Consumer Risks in Fintech and Their Regulatory Approaches

Today, the global fintech sector is worth $26 trillion, with the total spending by individual app consumers hitting $157 billion. Advanced technologies are changing the face of the financial sector as we know it, pushing and driving it. But newly-unraveled profitable horizons of fintech carry a lot of risks for consumers. 

This article takes you through the risks in fintech and how they can be identified and avoided based on the example of three popular fintech concepts.

Digital Microcredit Key Principles 

Digital microcredit or a microloan is issued electronically, online and there are just a couple of things you should know about this service, it is:

Short-term

Microcredits are usually requested to satisfy some urgent needs or even current day-to-day expenses. So they are simply not designed for long-term loans from the get-go.

Low-value

The main target audiences of microcredit providers are small business owners and students. They usually loan from a few hundred to a couple of thousand dollars. Different pricing models can be offered (flat rate or fees), but these “express” digital loans are never of sky-high value.

Mobile-friendly

Microcredits can commonly be accessed remotely via apps, SMS, SIM toolkits, and USSD data. And you can withdraw funds directly to mobile or bank accounts.

Rapidly Approved

Approval is automatic and almost instantaneous as it is powered by automated credit scoring. To get input information, such scoring systems usually rely on alternative data sources, such as:

• mobile device activity; 
• mobile transactions;
• social media data. 

Digital Microcredit Consumer Risks and Regulatory Approaches 

Apart from all its convenience, digital microcredit brings to the table the following consumer risks that require regulation.

Poor Disclosure and Transparency

Possible Issues:

• Methods for transferring prices, financial fees, and commissions are not disclosed;
• Access to information about terms and conditions (T&C) is insufficient, especially via mobile phones;
• Mobile transaction information provided too late;
• Small screens make it difficult to navigate the UI.

 Regulation Approaches:

• Require a total cost with a breakdown of costs and an orderly flow of information;
• Encourage extended standardization of pricing and promote access to full T&C (Terms and Conditions) early in transactions.
• Adapt the format of digital channels to work with pieces of information and access offline channels;
• Grant a user-friendly interface and built-in analytics of behavioral data to better encourage consumers to interact with available information.

Aggressive Marketing Practices

«Push» marketing and false advertising spawn the following risks:

• Encouraging impulsive borrowing ─ bad decision-making at high transaction rates;
• Use of behavioral biases about short-term risks (for instance, encouraging loans on as simple terms as possible).

Regulation Approaches:

• Clear warnings about the risks of taking expensive loans;
• Prohibition/restriction of solutions focused on facilitation of obtaining a loan (e.g., pre-approved loans);
• Intentionally slowed down transaction process;
• Presentation of the most profitable options.

Unfair Lending

Digital lending at high loss rates may put a consumer at a disadvantage with:

• Overpriced lending plans;
• Marketing without any solvency assessment of the TA;
• Unprofitable methods of prolongation and unfair methods of debt collection.

Regulation Approaches:

• An assessment of potential customers' ability to repay loans;
• Enhanced monitoring of loan portfolios, especially if automated credit scoring is employed;
• Limiting the issuance of multiple loans to reduce the likelihood of over-indebtedness.

Discrimination Due to Scoring

 The use of automatic analysis of customer solvency may entail:

• Biased solvency scores due to poor quality or incompleteness of input data;
• Poor ability of clients to use the algorithm;
• Lack of technical knowledge among regulators to evaluate algorithmic systems.

Regulation Approaches:

• Application of fair treatment rules.
• Control and protection procedures during the development, testing, and deployment of algorithms to assess and manage the risks associated with bias and discrimination;
• Regular audit of algorithms by external experts;
• Giving consumers the right to choose between automatic and manual processing of loan applications.

Gaps in Regulatory Perimeter

Such gaps undermine consumer protection with:

• Unequal rules of the game for different types of service providers;
• Lack of influence of regulatory authorities (they may be located in another country) on certain software solutions.

Regulation Approaches:

• Creation of a structure covering all related digital service providers, including banks, mobile operators, etc.;
• Using the coordination of local and international regulators;
• Adoption of additional measures ─ industry CoCs (certificates of conformity) and establishment of application development rules;
• Using an activity-based approach to ensure a legal playing field and comprehensive coverage, as well as the powers of other regulators.

What is Peer-to-Peer Lending (P2PL)? 

This P2P lending technology allows you to receive loans directly from other individuals, bypassing the bank as an intermediary. All parties can act both as lenders and borrowers, and interaction between them is carried out through specialized websites or web apps.

Peer-to-Peer Lending Risks and Regulatory Approaches

Gaps in Regulatory Perimeter

Possible Issues;

• P2PL cannot be fully covered by national financial structures and collective (mutual) investment funds;
• Users often get less protection than in the case of conventional lending.

