3 Regulatory Challenges Posed by Platform-Based Finance

Big tech platforms from Facebook and Amazon to Alibaba and Tencent have reshaped economies across the world. Their dominance in social media and e-commerce, combined with their growing interest in offering financial services, has prompted concern by policy makers who worry that existing regulations are not well suited to address risks in platform-based finance.

Platforms’ entry into the financial services space is most salient in places where digital marketplaces are highly developed, such as China, the European Union and the United States. However, the top big techs also operate in emerging markets and developing economies (EMDEs), distributing financial services through such affiliates as Ant Group, WhatsApp and Google Pay. Other leading platforms include Mercado Libre in Latin America, Jumia in Africa, Flipkart in India and Bukalapak in Indonesia.

From CGAP’s perspective, platform-based finance has great potential to advance financial inclusion, especially in developing countries. Yet there is need for an effective, balanced regulatory framework.  As we kick off a new blog series on regulating platform-based finance, let’s take a look at the financial inclusion potential of these financial services along with the three main areas where they pose regulatory challenges.

What is platform-based finance?

We use “platform-based finance” to refer to financial services that platforms embed within their online marketplaces to serve and grow their client base of market participants. We exclude digital marketplaces exclusively dedicated to financial services, as these are a different category of business. This definition aligns with the Financial Stability Board’s description of big techs in finance and the European Banking Authority’s taxonomy of digital platform business models. BIS recently adopted the term “platform-based finance” as well. Another term increasingly used is “embedded finance.”

Platforms have a unique ability to expand rapidly in scale and scope while driving down costs and retail prices. Integrating finance into their range of services only accelerates this process, giving platforms a strong incentive to enter the financial services space. When platforms embed a new service such as finance, in enhances a feedback loop among three elements the BIS termed “DNA”:

• Data. Moving into financial services enables platforms to amass even more customer data and gain extract insights from it using proprietary algorithms.
• Network effects. Integrating financial services exponentially increases connections between users across two-sided markets and rapidly grows the value of the platform.
• Interwoven activities. Embedding financial services increases the multi-sidedness of platform markets, extending platforms’ market power into adjacent sectors (further multiplying data points and network effects).

Given these benefits, it is no surprise that platform-based finance is growing quickly. Global transaction volumes more than doubled from US$145 billion in 2015 to US$304.5 billion in 2018. In Latin America, finance supplied through fintechs and platforms grew at an average annual rate of 147% from 2013 to 2018. This growth is linked to that of core markets, such as e-commerce. Consumers worldwide spent nearly US$4.29 trillion online in 2020, up from nearly US$3.46 trillion the prior year.

Why does platform-based finance matter for financial inclusion?

EMDEs are different from advanced economies in that their financial sectors remain mostly shallow, static and bank-dominated. Given these conditions, platforms have a potentially critical role to play in financial inclusion. Unlike banks and many other types of businesses, platforms have low marginal costs once scale is reached, since they usually neither produce nor own the goods and services being exchanged. This makes serving new, low-income customers viable even though the return on each transaction is very small. Adding low-income customers to a platform increases value due to network effects.

In addition to having better economics, platforms appear far more effective than banks at reaching lower-income segments. Big data and algorithms make this possible. Ant Group and Mercado Libre report using more than 1,000 data points per loan applicant, ranging from sales volumes to customer reviews and social media profiles. Deploying an internal scoring model, platform-based providers can lend to customers for whom there is little or no traditional financial data and who are assessed as high-risk by the credit bureaus and banks. Thus, ride-hailing platforms distribute instant loan offers to millions of their drivers, while e-commerce sites reach low-income customers with financial products tailored to their working capital needs.

What are the main regulatory challenges?

Platform-based finance raises a distinct set of challenges for regulatory authorities, who often have limited capacity to respond to innovation (and might have other urgent issues to address):

• First, platforms create risks in the area of data protection. Platforms collect and control masses of data on customers (and potential customers), extracting insights using proprietary algorithms. Control of the data and consumers' rights over its use are areas of debate in many jurisdictions and far from settled.
   
• Second, platforms may pose threats to competition. Platforms by nature seem to evolve in the direction of greater concentration. Platforms’ databases are not easily replicable. This, in turn, can drive exclusionary (“gatekeeper”) behavior by dominant firms, such as limiting competitors’ timely access to data, preventing others from sharing data and inhibiting data portability. A platform may exert similar pressure on customers by driving up switching costs or by resisting interoperability and retaining transactions strictly within its own digital ecosystem.
   
• Third, platform business models complicate decisions about when and how to regulate. Platform-based financial products are often issued by a banking institution or payment company linked to the platform, whether by common ownership or a partnership agreement. The platform itself might bear none of the financial risk. Moreover, platforms aggregate financial services with ordinary commerce; that is, platform-based financial services are delivered on the frontend by entities not licensed as financial institutions, even though financial laws may require companies to separate finance (especially banking) from other lines of business. Last, a platform’s activities extend beyond the domain of financial regulation, creating financial commitments and risks that might not be monitored. Other authorities may need to be involved in regulating the platform in areas like competition, labor, consumer and data protection, telecom and a range of commercial sectors. This necessitates a working mechanism for regulatory coordination.

Looking ahead

Regulatory change in some form will be needed for platform-based finance. But the priority now is mostly to monitor providers as they innovate and grow, and to map out an approach to regulation. Between the global big techs and the local unicorns (or soon-to-be unicorns), platforms will soon be a major force in finance if they are not already. They represent potential leapfrog progress on financial inclusion and livelihoods. Yet caution is in order.  Platforms are bringing rapid change and innovation to markets with huge needs but limited regulatory capacity.

This is the first post in a blog series on regulating platform-based finance. Upcoming blog posts will take a closer look at each of the three regulatory challenges introduced in this post.