Financial Technology: Information on Subsectors and Regulatory Oversight
Released: 2017-04-19T00:00:00

Letter

Marketplace Lending

Marketplace lending connects consumers and small businesses seeking online and timelier access to credit with individuals and institutions seeking investment opportunities. Marketplace lenders use traditional and may use less traditional types of data and credit algorithms to assess creditworthiness and underwrite consumer loans, small business loans, lines of credit, and other loan products.

What It Is and How It Works

The marketplace lending subsector originated as person-to-person lending where individual investors financed loans to consumers. The investor base for online marketplace lenders has expanded to include institutional investors such as hedge funds and financial institutions. Additionally, there has been the emergence of a market for securitizations of marketplace lending loans—both consumer and small business loan- backed offerings. Marketplace lending firms have evolved to offer a wide variety of loan products and services to consumers and small businesses and have recently begun to offer mortgages, life insurance, and auto loans. Although a number of marketplace lending models exist, publications we reviewed highlighted two common models: direct lenders and platform lenders. Direct lenders, also known as balance sheet lenders, use capital obtained from outside sources to fund loans and often hold loans on their balance sheet. Examples of direct lenders include CAN Capital, Kabbage, and SoFi. Platform lenders partner with depository institutions to originate loans that are then purchased by the lender or by an investor through the platform. Examples of platform lenders include LendingClub Corporation, Prosper, and Upstart. However, there are various permutations based on these two common models. For example, direct lenders like OnDeck have developed hybrid models, selling some whole loans to institutional investors while retaining servicing responsibilities.

The marketplace lending process for the two models typically begins with a prospective borrower filling out an online application on the marketplace lending platform’s website. Marketplace lenders use traditional and may use less traditional types of data and credit algorithms to assess creditworthiness and underwrite loans. Marketplace lenders use traditional credit data (e.g., credit scores, income, and debt repayment history) but, according to publications we reviewed, may also use less traditional data such as monthly cash flow and expenses, educational history, payment and sales history, and online customer reviews.

After assessing the creditworthiness and needs of the applicant, the marketplace lender will approve or deny the borrower’s loan request. Generally, the loan will include a principal amount, an interest amount, and the marketplace lender may charge a servicing fee for collecting and transmitting payments and handling collections in case of a default.

Funding a borrower’s request depends on the business model of the marketplace lender. Direct lenders typically originate the loan, hold most or all of the loans on their own balance sheets, earn interest on the loans, and carry credit risk for the entire loan (the risk is that the borrower does not repay), see figure 1. These lenders can raise funds to make loans by issuing equity to institutional investors (in addition to other means). Platform lenders match investors (institutional or individual) to loans that a depository institution, such as a bank, originates (see fig. 2). If the loan is made and transferred to investors, the platform lender services the account. Investors have the option of either partially or fully funding a loan.

Who Uses It

Consumers: can use term loans from marketplace lenders to cover personal expenses (such as home or medical expenses); consolidate debt; or refinance student loans, among other reasons. According to Treasury, three marketplace lenders offer consumer loans ranging from $1,000 to $40,000. Treasury also indicated that marketplace lending firms generally provide consumer loans to prime and near-prime borrowers although some marketplace lending firms target subprime borrowers or applicants without credit scores or with a limited credit history.

Small Businesses: can use short and fixed-term loans, lines of credit, and merchant cash advances from marketplace lenders, among other products and services, to finance business expenses and expansions, among other reasons. According to a Federal Reserve Bank of Cleveland publication, limited data are available about the types of small businesses that use online lenders, why they have chosen to apply, how successful they are in obtaining funds, and how satisfied they are with their experiences as borrowers.

Potential Benefits

Lower costs: Marketplace lenders’ online structure may reduce overhead costs because not all firms have brick-and-mortar locations. In addition, the algorithms used by marketplace lenders to underwrite credit decisions may result in lower underwriting costs when compared to banks’ underwriting costs.

Expanded access to credit: Marketplace lending may expand credit access to underserved populations that may not meet traditional lending requirements or that seek smaller loans than those that banks traditionally offer.

Faster service: According to Treasury, marketplace lenders can provide funding decisions within 48 to 72 hours from when applications are submitted. According to an SBA Office of Advocacy publication, LendingClub Corporation advertises that potential applicants can receive a quote within minutes and that its approval and funding process typically takes 7 days, Kabbage Inc. can provide same-day approval for small business loans, and OnDeck can provide funding within 24 hours. According to representatives from one industry organization we spoke with, faster service is beneficial to small businesses that may need quick access to credit in an emergency, such as a restaurant that needs its oven or refrigerator repaired to continue operations.

