Central banks and innovation

Fintech innovation, especially innovation in payments -a critical financial service most people use every day—is generating new challenges and often competing priorities for central banks.

On one hand, central banks want to create an enabling environment so Fintech can thrive and people can reap the benefits of innovation. This is especially true for developing economies still facing wide gaps in financial inclusion.  On the other hand, central banks’ primary statutory mandate is to protect financial stability and to protect customers of financial services. To do this, they must carefully assess and manage the risk that new products and new delivery channels might bring to both.

The role of central banks and supervisors is to reconcile confidence and innovation, to encourage the latter while ensuring that the people are reasonably protected from risks and their trust safeguarded. Central banks can no longer limit their involvement in the National Payments System (NPS) as issuers of the sovereign currency and operator of the wholesale payment system.  Many of them are already deeply involved in the retail payments market, and as such, must act to promote standardization and interoperability to guarantee safe, efficient, and inclusive payment services and enable innovation, thus boosting competition. Many central banks are crucial catalysts for the transformation of their payments market, either by creating an enabling and favorable environment, or by being on the forefront of innovation themselves through Central Bank Digital Currency (CBDC) projects.

Central banks also need to reconcile opportunity and sovereignty. The most conspicuous effects of innovation on the structure of the market have been its impact on competition, by opening up the payments market to non-banks to reap the opportunities offered by new providers, new products and new business models. While new entrants challenge incumbent banks, innovation could end up having a paradoxical, centralizing effect and a tendency to increase concentration, with the major transformation being the shift of dominant market positions from banks to Big Tech companies. Many National Payments Systems are increasingly reliant on global foreign providers, such as global card schemes and/or Big Techs, and the rise of Big Techs as major providers of payment services brings new challenges to authorities.  Some central banks have expressed concerns of losing sovereignty over their payments market as parts of it are being managed outside their jurisdiction. When Big Tech firms offer services directly to end-users, they could qualify as systemic providers of payment services if they reach a dominant position or very high volumes. Even if they do not offer services directly to end-users, but to other user facing institutions, they could still become critical third-party providers. In both cases, their failure could cause widespread disruption to the payment market and the economy.

Central banks need to prepare, with a strategic framework built around a set of policy objectives and choices. If cornerstones remain -the need for safe and efficient payment systems, integration with industry-level infrastructures, a principles-based regulatory framework that can evolve and cater to new concepts-, the skills, processes, methodologies using by central banks need to evolve. They need to build capacity, on operational risk, including cyber risk, on CBDC, and eventually revise core concepts, standards, and procedures. They need to design legal framework for crypto assets, review their consumer protection framework and strengthen their financial education efforts.

While innovation is sometimes presented as eliminating the need for a trusted third-party, and especially the need for central bank, we believe that innovation is making central banks more relevant and needed than ever.  Their role is not diminished by innovation in payments; it is, on the contrary, made even more critical. Central banks on the other hand have no choice but to introduce changes in their own work processes and procedures, build new capacities and, more generally, rethink their approach to money. They are adapting their operational role to the new demands of their citizens for more speed, convenience, and affordability. They are widening and deepening their oversight and regulation role to confront new products, new providers, including those like big tech coming from outside of their traditional purview of the financial sector, and the associated risks.

Innovators won’t wait for them, but regulators can stifle or foster innovation in their financial sector, they can shape the rules and standards for cooperation, interoperability, competition, if they grow their knowledge and build their expertise.  But central banks cannot and should not work in isolation. More than ever, cooperation and dialogue, with other authorities and with stakeholders, both domestic and international, is imperative and a requisite to navigate the ever-moving tides of innovation.