01

The digitalisation of financial products and markets continues apace. As the world struggles to emerge from the Covid-19 pandemic, the financial industry is having to adapt to once-in-a-generation societal changes, and technology is at the heart of its response. As financial services are unbundled and repackaged around a digital architecture, the market has become more competitive. The line between tradfi and fintech has blurred now that insurgents have become mainstream, “traditional” firms operate like tech companies, and tech companies are embedding themselves in the financial ecosystem.

The face of financial services is no longer the high street bank, but the digital marketplace. Representing the platformisation of financial services, these marketplaces are the new hubs for consumers to access products. Increasingly, these products include cryptoassets. New alternative investing platforms give users access to non-traditional asset classes that will not always be clearly within the scope of existing consumer protections, prompting regulators to consider whether existing regulatory frameworks are adequate.

Tackling friction in cross-border payments continues to be a major area of focus, with attention on both improvements to existing infrastructure and the development of alternative rails such as stablecoins and CBDCs. Alternative forms of digital money could present potential solutions to cross-border payments but also raise questions about the future of traditional forms of money and their role in society. The use of data and data protection regulation is also an increasingly pressing issue as the role of AI and machine learning in financial services continues to gain traction. Another factor underpinning innovation in finance is the growing focus on climate change and the role of sustainable finance and fintech solutions in achieving the immense challenge of transitioning to net zero and carbon neutral solutions. Fintechs need to be mindful of ESG compliance, especially those in the digital asset space given the energy-intensive nature of certain crypto activities.

The fintech sector has proved extremely resilient and is emerging successfully from the pandemic, with a huge amount of activity and interest. All in all, however, there is plenty of work to be done in policy, law and regulation to help both those providing and those utilising financial services navigate the seismic changes ahead.

02

The digital shift has precipitated record levels of funding into digital assets, payments and fintech generally. Global funding to start-ups is at an all-time high with a tsunami of capital flowing into private tech companies. Fintech has also been the big winner in venture capital with one in every five venture dollars going into fintech investments in Q2 2021 . Overall, 2021 saw a flood of fintech innovation capital and, by the end of Q3 2021¹, global fintech funding reached US$94.7 billion (with 3,549 deals), almost double 2020’s full-year total.

Asia has become a hot spot for fintech deals which reached a record high of 307 deals totalling US$5.9 billion in Q3 2021. The region has seen consecutive quarterly deal growth since Q2 2020, and funding growth since Q3 2020. We are seeing South East Asia tech companies, especially in Indonesia, as a destination for investment money looking to hedge China risk. The US is leading in funding, with levels exceeding the total funding for Asia, Europe, LatAm and Canada combined. In the third quarter of 2021, over 43 new fintech unicorns emerged globally, with the US being home to nearly half of all the total 206 existing fintech unicorns².

There has been some concern amongst commentators that this fintech boom is a bubble, created by sky high valuations and a fear among investors of missing out on the next big success story. It is certainly true to say that, as in any new and rapidly expanding sector, innovations in fintech face a material risk of failure. However, Fintechs are almost by definition agile and – just as Big Techs are diversifying into finance – are showing the ability not only to disrupt traditional financial services, but also to diversify into broader tech offerings (such as Paypal’s move to combine fintech with social media and e-commerce through the acquisition of Pinterest).

We therefore expect these upwards investment trends to continue into 2022, and for the healthy financing climate to lead to more fintech exits. Yet investors and fintechs will need to take account of geo-politics and the headwinds brought about by the prospect of a regulatory reset for the digital economy. It remains to be seen how long the heat in the market can be sustained as the impact of new policies and regulations, such as antitrust attention on control of data, and new/enhanced foreign investment regimes focused on the tech sector, start to bite.