Potential Risks

Payment term transparency: Marketplace lending firms offer various loan types and terms, particularly for small business loans. It can be difficult for small businesses to understand and compare loan terms such as the total cost of capital or the annual percentage rate. According to a Federal Reserve 2015 survey, one reason for small business lenders’ dissatisfaction with online lenders was a lack of transparency.

Small business borrower protections: Current federal laws and regulations applicable to marketplace lending generally apply to consumer loans and not small business loans or other commercial loans. For example, the Truth in Lending Act, which among other things, requires the lender to show the cost and terms to the borrower, applies to consumer loans but generally not small business loans. According to Treasury, small business loans under $100,000 share common characteristics with consumer loans, yet do not receive the same protections. However, the report also notes that small business loans may receive protection under the enforcement of fair lending laws under the Equal Credit Opportunity Act.

Use of less traditional data in credit decisions: Unlike traditional lending companies that look at a person’s credit reports (which include reported installment credit and revolving credit), publications we reviewed indicate that some marketplace lenders also take into account or have considered using less traditional data (e.g., utilities, rent, telephone bills, educational history) during the underwriting process. However, according to Treasury, data-driven algorithms used by marketplace lenders carry the risk for potential fair lending violations. According to staff from FTC, marketplace lenders must ensure that their practices meet fair lending and credit reporting laws. The use of less traditional data also introduces the risk that the data used are inaccurate and concerns that consumers may not have sufficient recourse if the information being used is incorrect.

Uncertainty about performance in full credit cycle: According to publications we reviewed, the marketplace lending subsector experienced considerable growth following the 2007-2009 economic downturn in an environment with tightened lending standards and low interest rates. In addition, little is known about how the industry will perform in other economic conditions such as a recession, which could lead to delinquency and defaults of marketplace loans. According to the Congressional Research Service (CRS), it is also possible that loan servicing could be disrupted in the event the marketplace lender goes out of business.

Industry Trends

Partnerships: According to Treasury, some marketplace lenders have sought partnerships with traditional banks and community development financial institutions (CDFI) in various models. According to a CRS report, in a white label partnership, a traditional bank sets underwriting standards, originates the loan, and holds the loan once issued. The bank can integrate a marketplace lending firm’s technology services to originate the loan. For example, JPMorgan Chase & Co. partnered with OnDeck to offer small business loans to JPMorgan Chase & Co. customers. In referral partnerships, banks refer customers who do not meet a bank’s underwriting standards, or who are seeking products the bank does not offer, to a marketplace lender. In turn, the bank may collect a fee from the marketplace lender. Referrals may also allow CDFIs to reach customers that may otherwise not be served. For example, in 2015, Regions Bank, Fundation Group LLC (an online small business marketplace lender), and TruFund (a CDFI) partnered to provide small loans to underserved small businesses.

Self-regulatory efforts: A number of self-regulatory marketplace lending efforts were established with the intent of developing responsible innovation and mitigating and reporting risks to potential borrowers seeking marketplace lending products. However, limited information is available on the impact of these efforts. Four examples are discussed below.

The Marketplace Lending Association (MLA) was established in April 2016 to represent the marketplace lending industry. MLA states that one of its goals is to support responsible growth in the marketplace lending sector.

The Online Lenders Alliance represents firms offering loans online. The Alliance provides resources including a consumer hotline, a portal to report fraud, and consumer tips.

In 2016, three small business lending platforms formed the Innovative Lending Platform Association. The Association developed the Straightforward Metrics Around Rate and Total cost (SMART) Box tool to help small businesses understand and assess the cost of their small business finance options. For example, some metrics described in the SMART Box tool include total cost of capital, annual percentage rate calculations, and average monthly payment amounts. Its goal is to include clear and consistent pricing metrics, metric calculations, and metric explanations to help small businesses understand and assess the costs of their small business finance options.

In 2015, the Responsible Business Lending Coalition launched the Small Business Borrowers Bill of Rights to foster greater transparency and accountability across the small business lending sector.

Regulation and Oversight

The regulation of marketplace lenders is largely determined by the lenders’ business model and the borrower or loan type. For example, marketplace lenders that provide services through an arrangement with a federally regulated depository institution may be subject to examination as a third-party service provider by the federal prudential regulator. The federal prudential regulators have provided third-party guidance or vendor risk management guidance to depository institutions that describes the risk assessment, due diligence and risk monitoring, and oversight that depository institutions should engage in when they deal with third parties, including marketplace lenders.

