FinTech, Artificial Intelligence and the Law

Regulation and Crime Prevention

Alison Lui, Nicholas Ryder, Alison Lui, Nicholas Ryder

• Publisher: Routledge
• Year: 2021
• ISBN:
  9781000412666
• Edition: 1
• Topic: Betriebswirtschaft
• Subtopic: Wirtschaftssethik

This collection critically explores the use of financial technology (FinTech) and artificial intelligence (AI) in the financial sector and discusses effective regulation and the prevention of crime.

Focusing on crypto-assets, InsureTech and the digitisation of financial dispute resolution, the book examines the strategic and ethical aspects of incorporating AI into the financial sector. The volume adopts a comparative legal approach to: critically evaluate the strategic and ethical benefits and challenges of AI in the financial sector; critically analyse the role, values and challenges of FinTech in society; make recommendations on protecting vulnerable customers without restricting financial innovation; and to make recommendations on effective regulation and prevention of crime in these areas.

The book will be of interest to teachers and students of banking and financial regulation related modules, researchers in computer science, corporate governance, and business and economics. It will also be a valuable resource for policy makers including government departments, law enforcement agencies, financial regulatory agencies, people employed within the financial services sector, and professional services such as law, and technology.

Part 1
Introduction

1 Introduction—mind the gaps

Alison Lui and Nicholas Ryder

The global pandemic of 2020 has created opportunities for digital payments, a type of financial technology (‘FinTech’). Lockdown restrictions across the world have led to a big surge in digital payments and online payment platforms globally. According to Mastercard’s research in 2020, 64% of European consumers prefer to pay by tap-and-pay cards (Mastercard, 2020). ATM cash transaction withdrawals in the UK fell by 62% in late March 2020 when the lockdown restrictions were imposed. In Spain, cash withdrawals dropped by 90% (Thomas & Megaw, 2020). Countries such as Russia and the USA however have seen a brief surge in cash withdrawals due to fears of cash hoarding. Rise in the use of digital platforms will boost digital financial products and e-commerce. At the same time, however, the sharp rise in digital payments has excluded the vulnerable, especially those who are unbanked, the elderly and victims of domestic abuse. More importantly, many consumers are still wary of FinTech due to a trust gap. According to the Edelman Trust Barometer (2020), only 47% of the 33,000 individuals trust digital payments and peer-to-peer companies. Forty-eight per cent trust blockchain and crypto companies, whereas 49% trust digital health and robo-advisory firms. The main obstacles to wider public trust in FinTech include data privacy; fear of the unknown and thus continued loyalty with incumbent banks; the fast pace with which the technology is moving; and the recent FinTech scandals such as Wirecard.

Trust in algorithms was the centre of debate when the algorithm used to predict A-level students’ grades in England, Wales and Northern Ireland in 2020 downgraded grades by up to 40%. Due to the pandemic, A-level exams were cancelled in the summer of 2020. To provide students with their grades, the algorithm Pkj = (1 − rj)Ckj + rj(Ckj + qkj − pkj) was used (Hern, 2020). It took into account an estimated grade; a ranking of each student compared with other students at the school within the same estimated grade boundary and the school’s past performance in the previous three years in each subject. This sparked a controversial debate about the algorithm’s fairness and accountability in the public sector. In private finance, algorithms are increasingly used in algorithmic trading, credit scoring, chatbot assistants and wealth management. Arguably, the importance of transparency and accountability of algorithms is even more crucial in a sector traditionally criticised for its opaqueness (Flannery, Kwan & Nimalendran, 2004; Morgan, 2002). Extant legal frameworks and regulations at national, European and international levels need to be scrutinised to see if they are effective. In light of recent developments in FinTech and artificial intelligence (AI), this chapter critically evaluates the gaps between FinTech, financial exclusion, regulation and supervision.

