The explosion in financial innovation is prompting a diverse set of worries from lawmakers, from potentially adverse impacts on lower-income and minority consumers to the increasing reliance on artificial intelligence to decide where investors should park their money, according to government researchers.
The Congressional Research Service, which provides policy and legal analysis, issued a report cataloging the effects of financial technology in the securities and banking industries, describing the issues at the forefront.
One such concern is the use of so-called alternative data by lenders when reviewing credit applications, an approach new enough that there is not much legislation that addresses the practice directly, according to the report issued April 28.
Alternative data refers to lenders using measures not typically found in a consumer’s credit report to decide whether the applicant is creditworthy. Examples include how frequently rent or utility payments are made on time, a person’s job or educational level, or even applicants’ mobile device location information and their social media use.
While advocates tout it as a way to expand credit availability to consumers who may be denied using traditional measures, some critics fear alternative data could result in violations of fair lending laws such as the Equal Credit Opportunity Act and the Fair Housing Act.
“The abundance of alternative data about prospective borrowers now available to lenders — either publicly accessible or accessed with the borrower’s permission — means lenders can incorporate additional information beyond traditional data provided in credit reports and credit scores into assessments of whether a particular borrower is a credit risk,” the researchers say in the report.
House Financial Services chairwoman Maxine Waters, D-Calif., and several Democratic colleagues in January asked the Government Accountability Office to look into the benefits and drawbacks of alternative data in mortgage lending.
“While some alternative data, such as rental payment history, may provide an objective measure of creditworthiness, others might enable discrimination on the basis of a protected class, or infringe upon consumer privacy,” they wrote in their Jan. 16 letter to GAO. “For example, scoring algorithms that utilize alternative data drawn from a consumer’s social media profile could allow CRAs (consumer reporting agencies) and lenders to evaluate creditworthiness based on personal characteristics such as the consumer’s race, gender and religion.”
The CRS report notes that although fintech lending remains a small part of the consumer market, it has been growing rapidly. Fintech firms provided a total of $17.7 billion in personal loans in 2017, more than seven times the $2.5 billion they lent in 2013.
Another issue facing Congress is the increased use of electronic payment methods over cash. Proponents of reducing cash use argue that it will lower the costs associated with producing, transporting and protecting bank notes, the report says. Conversely, phasing out cash could further marginalize people with limited access to the financial system.
While consumers today tend to prefer using debit cards and credit cards, “cash maintains an important role in retail payments and person-to-person transfers, especially for smaller transactions and lower-income households,” the report says.
Although the amount of currency in circulation has increased over the past 20 years, cash ceased being the top payment method in the U.S. several years ago. Debit cards were used in 28% of U.S. transactions in 2018 to cash’s 26%, according to the Federal Reserve.
Some businesses have even begun to reject cash payments, and opponents of allowing cashless retailers say they discriminate against lower-income individuals, often members of minority groups who don’t have access to credit and debit cards.
Jurisdictions such as New Jersey, New York City, Philadelphia and San Francisco have enacted laws that largely prohibit cashless stores.
Several bills have been introduced in Congress that would make it unlawful for physical retail establishments to refuse to accept cash as payment. Although the bills remain in limbo, the prospect of a cashless society will continue to grow as fintech advances.
Financial technology is also changing the so-called financial market plumbing, the behind-the-scenes systems invisible to consumers that can still affect their financial outlook.
Technology run amok contributed to a rapid drop in the Dow Jones Industrial Average of about 1,000 points in May of 2010, an incident subsequently named the Flash Crash.
A large trader used an automated program that flooded the market with sell orders over 20 minutes, helping to push the Dow down, according to a report from the Commodity Futures Trading Commission and the Securities and Exchange Commission. “The automated execution of a large sell order can trigger extreme price movements, especially if the automated execution algorithm does not take prices into account,” that report concluded after the agencies studied the problem for several months.
Despite a decade passing since the incident, however, there’s been little regulation of the underlying technology. Financial markets have installed so-called circuit breakers that shut down stock markets to interrupt such crashes, but critics liken that to treating the symptoms rather than developing a cure.
High-frequency trading, where supercomputers make trades in fractions of a second based on their programming, is responsible for as much as 60% of all trading in U.S. domestic equity markets.
Legislation to tax this trading has been introduced, and was part of the Democratic agenda in the 2016 elections, but has not passed.
The National Institute of Standards and Technology has floated the idea of more regulation, such as standards for development, testing and monitoring of the artificial intelligence that’s entrusted to make trading decisions. If Congress wants such standards, it could direct the agencies to develop them, CRS said.
Artificial intelligence is also on the rise as a more effective method to help investors make decisions. Programs known as robo-advisers are designed to take the emotion and human foibles out of investing.
Regulators worry, however, that such software could result in a large number of investors making the same investments at the same time, called herding. The CRS researchers found that it’s hard for regulators, and even for the companies running the software, to know why the robo-advisers make the recommendations they do. This raises the question of who is responsible to the client — the software designer or the investment manager using it — a question that’s yet to be answered by Congress or financial agencies, the report notes.