Depending on the facts and circumstances, including the type of activities being performed, marketplace lenders may be subject to federal consumer protection laws enforced by CFPB and FTC. Also, CFPB and FTC maintain databases of consumer complaints. In March 2016, CFPB announced it would begin accepting consumer complaints about marketplace lenders. However, according to CFPB staff, CFPB’s complaint system does not specifically categorize complaints for marketplace lending because consumers may not know whether to categorize those services as such. FTC encourages consumers to file a complaint if they believe they have been the victim of fraud, identity theft, or other unfair or deceptive business practices. According to FTC staff, fintech is not a category within FTC’s consumer complaint database and marketplace lending complaints are generally categorized as consumer loan complaints.

As previously discussed, certain regulations generally apply to consumer loans but may not apply to small business loans or other commercial loans. However, FTC has authority under Section 5 of the Federal Trade Commission Act to protect, among others, small businesses that are consumers of marketplace lending products or services from unfair or deceptive business acts or practices.

At the federal level, we previously noted that SEC regulates the offer and sale of securities to investors through disclosure requirements and antifraud provisions that can be used to hold companies liable for providing false or misleading information to investors. The Securities Act of 1933 generally requires issuers that make a public offering of securities to register the offer and sale of their securities with SEC and provide investors with disclosures that include information about the company issuing securities such as risk factors and financial information.According to staff from SEC, certain transactions by marketplace lenders may be exempt from the registration requirements of the Securities Act of 1933 depending on the particular facts of their securities offerings. At the state level, state securities regulators are generally responsible for registering certain securities products and, along with SEC, investigating securities fraud. Table 1 provides examples of federal laws and regulations relevant to marketplace lending.

Marketplace lenders are subject to state-level laws in each state in which they are licensed to conduct business. Specifically, some marketplace lenders that originate loans directly to consumers or businesses (e.g., a direct marketplace lender) are generally required to obtain licenses and register in each state in which they provide lending services. According to officials from CSBS, state regulators then have the ability to supervise these lenders, ensuring that the lender is complying with state and federal lending laws. CSBS officials noted that the states leverage the Nationwide Multistate Licensing System (NMLS) to facilitate compliance with state-by-state licensing mechanisms. NMLS is intended to enable firms to complete one record to apply for state licensing that fulfills the requirements of each state, for states that participate in the system.

Some agencies have taken a number of steps to understand and monitor the fintech industry, including the marketplace lending subsector. For example, in May 2016, Treasury issued a whitepaper on marketplace lending. In November 2016, SEC hosted a fintech forum where industry representatives and regulators discussed capital formation (including marketplace lending and crowdfunding) and related investor protections. On December 2, 2016, the Comptroller of the Currency announced intent to make special-purpose national bank charters available to fintech companies, such as marketplace lenders. OCC published a paper discussing issues related to chartering special-purpose national banks and solicited public comment to help inform its path moving forward. OCC plans to evaluate prospective applicants’ reasonable chance of success, appropriate risk management, effective consumer protection, fair treatment and access, and capital and liquidity position.

Mobile Payments

Mobile payments allow consumers to use their smartphones or other mobile devices to make purchases and transfer money. Consumers and businesses use these devices to make and receive payments instead of relying on the physical use of cash, checks, or credit and debit cards.

What It Is and How It Works

According to publications we reviewed, there are different ways to make mobile payments, including the use of a mobile wallet. Mobile wallets are electronic versions of consumers’ wallets that offer consumers the convenience of faster transactions without having to enter credit or debit card information for each transaction. Using a mobile wallet, consumers can store payment card information and other information on their mobile devices that is often needed to complete a payment for later use. Generally, mobile wallets replace sensitive information with randomly- generated numbers—a process called tokenization—that provides greater security when making a payment, and then transmit this information using existing credit and debit card networks. A variety of companies provide mobile wallets, including Apple, Google, and Samsung; merchants such as Starbucks, Walmart, and CVS; and financial institutions such as JPMorgan Chase & Co. and Citibank. Consumers may use mobile wallets to make payments to other consumers, referred to as person-to-person (P2P) payments, or to businesses, referred to as person-to-business (P2B) payments, either in mobile applications, through mobile browsers, or in person at a store’s point-of-sale terminal. In addition, other providers, such as Paypal or Venmo, allow individuals to create accounts to receive and make payments.

P2P payments: Consumers can transfer value from a bank account (checking or savings), stored funds in a mobile wallet, credit/debit card, or prepaid card to another consumer’s account. P2P methods use the Internet, mobile applications, or text messages and generally move funds through the automated clearing house (ACH) network or debit and credit card networks. A variety of fintech firms provide P2P services. For example, current P2P providers include PayPal, Venmo, and Google; social networks such as Facebook and Snapchat; and financial institutions such as Bank of America Corporation and JPMorgan Chase & Co.

