My Helpers

I just got my first robot.

It’s a vacuum cleaner, a Roomba from iRobot. Okay I know that’s not exactly cutting edge. My son’s floors have been cleaner than mine for years because he was an early adopter, but I’ve been holding out until the technology got good at rug tassels.

Needless to say, it did. The newer Roomba knows tassels when it touches them – it turns neatly to run its sweeper along them. It’s also more efficient than its predecessor thanks to intelligence that lets it perceive the contours of the space and plan a strategy to minimize time and motion. And of course, my version has a phone app, so I can control it from the other side of the world. I like it.

The only problem is that it doesn’t listen to me when I talk to it.
All my other helpers do. The one that’s the best company is Alexa – the Amazon Echo. She sits on my kitchen counter in her sleek black cylinder and, in her gorgeous voice, tells me the weather, and cracks jokes, and reads me the morning newspaper and answers fact questions and Googles things for me. She can adjust my lights and thermostat. And if I was a Capital One customer, she would do my banking. 

Cortana, too, listens and talks. She’s (yes, I’ve decided to think of these beings as “she” rather than “it”) has been simplifying my computer work for over a year. This month, she has also inhabited my Xbox. A while back, I made a little video demonstrating how I use my Xbox to simplify media entertainment, because I can just give voice commands to change channels or watch Netflix or BlueRay or find a movie on Bing. Or to exercise, or call someone on Skype and see them on my big screen. I thought that was pretty cool, but now Microsoft has brought Cortana into the Xbox. She’s has a smarter language brain than the “old” Xbox did – more natural.

And of course, I have my Iphone. It not only contains Siri, which most people seem to use now, but also a newer extra-super-smart voice app -- Hound. It was created by the founder of the music-recognition app SoundHound. Unlike Alexa, Hound has a flat robotic voice but wow, can she think. I can say, “Hound, find me an electronics store near the Boston airport that is open Sunday evening.” And she will.

I’ve gotten so spoiled commanding my smart devices by voice that it’s hard not to try to converse with, say, dumb TV’s in hotels. But of course, they will soon get smart. And so will Roomba’s listening skills --I have no doubt.

Natural voice technology, combined with artificial intelligence, will bring a huge leap in financial services. It is a simplifier.  It de-layers information. Alexa has absolutely no interface except voice -- no screen to touch, no keyboard. She just listens, talks, and controls physical items in the Internet of Things that are smart enough to interact with her.  For financial services customers, the ability to do tasks and answer questions simply by talking with a robot “coach” will close the last mile of access for people who don’t thrive on the way we present products today.

This Wired magazine article changed my whole way of thinking about voice.

Fintech is more tech than fin, in that it is driven mostly by the technology change, not financial product invention. The tech change, in turn, is remaking everything we do, leveraging changes that are that are converging, In finance the driving trends are mobile technology, artificial intelligence, block chains, and yes, voice tools. But those are only a few of the army of transformations heading toward us. Along with them come robots, drones, 3-D printers, CRISPR genetics and so much more. 

Even my limited experience with my primitive new helpers makes it easy for me to picture living in a completely different way. Among other impacts will be a transformation of the labor market.  3D printers can make buildings. Uber will pick us up in driverless cars – in fact, they’re testing these this month in Pittsburgh. My TaskRabbit errand or pizza delivery will come by robot or drone. Jobs that got outsourced to the developing world in recent decades are going to change again – going now to machines.

I recently spent an evening hanging out with some young MIT PhD candidates in genetic science. Most of the time I had no idea what they were talking about, but I caught enough to get a glimpse of technology that will change the very nature of life. Not surprisingly, it’s very advanced in China.

Scary, yes. Exciting, yes again. Also unstoppable.

All innovation brings mixed impacts, good and bad. Technology will spread high quality of life to nearly everyone by making amazing things universally available. Already more people globally have access to cell phones than to toilets. It will also bring profound dislocations.

Specific predictions are usually wrong, but it’s safe to say that profound transformations are upon us. They are catching us by surprise because they are growing exponentially, and partly because they’re converging. Talking to my Xbox seemed pretty cool last year. Now, a few months later, my old Xbox conversations seem, well, kind of quaint.

Allowing the good and mitigating the bad is the most important challenge facing government, including financial policymakers. That’s why, for financial services, I’m working on finding new ideas for how to do it.

If you want more food for thought, buy fintech guru Brett King’s book Augmented.

Meanwhile, much as I love my high-tech helpers, they’re nothing compared to my human ones. My work relies on an amazing team of young people who support it part-time. Here they are:

Harvard research assistant on my book:                      Amrita Vir
Podcast show notes:                                                    Jane Hencrickson and Rachel Cossar
Social media strategy:                                                  Rachel Cossar
Tech support, strategy and podcast/video editing:    Matt Van Buskirk
Making it all work:                                                         Katherine Foote        

They are the greatest.

Second Teaser to my New Video Series : The Five Tech Trends

Regulation Innovation / Briefing 1: The Five Tech Trends

The first thing to understand about fintech is that it is far more about “tech” than “fin.” Financial people tend to underestimate the size and speed of the coming change, simply because the forces driving it are mostly developing outside their field of vision -- in the technology world, not in finance. These massive innovations are essentially traveling through the financial realm, creating and altering financial products and channels in the process. Like all technology change, moreover, these shifts are global.

Their technology roots have many implications, including that regulatory responses will be shaped heavily by regulators other than the ones overseeing banking and finance.

The second thing to understand about these trends is that each is an enormous force in itself, but still looks deceptively small because the technologies are also converging. Most innovators are already leveraging several of them (which is one reason some fintech is radically breaking old molds). As they continue to merge, they will spark explosive change.

Regulation Innovation, accordingly, starts with examining the Five Tech Trends.

Trend 1: Big Data

Big data is the proliferating information being generated by our modern digitized lives. For consumers, it includes information gleaned about our buying habits, entertainment preferences, and social media activities. It also includes geolocation data gathered by location-aware devices like our phones and cars.

Another source is information gathered by the expanding use of cameras, large and small that use facial recognition technology. These can identify who and where we are and can assess our reaction to what we’re hearing or seeing – such as whether we frown or smile as we look at merchandise in a store. Here’s more on facial recognition.

Another enormous category is the burgeoning Internet of Things, or IOT – the interconnections between all the little computers embedded in devices surrounding us. These range from smart thermostats and baby monitors to electronic keys and cameras, to electronic scales and fitness trackers. We will soon have smart refrigerators and washing machines that automatically order resupplies when, say, the milk or detergent is running low. These devices have the ability to map intricate and voluminous data about our tastes, movements, associations and lifestyles.

In addition, government is contributing to the big data revolution by digitizing records. In finance, examples are the CFPB’s databases on consumer complaints and the Home Mortgage Disclosure Act. These have been designed to use “application program interface”, or API, capability, to make it easy for third parties to acquire and work with the data. While data like HMDA information is old, it can now be combined with other proliferating and detailed big data, boosting the power of all of it. The same trend is underway at all levels of government, from accessibility of property titles to records of birth, death, marriage and divorce. The Obama Administration views federal records as a national resource that should be available for public use to the extent consistent with protecting privacy. Such steps are creating explosive growth in the amounts and types of available data.

As discussed below, big data is driving toward financial inclusion by making it possible to know more about individual consumers and thereby fine-tune risk assessment and underwriting.

Still, big data is problematic simply because it’s so big. That brings us to the second trend.

Trend 2: Artificial Intelligence

Big data differs fundamentally from the information traditionally collected by financial companies. Unlike credit scores, verified customer information, or a bank’s own information on its customers, big data sources are massive and messy. Information is often inaccurate – it’s typically collected for reasons that don’t require accuracy at the individual level. Furthermore, the information is lodged in databases that don’t easily connect.

However, we are learning to put this new data to work through artificial intelligence, or AI. The terms“machine learning,” “deep learning,” and “neural networks” all refer to the ability of computers not only to amass and process information efficiently, but actually to learn -- to think. Today’s machines solve complex problems through rapid, powerful trial and error and pattern recognition. Some have the capacity to search, quickly, all the digitized information in the world (which, as noted above, is skyrocketing in volume).  Here is an excellent Wired Magazine article on how machine learning is changing our lives.

For example, we now have computers that not only can diagnose cancer by accurately reading radiology reports, but that have also noticed attributes of tissue outside the malignancies they were analyzing and pointed out important patterns that scientists had not even asked them to look for. In finance, an example is Goldman Sachs’ Kensho, which can answer thousands of complex “what if?” questions from investors and brokers, in simple text, in seconds (for instance, what would happen to homebuilding stocks if a category 5 hurricane hit the U.S. mainland?).

For a quick, fascinating look at AI, see these images of Google’s photo-search computers “dreaming.” After the engineers stopped feeding information to them, they continued to “think” about what they had “seen,” and this is what was on their minds….