Regulation Approaches:

• Implementation of existing requirements for collective investment funds or creation of new ones;
• Development of normative guidelines for resolving situations of uncertainty.

Conflicts of Interest

Possible risks in case of conflict of interests include:

• Imprudent assessment of credit risks;
• Unfair, incorrect assessment or allocation of credit;
• In-platform agreements giving priority not to consumers but to related parties.

Regulation Approaches:

• Develop common commitments to protect the interests of all parties contributing to conflict mitigation;
• Stimulate a pricing policy that prioritizes the interests of consumers;
• Introduce credit rating obligations for operators, whether or not they are registered creditors;
• Limit the investments of operators' employees in loans supported by their platforms.

Fraud or Other Misconduct

Common user risks include:

• Direct money loss or other financial damage;

Regulation Approaches:

• Licensing/registration, proficiency testing;
• Implementation of risk management mechanisms;
• Separation of rules for consumer funds and customer funds;
• Creation of compensation mechanisms.

Platform/technology Unreliability or Vulnerability

Possible dangers may include:

• Platform/technology unreliability causes or contributes to loss of funds, consumer inconvenience, or other harm;

Regulation Approaches

• Implementation by operators of risk management in general management mechanisms;

• Requirements for understanding process-related risks and ensuring operational reliability.

Business Failure or Insolvency of Operator

In such situations, losses are extremely likely, since problems arise in terms of:

• Loan yields;
• Allocation of credit funds and payments.

Regulation Approaches:

• Disposal of consumer funds carried out exclusively in the prescribed manner;
• Operators should have business arrangements in place to ensure the continuity of the transfer/settlement processes;
• Regular checks of the competence of operators and maintenance of relevant documentation.

Inadequate Credit Assessments

Possible dangers include:

• Unbalanced or misleading marketing;
• Distorted, false information about creditors, the lack of a correct basis for making informed decisions;
• Wrong format for presenting information that is ineffective for target consumers.

Regulation Approaches:

• Prohibition of misleading information;
• Restrictions on specific circumstances presenting an increased risk of misleading investors;
• Providing information on expected risks, profitability factors and limitations in the early release of applications;
• Use of pre-contractual information about individual loans, allowing to choose an individual option;
• Warnings or disclaimers to avoid inappropriately optimistic representations of risks.

What is E-money? 

E-money is, basically, a digital representation of fiat currency that can be redeemed at face value. In a broad sense, it is the electronic storage of monetary value on a technical device (card, wallet, etc.) that can be legally used for digital payments.

E-Money Consumer Risks and Regulatory Approaches 

Gaps in Regulatory Perimeter

• Global rules may not apply to all organizations offering e-money processing products;
• Consumer protection requirements may not apply to a product due to innovative differences.

Regulation Approaches:

• Ensuring that electronic money falls within the appropriate definition of a financial product or service;
• Allow transactions only for licensed organizations (including non-banks);
• Ensuring consumer protection.

Fraud or Other Misconduct Resulting in Consumer Loss 

This is a major risk of its own, in order to minimize possible consumer losses, one should focus on:

• Introducing requirements for licensing/registration, competency testing of issuers and related parties, and publication of authorized agents;
• Requirement of proper risk management;
• Shifting the burden of proving unauthorized transactions to providers;
• Requiring reporting of major fraud/security breaches;
• Prohibiting pre-negotiated commissions.

E-money Platform/Technology Vulnerability 

The unreliability of the platform/technology may cause great harm to end consumers. Regulation approaches in this case include:

• Establishing requirements for technology risk management and cybersecurity;
• Requiring operators to provide an acceptable level of operational reliability;
• Employing user notifications for expected/actual service outages.

Mistaken Transactions

In such cases, regulators must:

• Require a mechanism to verify transaction details prior to a transaction and understand how to terminate a transfer;
• Require reasonable efforts from providers to return funds sent in error;
• Put the burden of proof of the transaction on the providers.

E-money Not Covered by Deposit-Insurance Schemes

The electronic balance may not be insured against the insolvency of the issuer or the institution holding the electronic money. To mitigate the risk, regulators should guarantee that insurance is extended to e-money balances or escrow accounts.

Unsuitable E-money Products

To avoid these occurrences, one must:

• Require providers to develop and distribute products that meet the needs of the target market;
• Introduce individual requirements for evaluating the suitability of products.

Conclusion

Financial software development technologies contribute to global economic growth by developing and increasing the availability and efficiency of financial services. But at the same time, they can create felt risks, which are sometimes difficult to track due to the complexity of their differentiation and rapid transformation. 

Only experienced specialized specialists are able to correctly assess the situation and level the potential threat.