Bitcoin” and what a variety of ill-informed and misleading observers insist on referring to as “smart” “contracts” although they are in fact neither. This is where the real innovation will take place that will make the money of the future so very different from the money that we have now and I am very keen to see thinking develop in this area. There are obviously overheads associated with overloading the ledger with the distributed applications but on the other hand it may be that there are some truly revolutionary features that can only be delivered through such applications. The bank suggests a compromise whereby certain distributed applications are provided for the use of the PIPs in order to give them infrastructure that they can then use to develop innovative end-user services and this seems a good place to start.

All of which is by way of saying that Senator Brown’s proposal for a sort of Fed-PESA, while being well-intentioned, will tie a boat anchor to U.S. payments system. Far better to create smart money, money with an API, and unleash a next generation of creativity. Personally, I hope that the Bank of England decide to take the global lead in the race to create money for the digital future, rather than continue with digitised versions of money from the analogue past, and I for one would bet on them to succeed.