The use of new data analysis in financial services raises complex public policy challenges. Again, these trends are a massive force driving toward more financial inclusion, because alternative data and analytics can assess the risk profiles of consumers who have thin or no credit files or complex credit situations. These applicants are typically rejected in today’s systems, but may in fact be creditworthy. In some ways, new technology offers a 21st century, high-tech version of the kind of traditional banking where the banker personally knows a customer well enough to make a sound loan despite problematic circumstances. That system works well on a small scale and for borrowers fortunate enough to have such a banking relationship -- which, of course, many people do not. More data and better data analysis can open up a semblance of such nuanced evaluation on a larger scale.

On the other hand, regulators of course worry about new models that have not yet been tested through an economic downturn, especially given the failure of credit risk modeling in the financial crisis. Policymakers also have concerns about fair lending issues arising from new data uses, including disparate impact risk. In addition, new collection and uses of data raise concerns about privacy and cybersecurity.

Most banks do not yet employ these techniques, partly due to the regulatory uncertainties around them. However, many fintech companies do. As new data methods become refined, they may tend to give a competitive edge to innovators using them over companies that don’t, simply by enabling more sound and profitable lending decisions. For community banks seeking to grow, alternative data could make broader markets reachable. We may also reach a point where financial companies will be penalized for not using big data analytics, if it in fact proves to be both highly inclusive and predictive. Future videos and briefings will explore all these issues at the intersection of regulation and innovation.

 AI carries profound questions for the future. Many dramatic predictions about it have not yet proven out, but it seems clear that big change is coming and accelerating, and could profoundly change the human experience. One scenario is depicted in the movie Her, about a human-like, voice-only operating system -- with its startling final plot twist. This year Microsoft withdrew a new AI-basedchatbot (talk robot) named Tay after one day, because she had “learned” abhorrent views through her online conversations. People also worry about (or hope for) the evolution of trans-human technology like enhanced eyesight (watch for author Brett King’s upcoming book, Augmented). The growth of AI could reach a point that Vernor Vinge in 1993 called the singularity, in which computers with superhuman intelligence could create change as significant as the rise of human life itself. Ray Kurzweil, who received the National Medal of Technology and Innovation in 1999, has written The Singularity Is Near, predicting that humans will eventually transcend the limitations imposed by our physical bodies and brains.

Here is one of my favorite Ted Talks, by Jeremy Howard, on “the wonderful and terrible implications of computers that can learn.” He shows how computers can “see” and “listen;” can learn to recognize pictures and words; can “write;” and can collaborate with humans. He gives insights into how Google search can find information for us so instantly and accurately. He also addresses the daunting implications of all this for society. It’s my top background link for this briefing.

Natural Voice Technology

I believe voice technology will close the last mile of financial access for millions of people who have difficulty using today’s standard product forms and channels. Many people don’t understand (or are frankly bored by) financial information as normally presented. Voice tools can change that.

We already have sophisticated voice technology. Products like Dragon Dictation can instantly translate voice to text and vice versa, while other tools can translate one language to another, even mimicking the voice of each speaker. If you didn’t watch the Jeremy Howard TedTalk above, watch it now. At about 4:30, he demonstrates machine learning translating his own talk into Chinese. And watch this wonderful demonstration of schoolchildren using Microsoft Translator to communicate.

Many of us already use Siri, Apple’s voice assistant on our IPhones, to dial phone calls, make restaurant reservations, report the weather, or set up reminders and shopping lists. You can ask Siri fact questions. If you ask, “who is Bill Gates?” she’ll send a Wikipedia article to your phone and ask if you want her to read it to you. You can say, “Find pictures of polar bears,” and she’ll find them.

The same is true of Microsoft’s Cortana. I was in a hotel room last fall and she suddenly activated on my laptop. I said, “Cortana, what are you doing?” She said, “I’m working out the mechanics of a virtual fist bump.”

Here’s a blog post I wrote about my wonky week of getting Cortana, Google Photo, and an Apple Watch all within a few days, and being amazed as they all began doing things for me, often at their own initiative (technology taking the initiative is another theme we’ll explore, as is fintech’s playful use of humor). It was especially impressive that they sometimes cooperated – even though they come from three different companies.

And now, we have the Echo – Alexa -- Amazon’s new voice-only personal assistant. As I write this, she is sitting on my kitchen island where she does things like reports the weather, adjusts the lights or thermostat, and reads me the news. I’m going to say, now, “Alexa, tell me a joke.”

Here’s her answer: “What did one flag say to the other? Nothing, it just waved.”

An important thing about Alexa is that it has no way to interface with us, except voice. There’s no keyboard, no screen to touch. This Wired Magazine article is thought-provoking about the importance of this. It discusses the potential for voice interface to mirror the power that Steve Jobs recognized when he first saw the graphical user interface, or GUI, and knew that touchscreens would be the future of computers. The article predicts that the voice interface will bring technology to millions of people currently at or outside the margins of access (including the twenty million people in the U.S. who cannot see).

Importantly, voice technology “unlayers” information and brings it instantly to the top. Suppose you need your bank routing number. Instead of looking it up, you can have your voice assistant simply read it to you. Alexa is new, but Capital One has already created a banking app for it.

For a mindboggling demonstration of what voice interaction can already do, watch this demonstration of Soundhound’s Hound (be sure to stay for the financial questions near the end).

The power of voice will magnify as it converges with big data, AI and, as discussed below in Trend 5, mobile. It will put a personalized, smart, interactive, helpful financial coach, equipped with a supercomputer, in all of our phones.

Trend 4: Digital Currency and Blockchain

The blockchain was created by the anonymous inventor of Bitcoin. Also called “distributed ledger technology,” or DLT, it is a record of a chain of transactions, posted on the internet in a manner that’s transparent, unbreakable, and unfakeable. Because it’s on the internet, the information moves almost instantly and at nearly no cost.

The initial driver for its creation was a desire to make Bitcoin an alternative currency. Given Bitcoin’s colorful early scandals involving drug trafficking and fraud, the mainstream financial world originally tended to dismiss it. However, the ingenious design of the distributed ledger is now inspiring a profusion of innovation aimed at using it to transform many systems and to change our lives.

Given its roots in Bitcoin, blockchain technology has focused initially on changing finance. Innovators are applying it to models that range from being a “currency” -- “digital currency” or “crypto-currency” -- to an investment, to a new or enhanced payments infrastructure. Hundreds of innovators are putting it to use in payments -- seeking to wring nearly all the expense and delay out of them and essentially do for money what the internet did for information by making it instant, free, and shareable with anyone. (We’ll discuss some of these emerging models in the next briefing, Meet the Innovators.)

In addition, central banks in the U.S. and throughout the world are exploring the possible benefits, and risks, of creating government-issued digital currency. Governments and payments clearinghouse systems are also evaluating ways to streamline and accelerate central payments systems.

Beyond finance, blockchain solutions for other use cases arise almost daily – thousands of companies are working on them. These include recording legal titles and contracts, redesigning stock markets, and organizing complex flows of operations to strip out complexity, cost and delay from activities like large bank information and processing systems.

The U.K. Office for Science has produced an especially interesting report on the potential for distributed ledgers and the regulatory opportunities and issues arising from them. It begins by saying:

The progress of mankind is marked by the rise of new technologies and the human ingenuity they unlock…(We may be) witnessing one of those potential explosions of creative potential that catalyse exceptional levels of innovation. The technology could prove to have the capacity to deliver a new kind of trust to a wide range of services. As we have seen open data revolutionise the citizen’s relationship with the state, so may the visibility in these technologies reform our financial markets, supply chains, consumer and business-to-business services, and publicly-held registers.

The same report says, “(Distributed ledger technologies) have the potential to disrupt the whole economy, and society.”

The report’s reference to trust is critical, as blockchains make it possible to engage confidently in transactions with people we don’t know, without the help of mutually trusted intermediaries and without traditional contracts. The trust is built, efficiently, into the technology itself.

The blockchain is yet another technology that drives toward financial inclusion. Digital financial access is rising worldwide, especially in the developing world where (as discussed below) cell phones will soon be ubiquitous. The low cost of executing financial transactions on the internet is likely to disrupt the remittance industry. This efficiency, combined with the fact that digital currencies are almost infinitely divisible, will also make it economically viable to process micro-payments. People will be able to send and receive a few cents, opening up enterprise in the developing world and generating whole new business models everywhere.

In addition, real-time settlement of financial transactions can remove one of the factors that drives consumers into high-priced cash and payday lending services, namely the inability, today, to know when a check or electronic payment will clear.

Here is my blog post on the consumer benefits of Bitcoin.

This area, like the others, will raise enormous regulatory challenges that we’ll explore in later briefings.

Trend 5: Online & Mobile

Financial services have been online for years – a majority of banking is now done there. What’s new, today, is the successful advent of innovative business models delivering services entirely or mostly online, capturing enormous efficiencies compared with traditional branch-based infrastructure. Many also use very sophisticated data analytics and offer a markedly superior online user experience, or UX -- typically because they’ve been designed by technology people, rather than financial people. Some of these companies hope to change finance in the same way Amazon changed bookstores and retailing.

