The New Fintech Federalism.

• Author: Seymour, Benjamin T.

Introduction I. The Prevailing Paradigm and Its Flawed Extensions to Fintech A. State Regulation: Inefficient Inconsistencies B. Federal Regulation 1. Preemption and Its Abuses 2. The Perils of Fragmentation II. The New Fintech Federalism A. Entity-Based, Reciprocal State Law 1. Multi-State Cooperation 2. Unilateral State Action: The Evolving Case of Cryptocurrency 3. Passporting in a Shifted Discourse B. Activities-Based Federal Law: Casting a Wider Net 1. Curbing Preemption 2. Consumer Protection 3. Safety and Soundness 4. Systemic Risk III. Hastening the Transformation Through Legislation A. Codifying State Chartering B. Federalizing Usury Law C. National Safety and Soundness for Fintech D. Addressing Fintech's Systemic Risks Conclusion Introduction

The financial services industry has rapidly transformed over the past twenty years. From lending to payment processing, the core functions of banks are increasingly performed by financial technology (fintech) firms. (1)

Fintech companies use digital platforms and innovative data processing techniques, including automation and artificial intelligence, (2) to provide customers cheaper and more convenient financial products. (3) The onset of the COVID-19 pandemic and associated shelter-in-place orders further entrenched fintech's importance to the U.S. financial system, as many consumers flocked to digital providers. (4) Without the overhead of brick-and-mortar banks, fintech firms are remarkably lean, allowing them to pass savings onto customers. Indeed, many fintech firms are little more than startups. (5)

In contrast to traditional banks' generalist posture as one-stop shops, fintech firms typically specialize in a single kind of financial service. (6) This feature of fintech has produced two transformative impacts on the global financial system: (1) disaggregation, as the once-unified process of accepting deposits, extending credit, and processing payments has fragmented across various firms; (7) and (2) disintermediation, as these specialist firms have replaced traditional financial intermediaries like banks. (8)

American law has struggled to accommodate the disaggregating and disintermediating nature of fintech. (9) Instead, the United States has labored under a division of regulatory authority between the state and federal governments designed to govern a financial landscape comprised of banks and large shadow banks. (10)

To catch up to the market, state and federal officials have undertaken a diverse array of regulatory initiatives. Yet the resulting legal frameworks have varied widely, yielding a jumble of policies with contradictory means and incoherent ends. (11) Commentators have characterized the inconsistencies among federal and state responses to fintech as a crisis for the federalist structure of U.S. financial regulation. (12)

Numerous officials have relied on the prevailing regulatory paradigm of the past century, seeking to extend its already stretched logic into the realm of fintech and exacerbating its many shortcomings in the process. (13) These traditional approaches insist that states must control fintech activities that occur within their borders (14) using the longstanding tools of compulsory licensing, bond-posting, and consumer protection. (15) But for online fintech firms, the costs of complying with a morass of duplicative or conflicting state laws is onerous and in some cases prohibitive. (16)

At the federal level, proponents of the prevailing paradigm have embraced entity-based regulation. (17) They have expanded preemption for federally chartered firms, immunizing them from state laws. (18) For fintech companies, federal preemption has served as a vehicle for regulatory arbitrage, encouraging rent-a-bank schemes that undermine consumer protection laws. (19) The federal entity-based view also permeates the binary approach to systemic risk controls that fixates on large systematically important financial institutions (SIFIs), while overlooking the growing macroprudential threat posed by a fragmented fintech sector. (20)

But several regulatory initiatives of the past decade have broken with prior thinking and charted a different path, one that redefines the relative realms of the federal and state governments and promises a legal regime suited to the technological realities of twenty-first century finance. (21) This emergent paradigm--the New Fintech Federalism--constitutes a radical reversal of the prior division of authority between state and federal actors. Through both cooperative and unilateral initiatives, the states are increasingly adopting an entity-based approach rooted in interstate reciprocity that inures the benefits of jurisdictional competition and reduces the costs of redundant mandates. (22) Meanwhile, by focusing on financial activities, the federal government is pursuing a consumer protection framework less prone to arbitrage and a view of prudential risk suited to the fragmentation of fintech. (23)

