twimbit
UK-India Fintrade
A three-year project co-led by the University of Essex and RIS India, funded by the Economic and Social Research Council (ESRC) and the Indian Council of Social Science Research (ICSSR)

Key highlights from the literature review

We have undertaken a systematic literature review. It was implemented in the following way:

Methodology

  • A list of key words related to the fintech in the UK and India, as well as its role in facilitating trade was prepared.
  • These keyword were used to carry out a literature search using Google Scholar, restricted to sources after 2014.

Restricting the search to more recent work helps focusing it. Since the literature in the area is fast evolving, using sources that can have a greater reach is beneficial. In this regard Google Scholar includes alongside established bibliographical databases, work that is yet to be published as well as non-academic sources. The drawback of such a general search approach is that it would inevitable include results with low relevance or suspicious quality. For this reason any fond source was carefully vetted and only included if it met a minimum threshold in terms of being directly relevant and useful for any of the three work packages.

  • Three separate searches (for UK, India and trade) were carried out.

The initial 100 sources were examined and the ones that met the relevancy criteria were retained (ad added to the database). Then for each of the retained sources its one level up and downstream references (i.e papers cited in it or by it) were traced. These were vetted in the same way as the original references and either accepted or rejected. It is important that the purpose of the above process was to identify sources that are directly relevant to the present project, which naturally resulted in a large number of rejections.

Findings

The main findings can be summarised is three general themes:

  • Fintech in general (applicable to both the UK and India)
  • Fintech issues specific to the UK or India and
  • The role of fintech in trade.

Now, we will review these concurently:

The general fintech literature emphasises the importance of the financial ecosystem for the growth of fintech. In particular scholars have gone in painstaking detail to describe the components of a well functioning fintech ecosystem as well the characteristics of the corresponding ecosystems in different countries. The main conclusion from this strand of literature is that it is the quality of fintech ecosystems that matters.

The UK is often quoted as one of the leading countries in the fintech revolutions and a global fintech hub. Therefore it can be expected that its ecosystem is among the best. India’s fintech growth is however equally impressive. The differences in the financial ecosystems have led to different fintech paths with distinct advantages for each one. For example the UK appears to be leading in neobanking, investment and insurance platforms, while India enjoys comparative advantage in digital payments. Such differences are not coincidental.

The UK government’s fintech support policy is built on that the regulator who supervises the financial market provides direct and customized support to businesses which are under its supervision so that those businesses can easily understand the regulatory system and comply with less time and cost (Yang, 2017). Hence the fintech businesses fit within the existing regulatory framework and need to follow it. For example neobanks need to obtain a standard banking licence to operate. Yet such a distinction of slotting fintech in conventional regulation silos is to some extent superficial, since in addition to having technological subsidiaries of standard regulatory bodies, these work together and co-operate with technology focused regulators. So the often cited distinction between functional and technology regulation is misleading and unhelpful.

In India on the other hand, new fintechs are not given separate licences, but can only operate under the licences of existing financial institutions. This means that financial services are kept within existing structures and fintech innovations focus on the functions of such services. Furthermore the implementation of common payments framework makes such collaboration easier and more productive.

Yet when one digs deeper, the seemingly clear idea of fintech being restricted by regulatory constraints (in that they need to comply with them either directly as in the UK, or indirectly in India) becomes much more fluid. The introduction of regulatory sandboxes in both countries means that some of the existing restrictions can be removed (temporary or permanently). While other requirement may be imposed on them. And while initially in both countries acceptance to the regulatory sandboxes was on a cohorts (i.e. predetermined themes) basis, the UK has already transitioned to open applications. India still maintains cohorts approach, but it is being gradually relaxed. This hints for an increasingly inclusive nature of the regulatory approach.

The regulation approach to fintech in general has been based on the premise that it acts as disruptor. Such disruption may create instability in the financial system and FinTech institutions’ risk can spill over to financial institutions leading to financial institutions’ increase in systemic risk (Li et al., 2020). This means that the supervision and regulation of FinTech companies, is crucial to ensure financial stability. And such regulation can logically be implemented only when a predefined risk threshold is reached without compromising the system.