Among the online players, there is particular interest in “marketplace” lending (formerly called peer-to-peer lending) that matches borrowers and investors online. We’ll explore more about this in the next briefing on “Meet the Innovators.”

Even more innovative than online services, though, is mobile technology – it may, in fact, be the most revolutionary of all the five trends.

Financial people tend to think of mobile as being about payments, but finance is a tiny fraction of the change underway. We are seeing a fundamental reshaping of how we live, a shift potentially on the scale of the invention of money itself, or agriculture, or electricity or the internal combustion engine.

The smart phone has become a layer, an interface, between the individual and nearly everything in the world. It mediates what comes in to us, and what goes out. It is reshaping communication, relationships, social norms, information, education, entertainment, work, commerce, shopping, buying, selling, creativity, health and fitness, time-management and nearly everything else. People use the phone for self-expression, to share music, to share humor. They use it to seek advice. They use it to compare prices. They use it to track calories and monitor exercise. There is almost no realm of human life not being altered by it – people even use it to guide prayer. When the phone is converted to a watch or other wearable, it takes on additional capabilities.

This has huge implication for finance. One is mobile payments -- a topic we’ll explore extensively in the series. Beyond that, the phone will leverage all the five technology trends to become a single, powerful financial tool. It will consolidate all our financial information in one place; use that automatically and painlessly to build budgets; organize and handle payments; use behavioral economics to nudge us toward goals and away from financially damaging temptation; enable effortless saving and reinforce it by entertaining us with amusing text messages; block out dangerous products; and become our financial coach – eventually by voice.

Again, all the new technologies are converging in the phone. Since it knows where we are, it can alert us as we walk toward Starbucks if our budget can’t afford a latte today. It can remind a hurried mom with fidgety children to hold spending at the grocery story to hold to the $75 she can afford. If we overspend, it can recalculate and help us monitor a reduced daily budget. It can find the best choice of a credit card or car loan or mortgage and explain why. It also take the initiative to help – for instance, offering to talk about a retirement plan, for someone who doesn’t know how to start or where to turn.

It will also address the widespread failure of financial literacy education. Josh Reich, founder of Simple, points that when the automobile was invented, people couldn’t drive without understanding how it worked. Then we got automatic transmissions, and now most people can operate a car with no idea of what’s under the hood. (And now we’re even going to have driverless cars). Finance will go through the same transformation. After a century of U.S. federal policy fostering “financial literacy,” only a tiny percentage of people understand finance. Today’s technology, though, can help people build healthy financial lives without sophisticated knowledge, by using tools that deliver helpful information, right when it’s needed. The phone education can be customized, and can be made interesting and even enjoyable.

Smart phones will also put financial comparison tools in everyone’s pockets. These have already emerged, but big data and AI will massively enhance them and build them conveniently into the phone, synthesizing fast-growing data on consumer reviews and complaint scores, as with Yelp, Open Table or Trip Advisor. (Amazon already lets customers rate its credit card on the product page, just like a TV or a pair of socks.)

Even more profoundly, the financial coach in the phone can eventually flat-out prevent poor decisions by screening out products with hidden adverse terms, whether the person fully understands them, or not. This mimics the medical concept of a “smart membrane,” letting in the good and blocking out the bad.

Think about it this way: the new technology means that businesses will know everything about us, and we will also know everything about them.

Most importantly, cell phones are the most democratizing force in the history of finance. They can deliver services to almost everyone, everywhere, at very low cost. In the United States, they are disproportionately highly used by lower-income and minority consumers, including for financial tasks (partly because many of these households never adopted more expensive PC-based banking.) A 2015 Federal Reserve study found:

Mobile phones are prevalent among unbanked and underbanked consumers. —The share of consumers who are unbanked is 13 percent, and the share who are underbanked is 14 percent. —Sixty-seven percent of the unbanked have access to a mobile phone, 65 percent of which are smartphones. —Ninety percent of the underbanked have access to a mobile phone, 73 percent of which are smartphones. —Forty-eight percent of underbanked consumers had used mobile banking in the 12 months prior to the survey.

People have phones. They know how to use them. They already use them for financial tasks. As more financial tools come into the phone, people’s lives will be transformed.

Outside the United States, cell phones are even more ubiquitous, because many parts of the world never had landlines and so adopted mobile earlier. More people in the world have access to cell phones than to toilets. Governments, NGO’s and businesses worldwide are rapidly building a global population that has full access to digital financial services. The relative American slowness on mobile is creating disadvantages for the U.S. in ways we will explore in the series.

One more note on demographics. Millennials are now the largest generation in the history of the world, in the U.S. and worldwide. In 2015 they surpassed the Baby Boomers, who will henceforth decline sharply as a percentage of population. Just as the boomers did when their numbers surged, the millennials are already exerting an outsized influence on the culture and the economy. Their preferences, including for mobile services and fast, easy transactions, will reshape finance.

Those are the five tech trends driving financial innovation: 1) big data, 2) artificial intelligence, 3) natural voice technology, 4) the blockchain, and 5) online and, especially, mobile. Again, each is huge, but they are also converging. (Check out my bonus video, Why Does Jo Ann Barefoot Have An Xbox (since she’s never played a videogame in her entire life?  It explains that four of the five tech trends have already converged in my own living room, in my Xbox.)

Nodes of innovation in each of these trends will increasingly connect with the others. Most innovators are already leveraging several of these technologies at once, and will add more. When big data combines with machine learning, and creates services delivered through voice-based consumer help, modernized by the blockchain, and delivered through the smart phone, everything changes.

Each of these trends, and all of them in combination, will raise enormous regulatory challenges – most of which will cause permanent uncertainty about regulatory standards and expectations. We will examine these in Video 3, Meet the Regulators and discuss how to integrate them into a strategy for regulation innovation.

Suggested Action Steps:

• Have your innovation team assess your company’s use of alternative data and analytics
• Have it assess your company’s strategy for mobile services, and especially how it rates with millennial customers (hint: ask your young employees)
• Register innovation team members for a tech-focused conference like Emerge, Money 20/20, LendIt, Finnovate, or SXSW – SouthBySouthwest(I’ll be speaking at many of them)
• Subscribe to Barefoot Innovation, my free podcasts
• Watch for the next video and briefing, where we will Meet the Innovators who are leveraging all this technology to transform finance

And of course - SUBSCRIBE HERE

First Teaser to my New Video Series

Welcome to my video briefing series, Regulation Innovation -- Thriving on disruption.

Each video comes with a fuller written briefing that includes background resources. The series is designed to build over time, as a journey. You can start anywhere, but watch them all. 

Please share the videos in meetings, and circulate the briefings throughout your organization. And I hope you enjoy the little bonus videos offering my light-hearted take on some of these issues.

Here is my briefing on the introduction to the series.

Why fintech matters:  What is it, and why is it so disruptive?

Before exploring precisely why regulation and innovation are two sides of the same challenge, let’s look quickly at what’s happening (later briefings will go in depth on these topics).

Fintech is innovation that applies new technologies to financial services and channels to make them faster, cheaper, clearer, more manageable, more user-friendly and/or more engaging and fun (yes, fun). It includes online and marketplace lending; digital currencyand real-time payments; efforts to “uberbize” payments by making them disappear into the consumer experience; “robo-investing;” emerging “insure-tech;” and a vast array of personal financial management, or “PFM” solutions (usually mobile apps). The latter do things like smooth out financial volatility, make savings easy, organize bill-paying, and enable bill-sharing. The term sometimes also includes “reg-tech” that seeks to simplify compliance. 

They all leverage some combination of emerging technologies (usually several at once), including big data, powerful data analytics, natural voice technology, the blockchain, and the smart mobile phone, all of which we’ll explore in the series.

Broadly speaking, fintech innovators are trying to do these things:

• Identify everything that bothers people about traditional finance, and fix it
• Find additional things people don’t even realize bother them about today’s financial markets, and fix those too (just as Uber has solved problems we didn’t know we had until Uber removed them, like having to pay at the end of a taxi ride)
• Wring every possible cost out of delivering financial services, through mobile channels, new uses of data, blockchain technology, and leveraging the newcomers’ clean-slate edge over banks’ old legacy IT systems.
• Find broader markets and make financial services more inclusive, again, using mobile delivery and alternative data.
• Usually, make products simpler and more transparent
• Help consumers manage their own financial lives better, with easier and more powerful tools and by more actively engaging consumers through use of behavioral science and nontraditional methods like playfulness.

Their thinking reflects “blue ocean strategy” – growing not by competing with incumbents in a zero-sum “red ocean” game, but rather creating whole new markets through innovation that will simultaneously raise value to customers and cut costs for providers.