P2B payments: Consumers can also use their mobile devices to make payments to businesses in stores or on their mobile device. In stores, consumers can use mobile wallets to pay a business for goods or services at compatible point-of-sale terminals. These transactions rely on various technologies to transfer payment data between the consumer’s mobile device and the business, including quick response (QR) codes and wireless communication technologies that enable the payment information to be transferred by allowing compatible devices to exchange data when placed in very close proximity to each other (see fig. 3).

Who Uses It

The Federal Reserve’s 2016 report on Consumers and Mobile Financial Services found that of those with a mobile phone in 2015, 30 percent of individuals ages 18 to 29 and 32 percent of individuals ages 30 to 44 made mobile payments. By comparison, 13 percent of those ages 60 or over made a mobile payment (see fig. 4). From 2011 to 2014, the same general trend was true: younger adults were more likely to make a mobile payment than older age groups. However, the survey results are not comparable because the definition of mobile payments was revised for the 2015 survey.

According to a survey by the Pew Charitable Trusts of over 2,000 consumers, 46 percent of the U.S. population reported having made a mobile payment. Specifically, 39 percent of mobile payments users were millennials and 33 percent were between the ages of 35 and 50 compared to 29 percent of users over the age of 50.

Underbanked: FDIC and the Federal Reserve have found that underbanked consumers use mobile financial services. According to a 2015 survey by FDIC, 20 percent of households in the United States were underbanked, meaning that the household had an account at an insured institution but also obtained financial services and products outside of the banking system. According to qualitative research conducted by FDIC in 2016, underbanked consumers stated that they used P2P payments and a variety of financial products to manage their day-to-day finances. The Federal Reserve’s 2015 survey indicated that a higher percentage of underbanked consumers used mobile payments than fully banked respondents (34 percent versus 20 percent).

Potential Benefits

Convenience and efficiency: According to publications we reviewed, mobile wallets offer consumers the convenience of instant transactions without having to enter credit card information, PIN numbers, and shipping addresses each time they make a purchase. Mobile wallets can also streamline the checkout time. For example, consumers can wave their smartphone in front of an in-store terminal to make a purchase, which can be faster than swiping a credit or debit card.

Data security: Mobile payments can be protected by various security mechanisms, such as codes that must be entered to access a mobile device. According to publications we reviewed, mobile wallets may also improve data security by replacing a consumer’s payment card information with a randomly generated number, or token. Mobile payments can use this token to transact with a merchant, which better protects consumer account credentials.

Potential Risks

Many of the potential risks associated with mobile payments are the same as those that exist with traditional payment products. Some examples of those risks are discussed below.

Data security: Data security risks include the possibility of payment and personal data being lost or vulnerable to theft because of consumers’ reliance on the use of smartphones or other mobile communication devices. According to the Federal Reserve’s 2015 survey, respondents identified concerns about the security of the technology as one of the main reasons they do not use mobile payments. Security concerns include the event of a smartphone being hacked, the loss or theft of a smartphone, or if a company does not sufficiently protect mobile transactions, among other concerns.

Human error and confusion: According to publications we reviewed, mobile payment methods can create operational risk for human error. For example, consumers can deposit or send money to the wrong person when using P2P payments (e.g., if they type in the wrong phone number). Mobile payment methods can also increase consumer confusion regarding protections based on the underlying funding source. According to FDIC, consumers may not understand which regulators supervise the parties providing mobile payments and may be unsure which consumer protections apply.

Industry Trends

Mobile Payment Activities: According to the Federal Reserve’s 2015 survey, the three most common mobile payment activities among mobile payments users with smartphones were paying bills through a mobile phone web browser or app (65 percent), purchasing a physical item or digital content remotely using a mobile phone (42 percent), and paying for something in-store using a mobile phone (33 percent).

Partnerships: Some industry stakeholders we spoke with said that the relationship between banks and mobile payment firms has changed to more partnerships because banks and mobile payment firms recognize mutual benefits. For example, mobile payment firms can benefit from banks’ experience with regulatory compliance and banks can remain competitive by meeting the needs of their customers.

Regulation and Oversight

The regulatory and oversight framework for mobile payments consists of a variety of federal and state regulation and oversight. Determining which laws apply to mobile payments depends on several factors, including agency jurisdiction, mobile payment providers’ relationship to depository institutions, and the type of account used by a consumer to make a mobile payment.