1 Closing the gap in FinTech and financial exclusion

FinTech aims to close the gap between the financially and digitally included on the one hand and those who are excluded on the other. FinTech is an enabler to global financial inclusion, creating a more equitable world (Bisht & Mishra, 2016). A number of scholars opine that the use of FinTech can circumvent structural and infrastructural problems to reach the poor (Al-Mudimigh & Anshari, 2020; Chinoda & Kwenda, 2019; Beck, Senbet & Simbanegavi, 2014). Globally, mobile phones have improved financial inclusion in 49 countries (Chinoda & Kwenda, 2019). The large number of internet users and FinTech companies in Southeast Asia has improved financial inclusion (Al-Mudimigh & Anshari, 2020). In Africa, Evans’s research between 2000 and 2016 (Evans, 2018) reveals that the internet and mobile phones have improved financial inclusion, although Chikalipah (2017) argues that financial illiteracy is a major hurdle to financial inclusion in sub-Saharan Africa. Meanwhile in Europe, financial inclusion focuses on increasing customers’ access to the credit market and balancing this with financial stability (Ozili, 2020). More studies need to be carried out with regards to customer barriers to FinTech adoption and how to reduce these barriers (Kavuri & Milne, 2019). Furthermore, innovative research methods and ways to collaborate between financial players in reducing customer barriers to FinTech adoption are much needed.

Will FinTech democratise access to financial services and reduce societal inequity? Bartlett et al.’s (2018) study shows that algorithms can reduce discrimination of ethnic minority borrowers by up to 40% compared to FinTech lenders. Lenders charge Latin/African American borrowers 7.9 and 3.6 basis points more for mortgages, costing them $765 million in aggregate per year in extra interest. In another study, predictive analytics in screening borrowers’ creditworthiness is shown to reduce inequity. One of the advantages that financial intermediaries possess is information advantage in assessing borrowers’ creditworthiness. Nevertheless, Berg et al.’s (2018) study proves that this advantage, and indeed the financial intermediary model, may be threatened. Utilising 250,000 observations of digital footprints from German e-commerce, Berg et al.’s research reveals that the digital footprints equal or exceed the predictive power of traditional credit bureau score. This finding has potentially far-reaching consequences for both borrowers and financial intermediaries. Predictive power of digital footprints can reduce inequity and close the information asymmetry gap between incumbent banks and FinTech players.

2 Gaps in FinTech, regulation and supervision

Studies into how FinTech can impact upon financial stability are still short in supply (Minto, Voelkerling & Wulff, 2017). The conundrum is that currently the precise impact of FinTech on financial stability remains unclear. FinTech increases diversity in the financial sector, which may increase the relevant market players’ resilience to externalities. The more diverse the financial products, services and models in the financial market, the less exposed are financial providers to systemic risks (Minto et al., 2017). Schwarz (2012), however, disagrees and argues that FinTech can cause pro-cyclicality in the financial sector, concentrate risks and reduce public confidence in the financial system. Inter-connectedness of the global financial markets makes it easier for systemic risks to permeate and spread throughout the financial sector.

Asymmetric technology is widening the gulf between the huge advancement technology firms are making and the supervisors’ adherence to out-of-date technology (Zeranski & Stefan, 2020). The Wirecard scandal is a good example of this. It is a hybrid digital payments company but also owed a bank. Wirecard filed for insolvency in July 2020 after its auditors discovered a £1.7 billion hole in its accounts. Its share price dropped by 100% after Wirecard went into insolvency (Hannah, 2020). Two days later, the company CEO was arrested for market manipulation and false accounting. In addition to market volatility, many UK customers had their accounts frozen since the Financial Conduct Authority ordered all regulated activity to stop. Wirecard provided payment processing services for a number of UK-based cards and apps which did not have their own banking licences. The freeze led to customers, many of whom did not know that Wirecard was involved, unable to use their cards or access their bank accounts.

This scandal provides a clear example of three points. First, the FinTech ecosystem is inter-connected where Wirecard was processing payments for UK customers without their knowledge. From a regulatory perspective, Wirecard did not hold client money nor did it engage in risky lending. However, its risk was concentrated due to the inter-connected nature of the financial market (Salway, 2020). This supports Schwarz’s view that FinTech concentrates risks. Second, the Wirecard scandal demonstrates how a FinTech company can undermine financial stability and public trust in the financial system. Finally, regulators and supervisors need to innovate their strategies, rules and practice in monitoring FinTech companies. In the case of Wirecard, uncertainty and confusion arose between the German regulator BaFin and the accounting watchdog, the Financial Reporting Enforcement Panel, as to how Wirecard should have been supervised. Wirecard was regulated as a technology company rather than as a financial services operator. From a behavioural finance perspective, the German regulators may have adopted a laissez-faire approach in regulating Wirecard due to the buzz and frenzy linked to FinTech. The regulators may have seen a growing FinTech company as a sign of success in financial innovation, thus reluctant to intervene when there are looming signs of weaknesses (Zeranski & Stefan, 2020). As a result of this scandal, the EU Commission is reviewing the regulatory and supervisory mechanisms for hybrid FinTech companies. More research is required to examine country-specific regulatory and supervisory frameworks to curtail risks generated by FinTech and AI.