The New Fintech Federalism is a sound governmental response to a matter of straightforward economic logic. Because fintech firms offer services online, their business model is inherently inter-jurisdictional. (24) Accordingly, subjecting fintech firms to the divergent legal regimes of each state in which they operate entails steep compliance costs that threaten the economic viability of startups and hinder American innovation. (25) Yet allowing fintech firms to opt into a single state's laws is similarly undesirable. In deciding where to incorporate, a fintech founder will seek to maximize the value of her firm by choosing the regime most beneficial to her investors, (26) who are typically sophisticated venture capital fund managers. (27) However, the founder lacks an incentive to fully internalize the costs of her choice of jurisdiction on remote third parties (28) or unsophisticated consumers unable to protect themselves via contract. (29) Instead, founders will systematically shift choice-of-jurisdiction costs onto those constituencies, generating externalities. To cater to founders, states competing for fintech charters will adopt under-protective rules, since they receive the entire benefit of chartering fees yet suffer only a fraction of the costs imposed on the national population. (30) This spillover effect is most pronounced in smaller, less populous states.

The optimal regulatory regime therefore federalizes legal issues in areas that generate significant externalities, (31) such as consumer protection (32) and prudential requirements, (33) while fostering state competition in areas like fintech governance that are unlikely to produce substantial spillovers. (34) The New Fintech Federalism follows precisely this path by reversing the prevailing division of authority between state and federal regulators.

This Article is the first to identify the New Fintech Federalism, examining how its disparate set of legal experiments could revolutionize U.S. financial regulation. While previous commentators have discussed its constituent initiatives in isolation, they have failed to appreciate their collective significance for the federalist structure of American financial law--a reversal of the activity- and entity-based foundations of the prevailing state-federal paradigm. Beyond celebrating the New Fintech Federalism, this Article proposes a comprehensive legislative solution for Congress to realize its elegant marriage of jurisdictional competition and steadfast commitments to consumer protection and prudential safeguards. (35)

Part I of this Article analyzes the division of authority among state and federal regulators that has prevailed in the U.S. for over a century, with state restrictions on a broad range of financial activities and federal interventions in favor of banks and their affiliated entities. It discusses how extensions of this already infirm approach to fintech at the state and federal level have generated cumbersome compliance costs and abusive regulatory arbitrage. Part II surveys the legal reforms of the past decade that embody a new paradigm, defined by reciprocal state regulation of fintech entities and federal authority over externality-heavy financial activities. Because regulators remain committed to the status quo and many of these initiatives are nascent, Part III calls on Congress to enact legislation that codifies and builds upon the benefits of the New Fintech Federalism. It details a statutory intervention that would promote the interests of entrepreneurs and consumer protection advocates alike. Far from jettisoning federalism, this Article's proposed legislation would harness the distinctive strengths of the state and federal governments to bolster America's economic vitality and global competitiveness.

1. The Prevailing Paradigm and Its Flawed Extensions to Fintech

   Fintech firms in the United States operate in a federalist legal regime that was not designed for them. Exercising an array of regulatory tools developed to handle the exigencies of local commerce, states require fintech companies to submit to a host of burdensome rules in exchange for the privilege of performing financial activities within their borders. (36) Compliance with the diverse licensing, oversight, consumer protection, and safety-and-soundness rules of each state in which a fintech operates is a costly proposition for online firms. (37) Moreover, the cumulative social benefits from each additional regime are minimal at best. (38) Yet states have not only maintained their financial activities laws, but also affirmatively extended them to fintech firms through new licensing regimes aimed at activities like cryptocurrency trading. (39) Unsurprisingly, these traditionalist initiatives have merely replicated the costs of prior state statutes, while paying little heed to regulatory spillovers. (40) As a result, the dominant, activities-based approach to fintech among state regulators has inflicted unnecessary...