A three-way fight has begun to shape the future of digital finance

FINANCE IS BECOMING ever less the domain of sharp-suited bankers and credit-card executives. Instead, a ragtag cast of characters is overseeing an explosion of innovation that seeks to cut out the incumbents altogether. From established tech firms and fintech startups on America’s west coast to developers of various “decentralised-finance” (DeFi) applications, they are jostling to reshape digital finance. In 2022 regulators must respond and start setting out their stalls. by Rachana Shanbhogue: Finance editor, The Economist

The second trend is the nascent attempt to decentralise finance. Developers are building all sorts of financial applications on blockchains, which ensure security and trust without the need for any intermediaries. Novel assets of all kinds associated with the DeFi world, such as non-fungible tokens (nfts) and other crypto-tokens, will continue to proliferate. Third, central banks, usually bastions of conservatism, are also breaking new ground. As more economic activity moves online and physical cash falls out of favour, many are on the path to introducing digital currencies of their own.

This digital revolution encompasses three broad trends. One is the effort to offer an ever-widening range of financial products on a single platform. Facebook’s new digital wallet could make inroads. Banks, payment providers and bigger fintechs will continue to gobble up startups, with the aim of offering customers such a breadth of services that they will use a single platform for everything.

There is plenty of action to come in 2022. The People’s Bank of China will launch its e-yuan more widely; central banks from Jamaica and Japan to Thailand and Turkey will conduct various tests and pilots. Big rich countries will come a step closer to testing their own digital currencies. Innovation will continue in the private sector, too. New ideas have been well funded: venture capitalists poured nearly $60bn into financial-technology startups in the first half of 2021. More than a hundred DeFi applications are in the works.

Big rich countries will come a step closer to testing their own digital currencies

Such fast-paced, exhilarating changes provide a stark contrast with retail finance of old, with its sleepy way of doing business, exorbitant fees and dire customer service. There is much to like about the new finance. For customers it should mean a system that uses technology to serve their needs better and at lower cost. Financial inclusion is a problem even in the rich world: one in five Americans were either unbanked or underbanked in 2018. Small firms regularly struggle to access finance.

Competition should also erode the fat margins of the incumbents (Visa and Mastercard make gross margins of 65-80%). Transferring money across borders, such as through remittances from rich countries to poor ones, is still too expensive. And as people conduct more of their lives online, it makes sense for finance to become not just more digital, but also better embedded within other digital activities, such as entertainment and shopping.

It thus falls to regulators to preserve the potential, while guarding against the risks. As the boundary between financial firms and tech companies blurs further, and the value of amassing customer data increases, protecting privacy and security will be paramount. But that must be done without compromising the necessary anti-money-laundering checks. This calculation will apply as much to central banks’ digital currencies as to private financial services. (China’s trial of its e-currency, sadly, will offer little guidance on the matter, given the government’s preference for control over privacy.)

Realising this promise, however, requires warding off the threats that fast change also brings. Take the risks to investors. A few new fintech ideas may take off. Others will fizzle out, leaving investors with losses. The hordes of crypto-speculators could meet a similar fate. Paying $1.3m for an nft of a picture of a rock, as someone did in August 2021, may turn out not to have been a canny investment. For customers, the risk is that financial platforms’ greater access to data might invite misuse of market power. Novel financial products could be more vulnerable to scams—and in a decentralised world it will not be clear how and where to seek recourse.

The man for the job

Trickier still will be working out how to bring DeFi into regulators’ purview. It may be just as well that Gary Gensler, the head of the Securities and Exchange Commission, America’s main financial watchdog, once taught a class on blockchain technology at the Massachusetts Institute of Technology.

Just as their financial promise could grow, $2.5trn-worth of crypto-assets may start to carry risks for the wider financial system. Yet the industry retains an almost ideological resistance to regulation, and its lobbying clout is growing. Advocates of digital finance have been laying out their plans for the future of the industry. Now the time has come for regulators to explain how they see it.

Rachana Shanbhogue: Finance editor, The Economist■

This article appeared in the Leaders section of the print edition of The World Ahead 2022 under the headline “Make or break ”

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