3 Structure of the book

The aim of this edited collection is to explore critically the interesting and emerging symbiosis of FinTech, AI and the law. As a branch of FinTech, AI is becoming increasingly popular in the financial sector. The pandemic has changed the FinTech ecosystem by accelerating the shift to digital financial products and services. Therefore, the main research objectives of the edited collection are as follows:

1. To critically analyse the roles, values and challenges of FinTech in society;
2. To critically evaluate the legal and ethical challenges in FinTech and AI;
3. To make recommendations on effective regulation of FinTech and AI.

The book is divided into four parts. In Part 1, ‘Introduction—mind the gaps’, the editors will set out the gaps in FinTech, financial inclusion, regulation and supervision. Whilst FinTech aims to close the gap between the financially included and excluded, the widening of current gaps between technology, regulation and supervision has to be addressed urgently. Recommendations will be made in this chapter.

Part 2 is titled ‘The FinTech Ecosystem’. There are four chapters under this part. Chapter 2 opens with a thought-provoking chapter by Stephen Rainey on the roles and values of FinTech in a capitalist society. Rainey argues that the financial sector is somewhat disconnected from capitalistic interactions as it has become an autonomous sector. However, Rainey submits that FinTech has its values in our capitalistic society. In Chapter 3, Ruilin Zhu discusses a much-neglected area of FinTech, namely InsurTech. In his chapter, Zhu focuses on the apprehension of using digital innovations-empowered InsurTech on industry stakeholders in support of the development of insurance as a way to promote value research. He discusses the use of big data and AI in the insurance sector. Zhu uses two Chinese insurance companies as contextual examples, and narratives are presented for discussions aimed at identifying ways in which the insurance industries and technology sectors can achieve value proposition through InsurTech.

In Chapter 4, Sonia Soon explores the digital financial services ecosystem and the issues contributing towards its limitations, notably, the regulator’s role. She adopts a comparative legal analysis method and examines the different approaches to FinTech regulation in Asia, Africa and South America. She concludes that desired outcomes can be achieved when regulators and FinTech companies collaborate to meet their shared objective, which is to flourish the FinTech ecosystem and bridge the gap in financial inclusion, all while protecting the interests of the public and the country. In Chapter 5, Sharon Collard, Phil Gosset and Jamie Evans continue with the theme of financial inclusion and critically analyses the main financial inclusion challenges faced by individuals and households in the UK. Collard et al explore the potential for FinTech to help address these challenges and reflects on the opportunities and hurdles to make this happen. In doing so, she considers various ‘FinTech for good’ initiatives in the UK that aim to ensure the application of FinTech for social purposes rather than simply for profit. Using Nationwide Building Society’s Open Banking for Good programme as a case study, this chapter demonstrates the potential of using a Grounded Innovation approach as a means to ensure that social-purpose FinTech is inclusively designed from the start to increase its potential to meet the needs of the financially squeezed.

Part 3 of the book examines several challenges raised by crypto-assets. Ilias Kapsis starts off the discussion in Chapter 6 by addressing the regulation of crypto-assets. He argues that a more flexible, principles-based approach to regulation of crypto-assets may be required due to the challenges posed by crypto-assets. Henry Hillman continues with this topic in Chapter 7 with a critical discussion of initial coin offerings (‘ICO’). He critically analyses ICOs from four perspectives: businesses offering coins, investors, regulators (in this case, the Financial Conduct Authority) and the potential criminal. Recommendations are made on how market participants and regulators should react to ICOs. The chapter draws conclusions on the integrity of ICOs, especially whether they are a financial innovation or are pyramid schemes that have been taken to a new dimension. Financial crime is the theme of Sherena Huang’s contribution to this volume in Chapter 8. She examines the role of cryptocurrency in financial crime and classifies cryptocurrency illicit activities into two categories—direct and i...