This general idea leads however to a number of trade-offs, and quantifying these can lead to drastically different approach to fintech regulation

First, we have a trade-off between risks derived from (digital) disruption and potential benefits of a more resilient financial system. Trying to eliminate all such risks would logically suffocate fintech innovation, while allowing uncontrolled disruption threatens the stability of the financial system. How dangerous these risks are depend on the resilience and adaptability of the existing financial system, which means that more advanced financial ecosystems need a lighter touch regulation, which probably explains the different approach in the UK and India.

The fintech industry is constantly evolving and therefore regulation needs to evolve and adapt to it. If not it will impede the sector. The role of the regulatory sandbox in such adaptation cannot be overstated (Goo & Heo, 2020). It is an innovative answer to the problem of regulatory lag in an emerging industry (Ahern, 2019).

The main challenge to regulating fintech is therefore finding a balance between flexibility requirements and a dynamic approach to regulation. Flexibility to allow for adjusting the risk threshold and dynamic approach in feedback evaluation of the consequences of such changes to the overall functioning of the financial ecosystem. This is where in particular regulatory sandboxes can play a crucial role. Yet the literature seems to suggest another dichotomy between regulatory sandboxes and innovation hubs, with some authors (e.g. Buckley et al., 2020) arguing that the latter are superior. Yet defining these two terms on its own can be problematic and some such argument can be due to definitional issues. Furthermore, these two have different functions in that innovation hubs characteristics are closer to those of development sandboxes, which unlike the regulatory ones are aimed at developing financial innovation rather than its regulation. Yet in spite of the rhetoric, is the UK approach is not based solely or exclusively on the regulatory sandbox. There the functional channels type of regulatory oversight (e.g. the FCA Global Financial Innovation Network brings together 11 financial regulators to coordinate financial technologies developments), and actual innovation hubs (clusters). Similarly in India there distinct innovation clusters.

Technological innovations are creating disintermediation of the mechanisms of regulation (Brummer, 2015) Therefore they present a challenge to effective securities regulation which needs to be upgraded to account for a computerized market microstructure that is subject to continuous and often accelerating change. These market microstructure changes exemplify the way fintech transforms the industry itself (Sangwan et al., 2019). The problem is hence that we need to establish the rules of the game, but the game itself is changing, often in response to the rules themselves (Ahern, 2021).

An interesting theoretical result is that of an impossibility triangle (Brummer & Yadav, 2017), reminiscent of that of international economics. Specifically, it argues that when seeking to provide clear rules, maintain market integrity, and encourage financial innovation, regulators can only achieve two out of these three goals. Hence while innovation hubs and development sandboxes mainly deal with the last of these aims, the regulatory sandboxes have to balance all three. They can therefore be used to gradually adjust one side of this triangle at a time, hence providing a dynamic (dis)equilibrium view of fintech growth and development. And in this process the regulation approach itself will evolve with the financial ecosystem.

Regulatory sandboxes have been shown to provide assurances that bring in venture capital and hence indirectly lead to increased innovation. Such outcomes are however contingent on the other two side of the triangle (clear rules and market integrity), which or often ignored in empirical studies. Furthermore the role of the other components of the financial ecosystem is less well explored.

Yet we know that digitalisation of financial intermediation can increase the stability of the financial system.

Another important take from the fintech literature is that social interaction plays an important role not only in fintech development itself but also in the formation and development of regulatory sandbox environments (Alaassar et al., 2020). Social interaction can thus be as important as digital disruption (Brandl & Hornuf, 2020). This suggests that path dependency can be an important consideration.

FinTech can sometimes can operate at the fringes of regulation potentially disrupting it. (Buchak et al., 2018) The banking fintechs (challenger banks) in the UK and Germany are found to follow a different political dynamics. Online-only banks in the UK and Germany, challenged incumbents without breaking or remaking regulation (Hodson, 2021).

