The Regulators are Rightly Watching

Marketplace lending and distributed database technology got mentions in the “Potential Emerging Threats and Vulnerabilities” section of the U.S. Dept. of the Treasury’s Financial Stability Oversight Council’s 2016 Annual Report (PDF), released June 21, 2016. I read the section on distributed ledgers as largely positive for the technology’s potential, with a note to keep an eye on it, and the section on marketplace lending as somewhat negative, with a warning that lending standards may become lax.

The full comments on two leading FinTech technologies with my emphasis follow:

6.6 Financial Innovation and Migration of Activities

The financial system is characterized by frequent, often disruptive, innovations in products and business practices. Such innovation allows market participants to adapt to changing marketplace demands, fully exploit the benefits of new technology, and respond efficiently and creatively to new regulatory constraints. Precisely because innovations are new and potentially disruptive, they merit special attention from financial regulators who must be vigilant to ensure that new products and practices do not blunt the effectiveness of existing regulations or pose unanticipated risks to markets or institutions. Advances in information technology have long been an important catalyst for change in financial services. Marketplace lending, facilitated by online platforms which automate underwriting processes, and distributed ledger systems, facilitated by advances in cryptology and data processing algorithms, currently play a relatively small role in financial markets, but appear poised for substantial near-term growth. Financial regulators should continue to monitor and evaluate the implications of how new products and practices affect regulated entities and financial markets and assess whether they could pose risks to financial stability.

Marketplace Lending

Online marketplace lending refers to the segment of the financial services industry that uses investment capital and data-driven online platforms featuring algorithmic underwriting models to lend either directly or indirectly to consumers and small businesses. This segment initially emerged with companies giving individual, usually retail, investors the ability to provide financing to fund individual borrowers through what was known as a “peer-to-peer” model. However, marketplace lending has since evolved to include funding by institutional investors, such as hedge funds, banks, and insurance companies, seeking to provide financing that ultimately is used to fund consumer and small business loans of various types in order to gain access to additional lending channels and favorable rates of return. Marketplace lenders also use public offerings, venture capital, securitizations, and loans from banks as funding sources. While loan origination volumes and the number of marketplace lenders have grown rapidly in recent years, marketplace lending remains a relatively small part of the $3.3 trillion U.S. consumer lending market.

When individual or institutional investors provide funding, marketplace lending does not involve maturity transformation. Investors cannot withdraw funds before their notes mature, though in some cases limited secondary market trading is available. Therefore, outstanding marketplace loans that are funded by investors should not be susceptible to the sorts of run risks which can arise when there is a mismatch between the duration of funding and loan principal. On the other hand, marketplace lending is an emerging way to extend credit using algorithmic underwriting which has not been tested during a business cycle, so there is a risk that marketplace loan investors may prove to be less willing than other types of creditors to fund new lending during times of stress.

As marketplace lending continues to grow, financial regulators will need to be attentive to signs of erosion in lending standards. In other markets, business models in which intermediaries receive fees for arranging new loans but do not retain an interest in the loans they originate have, at times, led to incentives for intermediaries to evaluate and monitor loans less rigorously. Furthermore, given the rapid rise in the number of marketplace lenders who often compete with traditional lenders for the same borrowers, there is a risk that underwriting standards and loan administration standards of these lenders could deteriorate to spur volumes, which could spill over into other market segments.

Distributed Ledger Systems

A distributed ledger is a transactions database which can be accessed and potentially updated by a number of parties. Under traditional, centralized ledger systems, a single trusted party is responsible for maintaining an accurate database of transactions; this “golden copy” ledger serves as a reference for all other parties. In contrast, under a distributed ledger system, each member of a group is able to maintain its own golden copy ledger, which, after allowing for some delay in the transmission and encoding of new transaction information, is guaranteed to be identical to the ledger instances maintained by all other members of the group. Distributed ledgers are made possible through the application of encryption and algorithms that allow new transactions to be aggregated, encoded, and appended to an existing chain of transactions. These features enable network participants to validate the accuracy of new transactions and prevent the history of transactions from being modified.

Distributed ledger systems may enable market participants to manage many types of bilateral or multilateral transactions without the direct participation of trusted third parties. Proponents of distributed ledger technology believe it could help to significantly improve efficiency by replacing manually intensive reconciliation processes and reduce risks associated with trading, clearing, settlement, and custody services. Distributed ledger systems may mitigate risk and improve resilience in financial networks in a number of ways. Because distributed ledgers can be designed to be broadly accessible and verifiable, they could provide a valuable mechanism for enhancing market transparency. By eliminating the need for some transactions to flow through trusted third parties, distributed ledgers could reduce concentrated risk exposures to those firms and infrastructures. In addition, by improving the speed and accuracy of settlement systems, distributed ledger systems could reduce the counterparty and operational risks which arise when financial assets are exchanged. For example, distributed ledger systems may facilitate the automation of complex, multi-party transactions such as the payment of bonds and insurance coupons through the development of smart contracts.

Like most new technologies, distributed ledger systems also pose certain risks and uncertainties which market participants and financial regulators will need to monitor. Market participants have limited experience working with distributed ledger systems, and it is possible that operational vulnerabilities associated with such systems may not become apparent until they are deployed at scale. For example, in recent months, Bitcoin trade confirmation delays have increased dramatically and some trade failures have occurred as the speed with which new Bitcoin transactions are submitted has exceeded the speed with which they can be added to the blockchain. Similarly, although distributed ledger systems are designed to prevent reporting errors or fraud by a single party, some systems may be vulnerable to fraud executed through collusion among a significant fraction of participants in the system.

Distributed ledger systems have the potential to change the way some asset classes are traded and settled. Financial regulators have often worked with those market infrastructures and firms which facilitate trading and settlement, such as exchanges, dealers, and clearinghouses, to monitor markets and, in some cases, regulate market activity. To the extent that distributed ledger systems ultimately reduce the importance of these types of more centralized intermediaries, regulators will need to adapt to the changing market structure. Furthermore, since the set of market participants which makes use of a distributed ledger system may well span regulatory jurisdictions or national boundaries, a considerable degree of coordination among regulators may be required to effectively identify and address risks associated with distributed ledger systems.