Three of the federal prudential regulators—Federal Reserve, FDIC, and OCC—are authorized to examine and regulate the provision of certain services provided by mobile payment providers for federally insured banks and thrifts. For example, these regulators can examine mobile payment providers that are considered third-party service providers of a regulated depository institution if the payment provider offers services to customers on behalf of a depository institution. The federal prudential regulators can also take enforcement actions against mobile payment providers if the provider is an institution-affiliated party of the bank.

CFPB has consumer protection authority over certain nonbank institutions and enforcement jurisdiction over entities that offer or provide consumer financial products or services. In October 2016, CFPB issued a final rule to add prepaid cards and some of the payment services that fintech providers are offering, such as PayPal, to the definition of accounts covered under regulations applicable to electronic fund transfer systems such as automated teller machine transfers, telephone bill-payment services, point-of-sale terminal transfers in stores, and preauthorized transfers from or to a consumer’s account (such as direct deposit and Social Security payments). According to CFPB staff, the rule is aimed at providing wide-ranging protections to consumers holding prepaid accounts. Although this rule largely focuses on prepaid cards, the protections also extend to P2P payments and certain mobile wallets that can store funds.

Nonbank providers of financial products and services, including mobile payment providers and prepaid card providers, may be subject to FTC consumer protection enforcement actions. According to FTC staff, FTC has brought and settled enforcement actions alleging unfair or deceptive conduct by wireless providers providing mobile payment services.

Finally, at the federal level, the Federal Communications Commission (FCC) has jurisdiction over wireless providers, which provide the devices used for mobile payments or sometimes collect such payments through their customers’ billing statements.

According to FDIC, to date, no federal laws and regulations specifically govern mobile payments. However, to the extent a mobile payment uses an existing payment method, the laws and regulations that apply to that method also apply to the mobile payment. Table 2 provides examples of federal laws and regulations relevant to mobile payment transactions.

State regulators also have authority to regulate mobile payment providers. For example, most states have licensing and regulatory authority over money service businesses that provide money transfer services or payment instruments, which can include mobile payment providers. For example, fintech firms such as PayPal and Google Wallet are subject to state money transmitter laws. State regulators have made efforts to make the state licensing process less burdensome by conducting multistate exams and using NMLS to facilitate these processes.

According to interviews with some agencies, they formed working groups to monitor and understand mobile payments. These examples are listed below.

In January 2010, the Federal Reserve started the Mobile Payments Industry Working Group to facilitate discussions as to how a successful mobile payments (as opposed to mobile banking) system could evolve in the United States. The working group meets several times annually to share information and ideas. In addition, the Federal Reserve established a multidisciplinary working group focused on analyzing potential innovation in fintech including payments.

FDIC established a formal FinTech Steering Committee and two working groups, one focus of one of the working groups includes mobile payments.

CFPB met with payment innovators through its Project Catalyst.

CSBS formed an Emerging Payments and Innovation Task Force in 2013 to study changes in payment systems to determine the potential impact on consumer protection, state law, and banks and nonbank entities chartered or licensed by the states.

Digital Wealth Management

Digital wealth management platforms, including robo-advisors, use algorithms based on consumers’ data and risk preferences to provide digital services, including investment and financial advice, directly to consumers. Digital wealth management platforms provide services including portfolio selection, asset allocation, banking and account aggregation, and online risk assessments.

What It Is and How It Works

According to data from SEC, there were over 12,000 SEC-registered investment advisers in 2016. However, according to staff from SEC, because digital wealth management firms register as investment advisers and are not all separately counted or categorized, the total number of these entities is not known. Digital wealth management firms incorporate technologies into their portfolio management platforms primarily through the use of algorithms designed to optimize wealth management services. Fully automated platforms have features that let investors manage their portfolios without direct human interaction. Examples of current digital wealth management firms include Betterment, Wealthfront, Personal Capital, BlackRock’s Future Advisor, and Acorns.

Publications we reviewed indicate that digital wealth management platforms typically collect information on customers and their financial history using online questionnaires. These questionnaires may cover topics such as the customer’s age, income, investment horizon, risk tolerance, and expected returns, among other information. Digital wealth management platforms allow customers with a need to connect multiple accounts—often across multiple providers—to create a holistic picture of their wealth and more easily manage their finances across multiple asset classes and firms. Digital wealth management platforms use the information inputted by the customer to help the customer select a risk profile. The firms then use algorithms to generate a suggested investment strategy to the customer based on that risk profile. Platforms can automatically rebalance customers’ portfolios in response to the performance of the underlying investments, and the customers’ goals (see fig. 5).