The new technologies, themselves, are neither “good” nor “bad.” They’re just powerful -- often mold-breaking. Similarly, innovators’ motives may or may not be “good” – they range from idealism to straightforward profit goals. In general, though, the innovators believe they can sharply improve on traditional financial offerings. Some hope to do so by replacing parts of today’s financial industries. Some hope to sell to today’s incumbents. Many hope to partner with them.

These changes are highly disruptive. The Financial Times reports the Bank of England’s Andrew Haldane as saying (“astonishingly”) that the unit cost of US financial intermediation seems to be unaltered over a century. Innovators plan to change that, and a great deal more, through technology, in the same pattern seen in so many other sectors.

More than any other sector, however, financial services are pervasively regulated. This means inevitably that the impacts will disrupt not only the industry, but its regulatory framework as well.

As a result, the technology changes ahead will create enormous regulatory shifts. The industry will have to create entirely new ways to manage both the innovation and the regulation, together.

How are regulation and innovation intertwined?

The top two existential challenges facing nearly every financial company today are, first, regulation, and second, disruptive innovation. Most people view regulation and innovation as very different topics – like oil and water – but they actually are intricately intertwined. Neither can be gotten right unless they are addressed together. Here’s why.

First, regulators and disruptive innovators are often attacking the same things about traditional consumer finance. They’re both finding every place where the industry’s current business models benefit (knowingly or not) from customer confusion or inertia about complex products and pricing, and where old delivery channels and legacy IT create high costs, errors, or lack of access. Obviously regulators and innovators have different motives and tools, but they have locked in on the same vulnerabilities. For traditional companies, it’s a pincer attack. 

An example is bank overdraft protection fees. Most banks know the CFPB plans to issue new rules on these.  Many don’t realize, though, that innovators are meanwhile inventing products to keep consumers from needing to overdraw. Attracted by the revenue potential in the estimated $30 billion consumers pay in annual overdraft fees, they are aiming to create affordable and convenient alternatives (watch for Briefing 2 in our series, Meet the Innovators.) Similar dual assaults target payday lending and many other areas.

Second, regulation and innovation have both pushed financial services into a state of permanent uncertainty, impossible to manage with traditional tools. 
 

For innovation, the permanent uncertainty arises from the fast pace of change and the mold-breaking nature of new technology (which we’ll explore extensively in the series).
For consumer protection regulation, the uncertainty is fueled by a huge shift from rules-based to principles-based oversight. Most financial companies sense this but have not grasped its profound ramifications, maybe because the regulators have not formally articulated it.

One driver for the regulatory transition is that the financial crisis revealed massive failures in our traditional federal policy of using prescriptive rules and disclosures to protect consumers. While detailed rules will still loom large, they are already a shrinking share of regulatory risk, overshadowed by a rapidly rising focus on broad principles. Regulators have massive discretionary powers to punish unfair, deceptive and abusive practices (UDAAP), and credit discrimination, including unintentional patterns of statistical “disparate impact.” These are the tools they will increasingly rely upon, as innovation undermines policymakers’ ability to keep technical rules up to date. 
 
Principles-based regulation is inherently subjective, and therefore uncertain. While the post-crisis industry has established compliance programs for UDAAP, few have infused all decision-making with robust thinking about the emerging principles dominating regulatory risk. Companies must move beyond compliance models geared to reactive implementation of rules, and create new ones that work proactively in the absence of clear regulatory guidance. 

This means financial companies must learn to think for themselves about these principles, in order to predict and plan for unknowable regulatory reactions as technology changes the industry. They must also learn to predict coming innovation trends, and build compliance systems able to accommodate them efficiently and effectively. 

Rapid change will make this difficult. Here are “9 Dangerous Words” reflecting the challenge.

Third, regulation and innovation continuously reshape each other. Innovators introduce new products and channels; regulators respond with rules and principles and with oversight and enforcement; then innovators respond to those; and the spiral goes on – ever-accelerating and permanently interlocked.

Fourth, the high costs of regulation and innovation can only be optimized together.Companies that don’t invest enough in either area face enormous risks. Banks are spending 70-80% of their IT budgets on compliance, leaving scant resources for technology innovation. Fortunately, though, approaching the two challenges holistically can cut their combined costs. Updating legacy IT systems will solve tremendous problems in both realms, as will using new and better data and data analytics. Similarly, “reg-tech” solutions are emerging to make regulation easier, but again, only for institutions that connect both sets of challenges. Future videos in the series will explore how to do so.

Fifth, the path to innovation will be easier for companies that win regulators’ “trust.”Again, disruption of the industry will disrupt the regulatory system too. Agencies will face rapid and unmanageable change and critical decisions about what innovations to permit, and by whom.

Those decisions will be difficult, since the innovation underway will inevitably create risks to both consumers and the financial system, even as it generates benefits. Regulatory challenges will include protecting privacy and data security, assuring “fairness” in new uses of data, and updating disclosures for mobile and voice-based services. Consumers will be exposed to harm from well-meant but unfamiliar technology. And while most innovators are trying to create pro-consumer options, some will channels these new technologies into manipulative or predatory uses. Our fractured and bank-centric regulatory framework will also be mismatched with the industry’s changing competitive structure, especially regarding nonbanks. 

All these issues will be discussed in Video 3: Meet the Regulators. Their combined impact will be to give an edge to companies that regulators can trust to have both compliance strength and committed innovation strategies aligned with the regulatory principles of customer fairness and business soundness. The banks that are best at this will have an advantage in pursuing new ways to both partner and compete with innovators. Banks with weak and rules-based compliance systems will discover these have become a strategic barrier to competitiveness.

Here’s the good news: the interconnectedness of regulation and innovation will enablecompanies to reduce risks in both realms together. For most banks, vulnerabilities on regulation and innovation are lodged in the very same places – in legacy IT systems, old ways of using data, and outdated profit and compensation models and cultures. This means that fixing one, can help fix the other -- equipping companies to thrive on disruption.

Exponential change

Tackling the twin challenges of regulation and innovation is urgent, because the industry is evolving so fast. Accenture reports that global investment in fintech increased 75% in 2015, reaching $22.3 billion. After a late-year lull, it surged 67% in the first quarter of 2016. The U.S. saw 667 fintech investment deals in 2015, up 16%, while North American investment rose 44%, to $14.8 billion. A McKinsey study finds over 12,000 fintech firms invading every aspect of bank activity and predicts that the innovators could win up to 60% of traditional bank revenues in the next decade.

The change underway is exponential, driven by the phenomenon that Gordon Moore accurately predicted in the 1970’s, called “Moore’s Law” --  that computing power will double every two years. 

By its nature, exponential change masks the magnitude of what’s ahead because the transformation will hit quickly. Imagine, for example, that someone has a pond on which lily pads start to spread at a rate that doubles every day. Suppose that, on day 30, the owner realizes the water is half covered and starts pondering how to respond. 

The next day, this owner will find the pond completely covered. What took 30 days to reach fifty percent, takes only one day to reach one hundred.

Moore’s Law means that in five years, computing power will be 32 times more advanced. In ten years, it will be a thousand times more advanced. In twenty years, a million times. In fifty years, a quadrillion times. As computing power grows, technology change will accelerate with it, transforming every aspect of life. Here’s just one example:  imagine a world in which computing capacity is not finite and costly, but rather limitless and cheap – for everyone. The possibilities are breathtaking.
  
We’re living now on the steep part of this curve, using brains and institutions wired for linear change. The challenges we feel today will only intensify.

I highly recommend reading this thought-provoking post by Niv Dror on exponential change.

Reading before the next video:

• Here’s an article I wrote for Forbes on how fintech will disrupt finance and financial regulation.
• Here is a Q&A discussion I developed for Women in Housing & Finance’s 2016 fintech symposium, which teases out many of the keys to understanding it. 

Suggested Action Steps:

• Share this article with your team
• Form an innovation task force that deeply integrates innovation and regulation (include & empower young employees as part of it)
• Begin to educate the team on fintech innovation and assess the challenges likely to arise
• Come back next time for Briefing 1: “The Five Tech Trends,” to understand the five huge, converging technologies that are driving disruption.

 
Which is not like the others? 
Legislation, litigation, regulation…innovation

FOR ACCESS TO FUTURE CONTENT PLEASE SUBSCRIBE HERE and visit www.regulationinnovation.com

Guest Blogger: Amrita Vir on Millennials and Privacy

This is our first post by a guest blogger, and a very special one. Most of our readers know I’m at Harvard this year as a Senior Fellow in the Kennedy School’s Center for Business & Government, working on a book on financial innovation and regulation. I’ve been extremely fortunate to have a very talented graduate student, Amrita Vir, as my research assistant. Amrita is a candidate for dual MBA and Master of Public Policy degrees here at Harvard. She’s from Texas, a graduate of Southern Methodist University, and former consultant who has traveled extensively throughout the world.

One day last fall we were brainstorming about the book, and she told me a story illustrating how millennials think about privacy. I asked her to write it up and, even though our Boston springtime has now made her account slightly out of date, I’m sharing it with you as food for thought.

