Emerging Risks in the FinTech Industry--Insights from Data Science and Financial Econometrics Analysis.

AuthorMorales, Lucia
  1. Introduction

    Nowadays, the connection between finance and technology is a trendy and hot topic (Omarava, 2019; Chandry et al., 2022). Nevertheless, technology is not new to finance, and it has been there for quite a while. Technology, innovation, and finance share a long historical relationship, with technology and innovation playing a crucial role in developing the global financial system, shifting the boundaries between firms and markets (An and Rau, 2021). However, there is little awareness of finance and technology's historical connections. The buzzing word FinTech has been introduced to link finance and technology, appearing as if we are facing a revolution in the field. There seems to be a general belief that FinTech is a new and groundbreaking trend when the reality is quite different, as we are facing an evolution of a long-existing relationship. Besides, there is a significant lack of understanding concerning the risks associated with the growing dimensions of the FinTech sector. There are critical connotations regarding systemic risk that puts into evidence the existing vacuum on financial monitoring and regulation and its failure to move and evolve at the pace of financial innovation (Chaudhry et al., 2022). Undoubtedly, financial regulation has become a significant area of concern due to the 2008 Global Economic and Financial Crisis (GEFC), with the financial sector practices found at the epicenter of the global economic and financial mayhem. Within this context, Wojcik (2020) points to the significant challenges that emerge from the intense fusion of financial services and technology, which might have contributed to adding complexity and elevating and enhancing existing controversies surrounding financial regulation and stability, financial inclusion, and governance. Jones and Knaack (2019) raise concerns regarding existing practices and approaches to global financial regulation that is affected by a lack of guidelines towards non-bank credit intermediation, arguing the need for a standard-setting body to regulate the fast-growing FinTech industry. At the same time, Pierri and Timmer (2020) suggest that technology can play a crucial role in enhancing regulation and supervision practices. Technology can play a vital role in helping financial institutions improve credit allocation practices and monitor their performance. The outcome will be a potential reduction of default risks, minimization of spillover effects from non-traditional to traditional financial institutions, and effective monitoring of financial practices that could open the door to systemic risk. On the other hand, Hughes et al. (2019) argue that the era of FinTech has not been exposed yet to a significant shock that tests its resilience. Due to the importance of financial stability, this paper seeks to examine the FinTech industry's contribution to systemic risk. The paper is supported by data science algorithms in combination with traditional financial econometrics as we aim to explore the role of data science to enable regulators and supervisors in their complex decision-making processes as they assess the sector emerging risks. Consequently, the main research question to be addressed is: Do FinTech firms exhibit different risk profiles than non-FinTech firms? The research question seeks to offer insights supported by data science and financial time series analysis to help revealing potential differences on risk profiles between FinTech and non-FinTech firms.

    The conducted research study seeks to make a novel contribution by developing a risk assessment of the US FinTech industry with the support of unsupervised and supervised machine learning techniques. In addition, the research study is also supported by financial econometric modeling to account for the idiosyncrasies associated with financial data. The remainder of the paper is structured as follows: section 2 offers a brief historical overview of the FinTech Sector that aims to contextualize the outlined research question and the importance of the FinTech sector. Systemic risk in the context of the FinTech sector is examined in section 3. The discussions are followed by section 4 that offers insights on the regulatory framework and existing vacuum. Section 5 outlines the data and methodological framework supporting the study. The research findings are presented in section 6 and finally section 7 concludes the paper.

  2. FinTech Brief History

    The historical connection between financial services and technology can be traced back to the year 1866, as this year witnessed the successful laying of the first transatlantic cable. This event has been identified as the landmark between the fusion of finance and technology as fundamental infrastructure was provided to facilitate the development of the electronic fund transfer system. This achievement has been identified as the beginning of the FinTech industry. Since then, technology and innovation have played a critical role in fostering the financial system's growth by merging technology with the natural evolution of financial firms. The fast speed of developments has deviated in a rapid, changing, and evolving relationship that integrates some of the most up-to-date societal debates as the use of FinTech in the cryptocurrency world (Thampanya et al., 2020). In addition, the integration of artificial intelligence (AI) to the FinTech sector and its potential contribution to a greener and low carbon economy are emerging areas of interest, as the world economies seek to align with the principles of economic and financial sustainability (Tao et al., 2022; Ashta and Herrmann, 2021).

    The interlinkage of finance and technology has a long history and has evolved over three distinct eras, in which finance and technology have advanced together. According to Buckley et al. (2016), the FinTech timeline can be well-defined around three significant phases: i) FinTech 1.0; ii) FinTech 2.0; iii) FinTech 3.0 and 3.5, where each period is associated with a considerable landmark that has contributed to advancing the financial sector and its digital connection.

    i) FinTech 1.0 (1866-1967). The first phase started with the transition from analogue to digital. At this time, the world was facing significant changes and disruptions. During this period, the world experienced major disruptions because of World War I and II and the Great Depression. While the world confronted enormous challenges, at the same time, there were tremendous advances to connect people worldwide with the development of the telegraph, railroad, and steamships that brought significant changes in how people travelled and how financial information started to cross borders. This period is also considered as the starting point of the economic globalization process.

    ii) FinTech 2.0 (1967-2008). The second phase witnessed the consolidation of technology. Traditional financial institutions started to offer the first wave of digital financial services, showing how financial institutions led the transition from analogue to digital. During this phase, key achievements to be highlighted are the first handheld calculator's design; and the first ATM (Automated Teller Machine), with Barclays bank being the first to install it. In the 1970s, the world's first digital stock exchange--the NASDAQ was established, marking the beginning of global financial markets, and settling the grounds for today's practices. During this decade, another significant milestone to be considered is the launch of the first financial communications protocol--SWIFT (Society for Worldwide Interbank Financial Telecommunications). To this day, the SWIFT communication protocol is considered the universal communication procedure among financial institutions. The SWIFT protocol facilitates the movement and monitoring of large volumes of cross-border payments. Another remarkable achievement was the introduction of bank mainstream computers in the 1980s, making it possible to progress towards online banking that thrived in the 1990s. Further advancements took place by developing the internet and e-commerce business models towards the end of the 90s. During this phase, there were major changes and shifts as people's perceptions of money and their relationship with financial institutions started to be reshaped. The beginning of the 21st century revealed important changes in how banks' internal procedures started to reshape and banks' interactions with outsiders and retail customers became fully digitized. Online banking contributed to a major shift in how people perceive money and, in particular, on their relationship with banks and financial institutions. This era was brought to a halt by the GEFC in 2008. Traditional financial institutions' practices started to be questioned by their customers who requested new and alternative financial services and products, which led to a new FinTech phase.

    iii) FinTech 3.0 (2008-current). This phase witnessed the explosion of digital financial services with the emergence of FinTech startups. The GEFC was marked by the destabilization of the financial system and was followed by economic hardship. During this period, public distrust in the traditional banking system opened the door to different practices and the demand for new financial services, marking the beginning of a new phase--FinTech 3.0. The development of Bitcoinv0.1 in 2009 is another landmark that has changed people's understanding of money and its functions. Bitcoin can be considered another breakthrough for the financial world, as the boom of blockchain and cryptocurrencies has shown. The emergence of cryptocurrencies has been also associated with an upsurge of uncertainty and risks and raises concerns regarding financial regulators ability to keep up with the speed of development experienced by the sector. During this phase, the FinTech industry faced major changes in terms of mass-market penetration enhanced by...

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