Adviser-assisted digital wealth management platforms combine a digital client portal and investment automation with a virtual financial adviser typically conducting simple financial planning and periodic reviews over the phone. Examples of current platforms in this category include Personal Capital, Future Advisor, and LearnVest. To further differentiate themselves, they may offer value-added services like asset aggregation capabilities that enable the provision of more holistic advice than fully automated digital wealth managers, based on a comprehensive view of client assets and liabilities, as well as expense-tracking and advice on budgeting and financial-goal planning.

Potential Benefits

Increased access to wealth management services: Publications we reviewed indicated that digital wealth management platforms may expand access to underserved segments such as customers with smaller asset amounts than those of traditional consumers of wealth management services. For example, some platforms may not require customers to maintain minimum balance amounts. Traditional firms may require minimum investment amounts of $250,000, whereas some digital platforms require a minimum of approximately $500 or no minimum at all.

Convenience: Regardless of location or the time of day, investors with a smart phone, tablet, or computer can make changes to their data and preference inputs, send instructions, access their portfolios, and receive updated digital advice.

Lower fees: According to publications we reviewed, digital wealth management platforms may charge lower fees for services such as investment trade fees than traditional wealth management firms.

Potential Risks

Some of the potential risks associated with digital wealth management platforms may be similar to those that exist with traditional wealth management services. Examples of those risks are discussed below.

Insufficient or incomplete information from customers: According to publications we reviewed, some digital wealth management platforms generate investment outputs based on information provided by the client from questionnaire responses. A traditional wealth manager is able to ask and clarify questions and request follow-up information to capture a customer’s full finances and goals. However, automated responses may not allow the platform to capture a full picture of the customer’s circumstances or short-term goals, for example, whether the customer may need investment money to buy a new home. If the customer does not understand a question, or does not answer it completely, the platform may not assess customers’ full financial circumstances; for example, if a customer provides conflicting information on his or her finances, the digital wealth management platform may not have a full picture of the client’s financial condition or a customer may end up with an undesired portfolio.

Inaccurate or inappropriate assumptions: Staff of SEC’s Office of Investor Education and Advocacy (OIEA) and FINRA issued an investor alert on May 8, 2015, which cautioned that assumptions that underlie the algorithms used by digital wealth management firms could be incorrect. For example, the alert states that the platform may be programmed to use economic assumptions that will not react to shifts in the market. Specifically, if the platform assumes that interest rates will remain low but interest rates rise instead, the platform’s output will be flawed, which could adversely affect investors.

Consumer Data Protection: To use digital wealth management platforms customers must enter personal information. According to an investor alert issued by SEC and FINRA staff, digital wealth management platforms may be collecting and sharing personal information for purposes unrelated to the platform. The alert cautions customers to safeguard personal information.

Industry Trends

According to publications we reviewed, fintech firms, including at least one digital wealth management platform, are using or have considered using innovative technologies such as machine learning and artificial intelligence. For example, one platform is intended to track consumers’ financial account activity and apply user behavior to the advice it delivers.

Hybrid services have evolved that combine traditional wealth management and digital wealth management. For example, in 2015 Vanguard implemented a service that offers investors an option of consulting with a human advisory representative in addition to its automated investment platform. Traditional wealth management firms also offer digital wealth management services. For example, in 2015, Charles Schwab developed Intelligent Portfolios, available to customers with $5,000 in savings, and Deutsche Bank launched a robo-advisor within its online investment platform.

Regulation and Oversight

SEC regulates investment advisers, which generally includes firms that provide digital wealth management platforms. Other federal and state agencies have a role with respect to oversight of digital wealth management firms, depending upon the services a digital wealth management platform provides.

SEC and state securities regulators share responsibility for the oversight of investment advisers in accordance with the Investment Advisers Act of 1940 (Advisers Act). SEC subjects digital wealth management firms to the same regulations as traditional investment advisers and requires digital wealth management firms that manage over $110 million in assets to register as investment advisers. The Advisers Act generally requires anyone in the business of receiving compensation for providing investment advice to others regarding securities to register with SEC or one or more states. SEC’s supervision of investment advisers includes evaluating their compliance with federal securities laws by conducting examinations, including reviewing disclosures made to customers. It also investigates and imposes sanctions for violations of securities laws. SEC held a forum in November 2016 that discussed fintech innovation in the financial services industry, including the impact of recent innovation in investment advisory services, which includes digital wealth management. In January 2017, SEC’s Office of Compliance Inspections and Examinations announced that electronic investment advice is a 2017 examination priority. In February 2017, SEC’s Division of Investment Management issued guidance for robo-advisers that provide services directly to clients over the Internet. SEC’s Office of Investor Education and Advocacy issued an Investor Bulletin that provided information to help investors using robo-advisers to make informed decisions in meeting their investment goals.