-- Jo Ann

Boots Anecdote, by Amrita Vir
 

I recently moved to the Northeast from Texas, and the weather is a little different here. By that, I mean it snows here, and I am inadequately prepared. Last week, I was browsing through Amazon to try to find a pair of boots that were both impervious to snow and aesthetically pleasing. This was a difficult task, but I finally settled on a pair of maroon Sorel’s that looked pretty acceptable.

And then I got distracted doing schoolwork and completely forgot about the boots. I blame the over-consumption of information for my ADD.

Anyway. A couple of days later, I picked up my boot-shopping task. I spent a good thirty minutes digging through Amazon trying to find those boots, but they were nowhere to be found. How on earth was I going to find these boots again?

And then I thought to myself – who knew that I lingered too long on that Amazon page? Who would know that I really wanted to buy those boots? Who knew that I got distracted and unintentionally lost the page in the Internet cosmos?

…FACEBOOK!  

So I popped open a new tab, typed in facebook.com, and scrolled down until I reached the ads. Alas, there they were. My maroon Sorel’s were right there, ready to be ordered and delivered with my Prime delivery service two days later.

You see what just happened there? Apparently, I have so much faith in the magical powers of the Internet that his was the most logical course of action for me. I don’t think twice about the fact that not only did Amazon collect data on my movements on their site, but that Facebook somehow got ahold of it and used it to push ads in my direction. There is probably some price discrimination that comes with knowing my online shopping habits and history (if you saw my Amazon account, you would know that I’m a sucker for shoes, and this is also an example of me being a very easy target).

What does it say about me and my generation that not only am I completely desensitized to the fact that these companies are collecting my data and using it to manipulate my consumption? What does it mean that I not only anticipated it, but sought the outcome of this behavior in the form of a Facebook ad? Is this representative of a broader outlook on privacy and the ways in which we choose to engage with our technology?

In talking to Jo Ann, I realized that this is perhaps a generational viewpoint. Quite naively, I asked her exactly *why* people get so bent out of shape over privacy on the Internet. I guess I don’t see what the big deal is about the government or the private sector looking at my information, so long as they’re not using it against me. Don’t get me wrong, I want transparency about who is taking what information, but I don’t really mind anyone using it – especially in aggregate form and especially if it is ultimately helping me out – like helping me find my snow boots.

Maybe I’m shameless or desensitized or jaded. Or maybe I’m just a product of a generation that does not know how to define privacy anymore, or at least does not place the same value on it as generations past.

Fintech Q&A in Washington

I spoke this month at the annual Symposium of Women in Housing & Finance in Washington, DC. This year’s topic was fintech and was well-timed, since the OCC had just issued its White Paper on Responsible Innovation. In my session, I talked with OCC Chief Counsel Amy Friend, who has chaired the innovation task force, about their plans.

Before the conference, WHF asked me to help them create a Q&A document for the program. I’d agreed, thinking I could dash off a few quick sentences on each item.  As I worked on them, though, I found the questions (prepared by the OCC) to be exceptionally thought-provoking. The more I wrote, the more they clarified my own thinking -- even though I’m speaking and writing on these subjects every day.

So, I’m sharing them with you. 

Meanwhile, if you’re in the DC area, join WHF for great events and networking!
 

"A Q&A with FinTech Expert Jo Ann Barefoot"

Ahead of the 2016 Symposium, WHF interviewed Jo Ann Barefoot, CEO of the Jo Ann Barefoot Group, LLC which advises on financial technology and regulation. Jo Ann previously served as Deputy Comptroller of the Currency and served for three years on the Consumer Advisory Board of the Consumer Financial Protection Bureau.

WHF: How would you define FinTech and what are some emerging products/services in the FinTech industry?

Barefoot: FinTech is innovation that applies new technologies to financial services and channels with the goal of making them faster, cheaper, clearer, more manageable and/or more user-friendly. In my view, they are more “tech” than “fin.” For that reason, the financial world is tending to underestimate the scale and speed of the coming change, because most of the change is happening in the technology world rather than in finance. It’s developing outside the field of vision of most financial people.

Emerging products and services take many forms. They include online lending; “marketplace” or peer-to-peer lending that matches borrowers and lenders online; payments innovations like digital currency and the “blockchain” and efforts to “uberize” payments by making them disappear into the consumer experience; “robo-investing” that automates investment management; and a vast array of mobile solutions that aim to solve a spectrum of consumer problems, from providing short-term cash, to making savings easy, to helping people manage their finances in new, engaging ways through personal financial managementtools, or “PFM.”

The five main technologies being leveraged are big data; artificial intelligence and “machine learning;” natural voice technology; digital currency and the blockchain; and online and especially mobile. Importantly, most FinTech innovators are applying more than one of these. Just as Uber disrupted both the taxi industry and traditional payment processes, FinTech companies are trying to break category walls by combining, say, sophisticated new data analytics with mobile delivery channels.

WHF: Why are regulators turning their attention to the FinTech industry now?

Barefoot: The regulators are recognizing that these technologies are rapidly disrupting financial services and call for updated regulatory thinking. Financial services are by far the most pervasively regulated sector to undergo disruption, which inevitably means that the changes ahead will disrupt the regulatory framework too. The agencies face a range of challenges. One is the sheer speed of change, which is dramatically mismatched with the normal pace of regulatory action. A related issue is that traditional regulatory processes don’t easily lend themselves to ongoing collaborative dialogue, which will probably be needed to foster the “rapid learning” regulators will need to keep up with new developments. These forces are likely to push the regulators toward more use of principles-based, rather than rules-based strategies, because the market will change too fast for rules to stay current.

In terms of consumer impacts, the agencies are increasingly recognizing that regulatory actions could inadvertently undermine desirable innovation. For instance, Federal Reserve research has shown that lower-income and minority consumers are disproportionately high users of smart phones.  Mobile fintech creates an unprecedented opportunity to reach millions of consumers with more affordable products than has ever been possible before. Similarly, alternative Big Data and analytics are making it possible to make finance more inclusive by reaching more customers with “thin” or no credit files or complex credit histories. Robo-investing, too, expands the affordability of investment advice. Digital currency, meanwhile, is speeding up payments, which can reduce the difficulty of paying bills for consumers who have no financial cushion and currently rely heavily on cash to be sure their payments are credited on time.

On the other hand, the agencies also see fast-emerging new consumer risks from FinTech. These range from loss of privacy and cybersecurity, to likely increases in branch closings, to fairness and discrimination questions arising from use of alternative big data to evaluate credit worthiness.

Beyond these issues, regulators are concerned about the impacts of FinTech on the overall financial system. They are looking at risks to banks from adopting new technologies that have not been tested by time and the business cycle. They are working on how best to allow banks to partner with innovators, while assuring protection of the bank and its customers. They need to worry about whether regulatory burdens on banks will cause them to lose ground to nonbanks. They are also grappling with how to regulate a fast-growing and diverse nonbank industry that will include players ranging from “big tech” firms like Facebook and Amazon to legions of small startups. At the federal level, we have a bank-centric financial regulatory system, confronting an increasingly diverse nonbank marketplace. At the state level, regulators are working on equipping themselves to evaluate license applications and to oversee novel kinds of companies and to consider the challenges involved in enabling nonbank innovators to reach scale.

Regulators are also exploring how best to work together.  These issues impact our five federal agencies that directly supervise financial institutions, as well as agencies ranging from the FTC (which generally leads in privacy matters) to FINRA to the SEC. Coordination will be important.

WHF: You have used the term “Regulation Innovation” in the past. What does this mean and don’t the two words oppose each other?

Barefoot: I use the phrase “Regulation Innovation” partly because, as you say, it seems incongruent – it startles people! I think the most important thing for banks to recognize is that they are facing two overwhelming strategic challenges. One is regulation. The other is innovation. Today, banks manage these as separate issues, with different people and tools. In reality, though, the two are deeply intertwined, because the same weakness cause vulnerability in both realms.

A critical point is that consumer protection regulators and disruptive innovators are targeting the same aspects of traditional consumer finance. They are both identifying places where the provider benefits – knowingly or not -- from the customer’s confusion, inertia, or lack of financial education, or where pricing is high due to legacy structures and compensation arrangements. It’s like a pincer attack, from two directions at once. Examples include overdraft protection by banks and payday lending. The industry knows that regulators are reviewing these, but may not realize that innovators are attacking them too.  The more profitable a product or practice is, the more likely it is that innovators are aiming to compete with it.

Regulation and innovation are also connected in that both have entered a stage of permanent uncertainty. This may be obvious regarding innovation, but it’s also true of regulation. Change is coming so fast the regulatory clarity will lag behind. The traditional compliance model of waiting for regulators to provide rules and then implementing them will need to be remade. We’ll still have many rules, of course, but increasingly banks will have to use their own judgment about regulatory risk, in the absence of clear prescriptive regulations. The solution to this will be to build ever-improving consumer benefit and pricing into every product. Doing this will, simultaneously, defend against FinTech competition.