1 Source: State Of Venture Q2’21 Report - CB Insights Research

2 Source: State Of Fintech Q3’21 Report - CB Insights Research

03

One of the most striking interventions in the digital economy in 2021 has been in China, which has turned the tide on Big Tech with a regulatory squeeze using various of the regulatory levers at its disposal. What started as regulatory scrutiny in consumer finance has quickly moved into the antitrust space and cryptoassets. More recently, the focus has been on the interoperability of apps (within SuperApps), data flows and whether platforms should be broken up.

While the China clampdown is impacting domestic investment, it is also creating opportunities in India and South East Asia which is accommodating those leaving China’s markets or looking to diversify. Singapore, in particular, is experiencing growth as a “hub”. With support from the regulators, South East Asia is also seeing growth on digital banking.

The US is also experiencing a reset. Witness the changing tides of sentiment against US tech giants and new Biden appointees shaping the digital asset market, which has become too large to ignore. US regulators across the board have been resorting to regulation by enforcement and are also starting to think about specific regulatory frameworks for tech. Centralised finance is moving towards banking regulation but the explosion in DeFi, crypto, NFTs and stablecoins is presenting a regulatory challenge.

Consumer protection is also going up the regulatory agenda in both the EU and the UK but with more of an evolutionary than revolutionary approach as they look to foster safe and trustworthy innovation, building on existing strong regulatory frameworks and guidance. The EU has put out various specific proposals which we expect to see progressed in 2022, whilst post-Brexit the UK is still taking its time to find the right balance between addressing emerging risks and supporting innovation.

04

Markets in “first generation” cryptoassets like Bitcoin and Ether are continuing to expand rapidly. At the same time the range and complexity of digital assets is also growing, with the rise of Decentralised Finance (DeFi), Non Fungible Tokens (NFTs) and projects to digitise or tokenise traditional asset classes, from financial instruments to cash to real estate.

A notable trend is that institutional exposure to digital assets as a distinct asset class has been increasing significantly and is expected to continue to do so. Exposures may come in a variety of forms, such as direct trading, trading in derivative and related products, portfolio investment, integration of digital assets within service offerings and investment in digital asset market players.

Alongside this, the use of novel technologies, such as blockchain and distributed ledger technologies, to digitise assets and automate processes in traditional financial markets, continues to gain momentum. While many of these projects still involve a high degree of centralisation, increasingly greater degrees of decentralisation are being considered, including deployments on public blockchains.

The crossover between decentralised and traditional markets and related contagion risks will be of particular concern for policymakers. For example, the financial stability consequences of a crash in the price of Bitcoin are all the more significant if the crypto market is highly integrated with the traditional financial sector. Likewise, as DeFi arrangements continue to grow and gain institutional backing, the need to close regulatory gaps in this area becomes more pertinent.

Across the globe, regulators are considering how best to regulate the expanding spectrum of digital assets in order to tackle financial crime, protect investors and mitigate systemic risks while at the same time supporting innovation. The answers are not straightforward. Regulatory approaches continue to be bolstered, refined and clarified and we expect this trend to continue into 2022.

05

With the pandemic having turbocharged the payments revolution, innovation in payments will continue to drive greater convenience, lower costs and increasingly frictionless instant payments. This innovation will be led by digital marketplaces which are benefitting from society’s move to online shopping and which, in response, are investing more in their payments infrastructure. Meanwhile new payments products, such as buy-now, pay-later, will aim to embed the BNPL model in anticipation of future regulatory scrutiny.

Innovation has resulted in more choice for consumers in the way they make and manage payments, from APIs and Open Banking, to QR codes, e-money, digital wallets and BNPL. Competition between payment service providers, and the technology firms and digital marketplaces, will drive further innovation but also put pressure on business models. Many of these providers are reliant on each other as payments chains become more complex, increasing the potential for legal disputes between contracting parties.

Innovation is not limited to the private sector. An increasing number of central banks have now launched or begun piloting a CBDC. Ironically, many of the more economically developed jurisdictions have reached less advanced stages, as they take their time to consider the use case, potential implications and design. There has been a significant amount of cross-border collaboration between many of these jurisdictions to develop common frameworks and to try to ensure that different domestic CBDCs can interoperate with one another.