State securities regulators generally have registration and oversight responsibilities for investment adviser firms that manage less than $100 million in client assets, if they are not registered with SEC. According to staff from SEC, state securities regulators can bring enforcement actions against firms with assets of any amount for violations of state fraud laws. For example, the state of Massachusetts’ Securities Division issued a policy in April 2016 stating that fully automated robo-advisers may be inherently unable to carry out the fiduciary obligations of a Massachusetts state-registered investment adviser. The policy states that until regulators have determined the proper regulatory framework for automated investment advice, robo-advisers seeking state registration will be evaluated on a case-by-case basis.

FINRA, a self-regulatory organization, is also responsible for regulating broker-dealers doing business with the public in the United States.

Broker-dealers can use digital investment advice tools to provide investment services to clients. According to FINRA staff, FINRA may test the use of digital wealth management technologies by broker-dealers as part of its examinations. According to FINRA staff, FINRA has taken one enforcement action against a broker-dealer offering clients robo- adviser-like functionality. In March 2016, FINRA issued a report to share effective practices related to digital investment advice tools and remind FINRA-registered broker-dealers of their obligations under FINRA rules, including that broker-dealers are required to supervise the types of businesses in which they engage.

CFTC has oversight authority with respect to commodity trading advisers under the Commodity Exchange Act. According to CFTC officials, digital wealth management firms that meet the statutory definition of a commodity trading adviser would be subject to the same oversight and compliance obligations as other traditional commodity trading advisers. The act generally requires that commodity trading advisers register with CFTC.

Digital wealth management firms are subject to consumer protection laws that are enforced by FTC. FTC is charged with protecting consumers against unfair or deceptive acts or practices in commerce. According to FTC staff, FTC enforces applicable consumer protection laws in regard to fintech services, such as digital wealth management, just as it applies those laws to other products and services. According to staff from CFPB, certain aspects of digital wealth management such as data aggregation, credit, or linked deposit accounts may also be subject to consumer oversight authority by CFPB.

In April 2016, the Department of Labor (DOL) adopted a regulation that would expand the circumstances in which those who provide retirement investment advice, including digital wealth management firms, would have to abide by a “fiduciary” standard, acting prudently and in the best interest of their clients. The rule was scheduled to be applicable in April 2017. However, the President issued a memorandum on February 3, 2017, that directed the Secretary of DOL to examine the fiduciary duty rule to determine whether it may adversely affect the ability of Americans to gain access to retirement information and financial advice. In April 2017, DOL extended the applicability date for an extra 60 days.

Distributed Ledger Technology

Distributed ledger technology (DLT) was introduced in 2009 as a technology intended to facilitate the recording and transferring of bitcoin, a virtual currency, specifically using blockchain. DLT has the potential to be a secured way of conducting transfers of digital assets in a near real-time basis potentially without the need for an intermediary.

What It Is and How It Works

DLT is a generic technology for a distributed database, while blockchain is one type of DLT. According to one study we reviewed, DLT involves a distributed database maintained over a network of computers connected on a peer-to-peer basis, such that network participants can share and retain identical, cryptographically secured records in a decentralized manner. A network can consist of individuals, businesses, or financial entities.

One type of DLT is blockchain, which is a shared ledger that records transactions in a peer-to-peer network. Blockchain is a series of digital blocks of information (transactions) that are chained together. The party initiating a transaction sends a message represented as a block to a network of participants that can include financial institutions, financial market participants, and regulators. For a transaction to be included, network participants must validate the transaction. Once a transaction has been confirmed, details of the transaction are recorded on the blockchain that can be visible to network participants (see fig. 6).

DLT solutions can have different types of access control. For example, there may be “permissionless” (public) ledgers that are open to everyone to contribute data to the ledger and cannot be owned; or “permissioned” (private) ledgers that may have one or many owners and only they can add records and verify the contents of the ledger. According to one study, permissioned DLT is not fully decentralized.

According to publications we reviewed, an important feature of blockchain is that transactions added to a ledger are validated by network participants. This validation process is referred to as a consensus mechanism. Consensus mechanisms can help prevent the problem of double spending. Publications we reviewed indicate there are different kinds of consensus mechanisms that include proof-of-work and proof-of- stake. Proof-of-work may be used in permissionless DLT and proof-of- stake may be used in permissioned DLT. Consensus mechanisms also incorporate security aspects such as cryptography and digital signatures that are listed below:

Cryptography is used to encrypt data to ensure transactions are valid and provide identity verification. For example, during asset transfers, a form of cryptography known as public key cryptography usually forms the foundation of the transaction validation process.