Another trait linking the two areas is that they both are, increasingly, all about data, and especially understanding the overall patterns that data reveal. Most banks’ IT systems have evolved over decades and are weak in connecting data to gain a holistic picture. Today, regulators are analyzing data, such as CFPB complaint numbers, and finding patterns that raise concerns about unfair and deceptive practices (UDAAP) or discrimination. Most banks are blind to these because their compliance systems look mainly at technical regulations, while greater risks are arising “in the cracks” where compliance never looks, such as in unintended impacts of operating systems or in disconnects between what is marketed and what some customers receive. Principles-based regulation, especially UDAAP, has become the top risk in consumer protection, and it is often detected initially by looking at data.

The good news is that the interconnection of regulation and innovation means that fixing one, helps fix the other. The more banks assure that products and practices are transparent and well-priced, the more they will be well-positioned to prevent both regulatory and FinTech competitive risk.

Finally, banks (and policymakers) should focus on burgeoning innovation in “Reg-Tech” – new technologies that can make regulation simpler and more automatic, leveraging the same strengths that are driving FinTech solutions.

WHF: What are some of the biggest changes that have taken place within the financial services industry as a result of FinTech?

Barefoot: The industry is in the early stages of responding. Most large banks have created innovation teams or labs and are actively inventing, buying, and/or investing in new ideas. Some of this is explicitly designed to be a learning experience, while other efforts aim at practical problem-solving for customers or operations issues. Large banks are also exploring how to use the blockchain – the “distributed ledger” invented by Bitcoin – as a new approach to managing complex internal operations that involve chains of activity or transactions.  (The blockchain is a transparent way of tracking a chain of transactions or records, such as payments or, say, legal titles, on the internet. This makes the information move instantly, at very low cost, and in ways that can be viewed and verified by all interested parties and therefore, cannot be duplicated or faked).

For smaller banks and credit unions, most have taken steps to create more mobile apps. Some have begun partnering with innovators in areas like online lending – for instance, Lending Club has a partnership with BancAlliance for working with community banks. Most small banks will not be able to invent their own innovation. They will need to get good at working with innovators while still satisfying regulatory standards about third-party risk management. It’s a tough challenge.

One thing most banks are not doing is upgrading their IT and data systems enough to compete well in this fast-changing market. I believe it will be necessary to do so. Banks underestimate the degree to which innovators have an advantage, simply because they are working with clean, powerful data.

WHF: You were a financial regulator and now you advise financial institutions. What regulatory challenges does the FinTech industry face?  What are some of the compliance concerns?

Barefoot: The FinTech industry faces enormous regulatory challenges. One is the sheer cost of compliance – most startups can’t afford the expertise and systems needed to be sure to get everything right, although the smart ones are finding ways to do so and are building a compliance focus into their businesses early. A related challenge is the difficulty of assuring cybersecurity and getting anti-money laundering compliance right, on a small budget.

Another issue is that regulators often don’t understand these enterprises. For instance, digital currency companies need state money transfer licenses, and some states today are not yet familiar with these new technologies. Also FinTech tools are usually mobile – often mobile-only. This makes it complicated to manage disclosures even electronically, not to mention the ones requiring paper mailings.

Some innovations are breaking regulatory molds. Is digital currency a currency, an investment, or a payment system?  Marketplace lending is being affected by a court case invoking usury laws written long before this form of lending existed, and also faces the question of whether its investors, including individuals, could be subject to fair lending laws if they select loans to fund using criteria that could create disparate impact.

Another challenge is that innovators often use alternative data to evaluate creditworthiness.

Again, this can help drive toward more inclusive but sound lending, but raises many unresolved issues about fair lending disparate impact. It is not clear what data standards and algorithms will survive regulatory scrutiny over time.

WHF: Are traditional banks and FinTech firms’ natural competitors or can they co-exist?

Barefoot: They can definitely co-exist! However, both face big challenges and a great deal of change. I believe traditional banks will have to embrace innovation fully and will not survive if they don’t. Similarly, many FinTech firms will fail. Over time, I think some FinTech firms will probably emerge as top-tier financial providers. I think many will be bought by banks. Many will become banking vendors and partners.

I also believe large nonbank technology firms will become major financial players – candidates would include Facebook, Google, Amazon and Apple. All of these already offer some form of consumer financial services, have huge customer bases and data, and are liked and even loved by many customers. They are also young companies with strong innovation cultures. Telecom and internet providers will increasingly enter the market as well (and already dominate in some parts of the world), although they have less natural strength in innovation and customer popularity.

Ultimately, the new technologies will permeate the whole market, creating business and market models that are cheaper, faster, more inclusive, and much more transparent to customers (including through Yelp-type customer reviews). We’ll still have banks, and nonbanks, both serving customers directly and working in partnership with others to provide financial solutions.

WHF: What, if any, traditional consumer financial services are at risk of becoming obsolete because of technological innovations?    

Barefoot: As noted above, the most vulnerable areas are the ones being targeted simultaneously by innovators and regulators based on a perception that customers don’t really understand the product and pricing. Examples include deposit overdrafts, payday lending, and compensation models that may incent higher rather than lower pricing. Also vulnerable are any products and processes that are lengthy and burdensome for customers and anything that has high built-in costs due to high personnel or infrastructure needs.

The more profitable a product or channel is, the more likely it is that innovators will target it to remove costs, delays, and customer frustrations.

Beyond specific products, banks have broad vulnerability due to their “full-service” strategies and the fact that they often bundle services together with cross-subsidized pricing. Innovators are trying to pick off each product one by one, with simple solutions and minimized pricing.

While many customers do want the convenience of one banking relationship, the smart phone is increasingly making it easy to manage one’s finances with tools other than a consolidated banking arrangement.

Branches are also very vulnerable. Branches will not disappear overall, but many will close and others will be repurposed. Most banking transactions are already done online and as online and mobile services grow, banks will face challenges with how best to manage and streamline costly branch systems. (These will include Community Reinvestment Act issues.)

A vulnerability that banks tend to underestimate is that many innovations offer a better “user experience,” or UX. This is mainly because innovators are designing them from scratch and are fully integrating all elements – human-centered design, the latest technology, and compliance – in a seamless whole. This is different from taking an existing bank product and putting it into a new channel, like mobile. Banks are well-advised to hire people from technology backgrounds outside of banking, and also to listen to their own younger employees, who tend to be users of innovative solutions.

Finally, all bank products are vulnerable to the potential of disappointing millennials. This is the largest generation in world history and the first to be “digital natives.” Already their tastes and habits are reshaping the larger culture, just as the huge Baby Boomer generation did. Their preferred technologies are rapidly spreading to older customers, in the same way email and cell phones started with young people and expanded to everyone. Millennials expect technology to get constantly better, faster and cheaper, and they think of financial services in terms of technology tools.

Also, millennials expect high engagement, and innovators are giving it to them. Many FinTech companies have strong personalities and are funny. This raises the customer’s active interest and builds lasting relationships. Banks are, sad to say, vulnerable of seeming boring by comparison.

WHF: What advice can you give to someone interested in starting a FinTech startup company?

Barefoot: My top recommendation, other than generic advice for any entrepreneur, is to focus from the start both on “compliance” and, more deeply, on consumer benefit.

On compliance, build or buy clean new compliance tools that use technology to assure and document compliance, rather than doing it the traditional ways.

On consumer benefit, be ready to make the case for why the product will be good for consumers. Think through how it might be harmful, and design those vulnerabilities out of it. Strive for very high transparency. Strive for simplicity. Strive to be trustworthy, as trust is the factor that will make or break most of these companies over time. Also invest in strong data protection, AML compliance, and in winning the confidence of banks, as a customer or partner.

Finally, commit to continuous innovation. Even high-tech companies lose their edge today if they stagnate. The technology is changing constantly. The products should keep getting better and better.

Regulating FinTech: Fostering innovation while preventing harm

Guess where the following statement appears on the web:

“We promote competition through disruptive innovation— innovation that offers new services to customers and challenges existing business models.”

A fintech company? A bank vendor? A consulting firm? A think tank? A trade association?

None of the above. Actually, it’s a regulator. Can you guess which regulator?

Hints: It's not the Comptroller’s Office. Not the Federal Reserve Board. Not FDIC. Not even the Consumer Financial Protection Bureau.

It's the Financial Conduct Authority, in the UK.

“We promote … disruptive innovation … that challenges existing business models.”

Disruptive innovation—by a regulator?

Will fintech change regulatory philosophy?

The UK has a national strategy aimed at being the fintech capital of the world. To that end, it is actively working to attract and nurture innovative financial companies, using a range of tools that include regulatory policy.