Potential issuers of systemic stablecoins await clarity from regulators as to the proposed regulatory framework. It remains to be seen whether regulatory proposals will be compatible with a commercial stablecoin proposition. Meanwhile Asian countries are forging ahead with other innovations and we expect to see more projects such as the Singapore and India linkage of real-time payment services through mobile phone numbers and UPI virtual payment addresses.

06

Regulators in major markets are adopting divergent approaches as they seek to strike the right balance between incentivising effective risk management and not stifling innovation.

The EU’s first-mover proposals for an AI-specific regulation have provided a benchmark for a comprehensive, risk-based approach. As things stand, there are some concerns that the calibration to risk approach and the broad categories of high-risk activity could stifle innovation and even create barriers to the adoption of AI in the EU. However, the proposed regulation has a long way to go and will need to pass through the EU’s legislative machine – where material changes could still be made – and will then apply two years after it is adopted. This means any new obligations are unlikely to start to apply before 2024.

The UK’s own approach to regulating AI is evolving, as it considers a “light-touch” regulatory framework to foster innovation, At the same time it is also considering deviations from EU standards for data protection again to support innovative tech. China has responded to GDPR with a similar, but sometimes more stringent, data protection regime, as well as making its own proposals on global standards for AI. Data protection and cyber rules are proliferating in the US, as well as increasing enforcement against digital platforms.

Several markets are also following the lead of the UK and EU in issuing wide-ranging operational resilience requirements. This broad range of unharmonised international requirements will place increasing pressure on financial institutions to focus resources on the increasingly complex interaction between the technology, risk, compliance and procurement functions.

07

Greater consumer adoption of new financial technologies means that regulators are even more focused on taking steps to ensure both they and firms mitigate the risk of consumer harm. But many novel financial product and service offerings don’t neatly fit into the existing regulatory and legal frameworks. These products and services seem to pose greater inherent risks than traditional financial service products: for instance, with some products (e.g. crypto) being far more volatile and vulnerable to market manipulation/scams/being used for financial crime. When combined with the fact that many of the companies offering these products are young and have relatively immature compliance frameworks, there is a recipe for future regulatory investigations, potential enforcement and litigation.

This is especially the case as regulators’ expectations of what companies will do is rising across many subject areas: from preventing financial crime to transparently and fairly processing personal data, from acting more in consumers’ interests to acting responsibly when it comes to topics like ESG and D&I. And, where the risk of civil claims, either class actions or individual, is increased by the availability of litigation funding in many jurisdictions, this has in turn fuelled creativity in how civil claims are formulated and pursued.

In the US, the popularity of cryptocurrencies and the volatile market have attracted the attention of federal and state agencies in recent years. The Securities and Exchange Commission (SEC), Commodity Futures Trading Commission (CFTC), Internal Revenue Service (IRS), Financial Crimes Enforcement Network (FinCEN), and the New York State Department of Financial Services are among the agencies that regulate the use of cryptocurrencies. Governmental investigations and enforcement actions are typically based on allegations of fraud, misconduct, money laundering, and compliance with securities laws.

While regulators struggle with how to best bring about enforcement, cryptocurrency users are not waiting around. They are suing. Cryptocurrency users are exercising their rights under existing federal, state and contract laws to recover damages. They can do this because much of the malfeasance in cryptocurrency markets is not novel, just repackaged. Private litigation, i.e. enforcement by people rather than regulators, has thus far addressed three general issues in blockchain breakdowns: (i) “traditional” securities fraud; (ii) initial coin offering (ICO) failures; and (iii) platform disruptions.

On the civil side, investors are also bringing lawsuits claiming fraud, market manipulation and violation of securities laws. Complaints alleging breach of contract, intellectual property infringement, trade secret misappropriation, and others have also been increasing.