Moving on to the issue of fintech startups, there is a possibility of boom and bust cycles and therefore there is need for regulation to avoid such cycles . Therefore a resilient fintech ecosystem is essential for fintech emergence and growth (Cumming & Schwienbacher, 2018). In the UK start-ups funding is implicitly supported by a range of taxation benefits such as the Enterprise Investment Scheme and the Small enterprise investment scheme. Although being general investment incentives which are not specifically aimed at fintech start-ups, these provide a steady supply of funding, particularly in the presence of well established system of Venture capital trusts which effectively administer these schemes. In addition to that the R&D tax credits are another taxation incentive, probably more applicably to the later (growth) stages of business start-ups which is more important for more technology driven sectors such as the fintech industry. Indeed further expansion of such tax incentives has been argued for (Kalifa, 2021).

In recent years in European context venture capital is shown to be aligned to (drawn to) digital disruption (Khan et al., 2021). The same applies to the UK (e.g. the share of fintech in venture capital investments)

This effect is stronger in better developed financial systems. Hence as a major finance hub, the UK enjoys considerable competitive advantages in that regard. Overall, better developed fintech ecosystems are crucial to the funding environment for fintech firms.

Better developed financial sectors facilitate fintech startups (Haddad & Hornuf, 2019). Availability of venture capital and digital infrastructure also affect fintech positively.

However venture capital investors require a critical mass of FinTech entrepreneurship in a country to be able to positively influence FinTech entrepreneurship (Kolokas et al., 2020). Banks however do not require this, which suggests an initial role of banks followed by venture capital involvement in the later stage (when VCenters the scene). Banks can invests in early stages of fintech start-ups, although they only enter into partnerships with established fintechs (Brandl & Hornuf, 2020; Hornuf et al., 2021). One can note that the different regulatory approach of the UK and India fits neatly in this argument. The greater availability of venture capital in the UK means that the initial role of the banks is not so essential and therefore a more competitive environment where incumbents and newcomers are allowed to directly compete with each other can be fostered. In contrast to this, the restricted role of venture capital iin India means that this initial role of the banks is important and by anchoring new fintechs to the banking licences of existing institution, not only ensures this but also facilitates it is connecting banks and startups.

Moreover, we can argue that VC and credit markets (i.e. banks) become substitutes. This argument can be developed in the UK context, with the role of the financial ecosystem in providing start-up finance. Also the role of crowdfunding, lending platforms and tax incentives (EIS, SEIS). These provide alternative credit channels (to the banks) and hence increase competition thus facilitating the achievement of a critical mass.

Fintech clustering and incubators have been found to attract start-ups, reduce exit and failures, but also increase the probability of acquisition of fintech startups (Gazel & Schwienbacher, 2021). Thus the trend is toward fintech listings (IPOs). The UK experience (number of listing) confirms that.

Fintech startups reduce default risk and sustainability of the financial sector in general. But this can only happen if they succeed and become established part of the financial system (Haddad & Hornuf, 2021)

Yet attracting funding is subject to challenges. It is a high risk / high reward type of problem. Reducing systematic risks (bust) benefits it, tax advantages also help. There are problems in valuing fintech startups in that conventional valuation methods often break down ( see e.g. Moro-Visconti, 2021). For example a real options approach to evaluating fintech startup decisions have been advocated, but it is also problematic given the incompleteness in the formulation of contingent states needed to implement it (Lee & Shin, 2018)

Empirical findings indicate that having more than one round of funding has positive growth implications while having a single founder affects growth negatively (Herck, Giaquinto & Bortoluzzo, 2020). The impact of the seed financing and the single founder is weaker in an emerging market. This adds up to the crucial important of an efficient financial ecosystem, since a more developed one is logically more likely to results in multiple rounds of funding. Yet successive rounds of funding indicate a proof of concept and therefore a kind of start-ups life-cycle, where at each subsequent stage the risk-reward trade-off changes.

The issue of fintech role in bilateral trade is a bit more complicated. The literature contains a number of theoretical advantages of financial technologies that can benefit international trade in particular such based on integrated ledger systems (e,g, blockchain) and discussion of the advantages of such architecture is e.g. logistics or international payments systems. Yet, although the principles are clear and there are national examples of such (e.g. small businesses integration of accounting and banking systems in India) there is no evidence of actual implementations of such systems in international trade yet. The trade facilitation role of fintech is therefore difficult to assess. The fintech trade itself involves trade in services (computer services and business support) which mainly flows in one direction, and foreign direct investment.

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