This proactive stance contrasts sharply with traditional regulatory approaches worldwide, including those used in the U.S. (thus far). Normally, policymakers focus on addressing emerging risks as markets change. While many regulators may try to minimize interference with industry practices, it’s rare that regulatory strategy seeks, affirmatively, to embrace the upside potential of innovation.

Increasingly, however, innovative technology is forcing this kind of balanced thinking into the regulatory arena. In the UK, this is partly conceived as a national strategy for economic competition, but is also explicitly designed to capture the massive potential benefits that innovation is creating for consumers.

Regulators are striving to balance on the knife-edge of preventing new risks—which will undoubtedly develop—while still allowing pro-consumer fintech to flourish.

Upside of philosophical shift

The potential consumer benefits are enormous. Fintech innovation is driving the whole sector toward:

• Sharply reduced costs, especially through mobile delivery channels.

• High transparency to consumers.

• More inclusiveness through, again, lower-cost channels and also use of alternative data that can fine-tune risk evaluation of people with limited or complex credit histories.

• Consumer empowerment through easy personal financial management tools and simplified savings and investment.

• Faster payments that reduce uncertainty about when payments will clear, thereby helping consumers who have timing problems covering their bills.

Regulators throughout the world are starting to realize that their own actions could inadvertently undermine such upside potential, as they pursue legitimate efforts to address downside risk.

Finding the right mix of policies is not a simple task.

UK’s regulatory innovation

The FCA has created a “Project Innovate” initiative and an “Innovation Hub.” Though a regulatory body, it is pursuing strategies that range from directly nurturing promising start-ups to adopting policies that foster innovation. [Read Jo Ann Barefoot’s earlier “Lessons from London? ‘Fair banking’—with English on it”]  

For example, the FCA has sought public comment on two questions. One, is what regulations are impeding innovation? The other is whether there is a need for new regulations to foster innovation. These reflect fundamental strategic thinking about the role of financial regulation.

Another example is the FCA's exploration of whether to create a formal “regulatory sandbox” to enable innovators to test new ideas that might raise regulatory concerns or that do not fit squarely into the structure of current rules.

Click the image to view a video from FCA. (Scroll to bottom of page you land on.)

I had the chance to participate last year in FCA’s roundtable discussion of the sandbox proposal and was struck by the far-ranging new thinking underway.

For example, the agency invited input on whether to create a “virtual sandbox” in which consumer data could be collected and centralized so that innovators could test ideas without having to use real customers as “guinea pigs.”

Another idea is to permit industry associations to play an “umbrella” role, streamlining access to the sandbox approval process for small innovators.

Numerous other challenges are under discussion, from how to define and measure consumer benefit, to how to protect providers’ intellectual property and competitive positioning, to how to make a sandbox permission process simple enough that it would help, rather than hinder, fast-moving innovation.

UK regulators describe their efforts as experimental. (I notice that both public and private sector leaders often use the word “journey.”) No one I know, in government, banks, or startups, thinks they have figured out all the answers.

As a former bank regulator myself, what I find fascinating is that they are trying to move toward a different way of operating as they navigate the extreme uncertainties and rapid change ahead. There is an effort to be more flexible, more collaborative, and more nimble—faster.

While no one seems actually comfortable with this, there is palpable excitement about its potential.

Bear in mind, too, that innovators in the UK have the opportunity to “passport” their operations throughout the European Union. That, combined with this innovative regulatory strategy, makes the UK an excellent place for innovative companies to do business.

Principles versus rules

The UK contrasts with the US in another aspect of regulatory policy:  It relies much more heavily on “principles-based,” rather than rules-based, regulation for consumer financial protection.

The UK does have extensive technical rules governing consumer financial products and practices, but the regulators moved, years ago, toward emphasizing broad standards for “treating customers fairly.”

UK regulators also require senior executives to attest that their institutions have done so.

Here again, one hears people use the word “journey” to describe the difficulties of regulating “conduct,” as opposed to straightforward (if complex) compliance with procedural rules. Conduct and fairness are subjective concepts, difficult to apply.

Personal accountability standards can have unintended consequences, sometimes driving providers out of market sectors where regulatory risks are high and/or hard to predict.

Still, these regulatory strategies emerged in the UK before the US agencies began to emphasize similar approaches regarding unfair, deceptive and abusive practices (UDAAP). As a result, the UK has arguably moved further in clarifying broad principles and building consensus about what their regulators  mean.

The regulators have even taken steps toward trying to measure consumer outcomes, rather than compliance inputs, as the primary way to judge banks’ performance toward consumer protection goals.

Can US adopt this model?

None of this means that the UK is a fully apt model for the US.

As always with regulators and the regulated, there are many contentious issues between the financial industry and the FCA. Also, the UK’s challenges are simpler than ours in many ways. The country has a much more concentrated banking system, unlike the U.S. with our thousands of institutions.

The UK also has a vastly simpler regulatory structure, with two primary agencies—the FCA addressing “conduct” issues (and containing the semi-independent Payments Systems Regulator) and the Prudential Regulation Authority in the Bank of England overseeing prudential risk.

This contrasts sharply with our U.S. structure, in which we have five federal agencies directly overseeing financial institutions in addition to performing other critical missions, plus 50 states also chartering and regulating banks and also licensing and overseeing thousands of nonbank financial firms, especially lenders and money transmitters.

Nevertheless, the US can learn from observing the UK’s “journey.”

This side of the pond

Here in America, the regulators are moving in directions that parallel the UK’s efforts.

On principles-based regulation, they have already vigorously shifted to a proactive stance.

Coming out of the financial crisis, CFPB and also the prudential agencies have all emphasized UDAAP and fair lending as critical priorities. While technical rules continue to proliferate, the highest consumer regulatory risks for US banks today concentrate overwhelmingly in areas where product terms and practices are viewed by regulators as deceptive, unfair, or discriminatory.

Furthermore, this trend will only intensify as the sheer speed of technology change forces regulators to rely more on principles than rules, simply because detailed rules will increasingly lag behind market and product transformation.

On the innovation front, too, U.S. regulators are also starting to shift gears.

• Comptroller of the Currency Thomas Curry appointed a task force last year on Responsible Innovation, addressing both consumer protection and prudential regulation. In announcing the initiative, Curry noted that regulators have a cultural “tendency to say no,” and that the OCC needs to build a deep understanding of technology change, along with an ability to be “nimble.” The agency may issue a report this spring.

• Similarly, the Federal Reserve Bank of San Francisco held a first-ever conference last year on innovation and regulation, with participants drawn from industry, Silicon Valley, consumer advocates, and think tanks.

• The Treasury Department, too, held a conference on financial inclusion with a strong innovation focus late last year.

• CFPB has continued to evolve its Project Catalyst program, which seeks to identify pro-consumer fintech. Recently CFPB issued in final form its policy to facilitate consumer-friendly innovation.   

• At the state level, the Conference of State Bank Supervisors has been exploring the same kinds of challenges.

• Meanwhile the Federal Trade Commission is doing extensive work on privacy and fair usage of “big data,” including the Internet of Things (IoT).

Questions all should be asking

There is no shortage of meaty and critical topics:

1. How should fintech startups be able to access and partner with the banking system, under what sets of rules and standards?

2. How should we address rising concerns about data security and privacy?

3. How should we address the opportunities and risks involved with use of alternative and “big” data and data analytics in risk evaluation and fair lending?

4. What are the implications of digital currencies, the blockchain, and real-time payments?

5. Do we need regulatory standards regarding data aggregation practices? Should consumers’ banking data be portable, as in the UK, and who should actually “own” it? 

6. How can our bank-centric regulatory system cope with burgeoning innovation by nonbanks, from tiny startups with a cool new phone app, to some future Uber of finance, to, say, mold-breaking services from “Big Tech” firms like Facebook, Amazon, Apple, and Google—all of which have consumer financial services in some form, already?

The technology forces disrupting finance will also disrupt our regulatory framework, because this industry is subject to such pervasive rules and supervision.

All players are living through an epic shift. The story’s outcome will depend on how well regulators, industry, innovators, and consumer advocates work together to embrace and shape innovation.

This article also appeared on BankingExchange.com. You can find it here.

Launching My Video Series

Eighteen months ago, someone made a suggestion to me. Why not take the consulting advice I give to my advisory clients and package it in a form that's affordable and widely accessible - as videos? Instead of reaching the few clients that can pay to fly me around and meet in person, why not use technology to share my thinking with everyone who's interested?

I loved the idea. It turned out to take a lot of work, but I'm excited to say that I'm finally, today, launching the series.

I'm calling it Regulation Innovation.

Is that an odd name?

Here's a question:  Which of these is not like the others?

Regulation, legislation, litigation, innovation....

Obviously innovation doesn't belong on that list.

Except...it does.
 

These two drivers - regulation and technology innovation -- are the two transformative forces that are disrupting consumer finance.  They are the top challenges facing virtually every company, both in cost and risk.

The industry handles them as if they are unconnected - even opposite, incompatible, like oil and water. In reality, they are tightly linked:

They have the same targets. Regulators and disruptive innovators are attacking the same consumer problems -- especially lack of product clarity and high product costs.

Both therefore threaten the same profit centers -- it's a pincer assault.
 

They mostly have the same causes, especially outdated technologies, cultures and structures.
 

This means they have overlapping solutions. Fixing one can efficiently fix the other.
 

They are disrupting each other. Finance is so highly regulated that disrupting the industry disrupts the regulatory process too, and vice versa.

They are creating a new state of permanent uncertainty, driving change that's too fast, fluid and unforgiving to manage by traditional means.

They will break and remake companies and industries

Leaders in the financial world need to understand these two forces, and understand how to thrive on - not struggle through - disruption.

Regulation Innovation is my video guide for these leaders.

• It's for both regulatory and business people at all levels, and for traditional companies and innovators of all sizes.
• It's practical -- short videos, maximum insight, concrete advice.

 It's a training tool

The initial videos cover:

• Welcome to the journey: Quick overview of the series
• The 5 tech trends: The key technology trends disrupting consumer finance and regulation, and why financial people are underestimating them
• Meet the innovators: Understanding the disruptors. Who are they, how do they think, what are they trying to do, how do they relate to the traditional industry?
• Meet the new regulators:  Understanding the daunting shifts facing regulators and policy-makers, and how they plan to meet them
• The 6 challenges:  the top challenges facing every financial provider
• The 7 strategies: Strategic approaches for each of the six, and overall

Click here to see the introductory video.

And also watch our bonus video that answers the burning question, "Why does Jo Ann Barefoot have an Xbox -- since she's never played a videogame in her entire life -- and what the heck does it have to do with regulation and innovation"

Like any innovator, we're launching with an MVP (minimum viable product) which will evolve based on feedback. Please sign up, share the site with your colleagues and friends, and I'll look forward to everyone joining me on the journey!

One Way Street

I made fifteen speeches last fall on how technology is disrupting consumer finance and the huge regulatory challenges created by this transformation. My travels included moderating a panel at Money 20/20, the largest financial conference in the United States and maybe globally.  Over 10,000 people gathered in Las Vegas to explore the frontiers of fintech.

Nearly every session I saw there mentioned regulatory challenges. The same was true at the Milken Institute London Summit a few weeks earlier, which tackled technology issues ranging from finance to health, and at the Emerge conference last summer in Austin, and every tech-focused venue I attended.

It got me thinking: Why do innovation conferences talk constantly about regulation, while regulatory conferences barely mention innovation?

There are exceptions of course, but the contrast is still striking. Money 20/20 (which has a full regulatory track) drew a record audience. I’ve never seen 10,000 people assembled in one flat-floored room before (as opposed to stadium seating). You could hardly see the back of the room. Everyone was working on fintech: payments, mobile, digital currency and block chain, online lending, mortgage lending models, savings and investment tools, alternative data, cybersecurity, privacy, financial inclusion and access, global consumer empowerment, the millennial market, and on and on. Startups pitched ideas. Huge companies unveiled initiatives. The exhibit hall’s glitz rivaled the Vegas strip. Three thousand people saw a show. Hallways were jammed. Parties were everywhere. The energy was palpable.

Regulatory conferences have been setting records too – thousands of people are attending them.  Appropriately, they talk about regulations. Compliance experts, lawyers, regulators, and consultants explain what’s changing, how to interpret it, how to comply, what’s ahead. They all offer valuable insight, but they rarely address fintech, much less hail from that world. Most have not yet plugged into the innovation energy surge.

They need to, because innovation is revolutionizing financial services generally, and compliance specifically. Here’s why.

Disruption: Financial services is the first industry to face technology-driven disruption while also being pervasively regulated. This means that the disruption of the industry will disrupt the regulatory system too.

Speed: Financial people underestimate the speed and size of the coming transformation because the critical changes are happening outside their field of vision -- in technology, not finance.

For instance, people in finance think of “mobile” as being about mobile payments, but payments are actually just a tiny sliver of how mobile technology is remaking our lives, including our money lives. Financial people view Bitcoin and the blockchain as a payment issue too, while this technology will actually restructure huge swaths of the economy, business models, and even internal operations. Financial people address privacy by complying with Regulation P’s requirements for handling their customers’ information, while privacy is meanwhile being deeply rethought as big data and artificial intelligence revolutionize finance and everything else. Financial people think of consumer credit regulatory issues in terms of rules like the Equal Credit Opportunity, Fair Housing Act, or Fair Credit Reporting Act, while innovators are using alternative data and new data analytics to invent new models for underwriting and pricing, opening huge frontiers of both business and regulatory change. Finance people see “robo-investing” as an exotic new issue, missing how “machine learning” and artificial intelligence will revolutionize every aspect of how people invest, save, spend, borrow, and manage their money.

And that list doesn’t even include innovations that have barely reached the financial industry’s radar at all.  One is breakthroughs in natural voice technology that, combined with big data and machine learning, will completely change financial “education” and how consumers are coached to make money choices. Another is what will happen as people easily and automatically receive ratings of financial companies and products in their phones. Another is the movement into finance by “Big Tech.” Google, Facebook, Apple, Amazon and others already offer consumer financial services and are likely to expand them. These companies are deeply embedded in the daily activities of hundreds of millions of people. They could provide more financial products and/or become an intermediating layer – a filter or advisor -- standing between their customers and traditional providers, changing the very structure of the market.

Surprise: A third reason the financial industry underestimates these changes is that the huge tech trends driving it – big data, artificial intelligence, mobile, the block chain and voice technology – are converging. As they merge, everything will escalate and accelerate.

Lagging regulatory guidance: Fourth, innovation-related issues will bring high spikes in regulatory risk because their novelty and rapid evolution will outpace policy-making. This will force the industry into a regulatory wilderness with few guideposts and unfamiliar dangers lurking everywhere, as regulators decide after the fact that new activities are causing consumer harm.

Aging regulatory tools: One more blind spot is that, despite conventional wisdom, some innovators actually have compliance advantages. This is partly because their products tend to be simple and transparent, and partly because some startups use clean, new high-tech compliance tools that are both effective and efficient. The widespread assumption that startups will be hobbled by regulatory barriers is partly true but flawed. They may even raise the bar for everyone.

The traditional industry already faces dilemmas sparked by these shifts. Compliance and risk staffs find themselves trying to protect their companies against regulatory risks that cannot be clearly assessed, amidst pressure from business units pursuing innovation. The compliance profession has evolved around expertise in implementing detailed technical rules, not navigating regulatory ambiguity, especially on the unfamiliar terrain of high-tech new products, channels and partnerships.  

Legal and compliance staffs are already confronting questions like these:

• Can our bank partner with an innovator, or buy one, or provide it with banking services?
• How can we assure such third parties satisfy regulators’ rules on third-party risk including on cybersecurity, privacy, AML, and reputation risk?
• Can/should we, or our third-party partner or vendor, use alternative data and data analytics to evaluate and price consumer loans, without risk fair lending violations, especially on disparate impact? If we don’t, could we eventually face criticism for not using these inclusive alternatives?
• Should we allow/prevent our customers from letting personal financial management (PFM) and other providers, including small startups, access and help manage their accounts?
• Can we implement a mobile banking or payment service and get disclosures right?
• Do we have the holistic data needed to know whether consumer outcomes raise UDAAP risks?    
• Should we explore helping our customers access robo-investing options and if so, what are the regulatory challenges?
• How much should we communicate with customers by text, on what subjects?
• Can we close or repurpose branches in lower-income neighborhoods, since most of our banking has shifted to being online? And can/should we design special mobile services for lower-income customers?
• Can we offer technology-based services in languages other than English, without triggering discrimination risks if we cannot automate and deliver every phase of the product life-cycle in the alternative language?
• Can we strengthen our AML and security protocols for non-loan products by requiring higher-risk customers to send us a picture of their photo ID and a selfie, without risking fair lending violations?
• Can we make our services appeal more to millennials without violating rules that add complexity, delay, and low utility compared to innovative competitors?
• How would payments system innovations, including real-time processing, impact our business and regulatory models for services like overdrafts or money transmission?
• How should we view the move by some banks to create open platforms, so innovators can write apps on their systems?

Regulation and technology are the top challenges facing traditional financial companies. The two seem different, even unmixable. In reality, they increasingly are two sides of the same coin.

Partnering is especially crucial. One Money 20/20 speaker said startups used to believe they would overthrow the banks, but now just want to partner with them. One person said to me, “Everyone has to pair off -- choose a partner and go to the dance.”

What does it take to do that well, for the traditional company and the innovator? That seems like great topic for regulatory conferences in 2016.

Or, how about inviting tech innovators to talk about the big changes coming and what they will mean for finance?

And what if both groups – innovators and regulatory experts – started attending each other’s conferences, and built a real, bustling two-way street?

A two-part version of this post also appeared in a guest blog at Banking Exchange magazine.

Part 1

Part 2