Digital signatures are based on cryptography and are used in DLT to certify the authenticity of transactions (i.e., to show that a person is the true owner of an indicated digital identity). When a person creates and sends a DLT transaction, the transaction must also bear that person’s digital signature.

Who Uses It

According to publications we reviewed, agencies, financial institutions, and industry stakeholders have identified potential uses for DLT in the financial service industry through the clearing and settlement of financial transactions. Examples of these transactions include: private trades in the equity market; and insurance claims processing and management.

DLT can also incorporate smart contracts. Smart contracts can automate different kinds of processes and operations. For example, smart contracts can facilitate the automation of complex, multiparty transactions, such as the payment of bonds and insurance coupons. According to one study, there are several versions of smart contracts composed using computer code.

Potential Benefits

Transparency: According to publications we reviewed, DLT has the potential to facilitate transparency between financial institutions, regulators, and other financial market participants. DLT can increase transparency between participants by creating a shared record of activity where participants have access in real time. Changes by any participant with the necessary permission to modify the ledger are immediately reflected in all copies of the ledger. Because distributed ledgers can be designed to be broadly accessible and verifiable, the technology could enhance financial market transparency.

Efficiencies: According to publications we reviewed, DLT can enhance efficiencies in securities and payment clearing and settlement times. Specifically, DLT has the potential to reduce settlement times for securities transactions by facilitating the exchange of digital assets during the same period of time as the execution of a trade. According to staff from SEC, while the financial services industry is moving toward shortening settlement cycles, DLT may offer efficiencies should it be deployed in securities clearance and settlement functions. In 2015, SEC requested comments on how blockchain technology could facilitate the role of a transfer agent and separately, in 2016, requested comments on the utility of DLT in shortening the settlement cycle for most broker-dealer securities transactions. In addition, conducting international money transfers through DLT can provide real-time settlement.

Potential Risks

Like most new technologies, DLT can pose certain risks and uncertainties, which market participants and financial regulators and agencies will need to monitor.

Operational risk including security risk: According to a publication by the Board of Governors of the Federal Reserve System, operational failures include errors or delays in processing, system outages, insufficient capacity, fraud, and data loss and leakage. According to a FINRA report, given that DLT involves sharing of information over a network it poses security-related risks. The Financial Stability Oversight Council noted that market participants have limited experience working with distributed ledger systems, and it is possible that operational vulnerabilities associated with such systems may not become apparent until they are deployed at scale. According to officials from CSBS, permissionless DLT presents security risks (e.g., anti-money-laundering and Bank Secrecy Act) that can be mitigated.

Industry Trends

Publications we reviewed suggest some financial institutions have taken several approaches to adopt DLT. For example, some financial institutions have initiated blockchain projects, joined a multiparty consortium, or announced partnerships to examine DLT’s potential. In addition, the largest securities depository and a large stock exchange have used DLT.

According to the World Economic Forum, 80 percent of banks are expected to initiate blockchain projects by 2017.

The R3 industry consortium made up of over 50 financial institutions designed a DLT platform for recording and managing financial agreements named Corda.

The Depository Trust and Clearing Corporation proposed to build a derivatives distributed ledger solution for post-trade processing. Through this initiative, the Depository Trust and Clearing Corporation seeks to reduce costs and increase efficiencies in the post-trade process.

In December 2015, the stock exchange Nasdaq enabled its first trade on a blockchain using its Linq ledger through a private blockchain developer. Nasdaq Linq is a digital ledger technology that leverages a blockchain to issue and record transfers of shares of privately-held companies.

Regulation and Oversight

Continued development of DLT is needed to understand how DLT and its components will be regulated by the existing legal and regulatory system. Additionally, it is unclear whether new regulation will need to be created because DLT can present new and unique challenges. According to the Financial Stability Oversight Council, financial regulators should monitor how a DLT network can affect regulated entities and their operations. Representatives of financial regulators have noted the importance of implementing DLT in a manner that is transparent and satisfies regulatory requirements.

With respect to virtual currencies, federal and state regulators have taken varied approaches to regulation and oversight. For example, in 2015, CFTC stated it considers bitcoin and other virtual currencies to be included in the definition of “commodity” under the Commodity Exchange Act. SEC’s Office of Investor Education and Advocacy has stated that the rise of bitcoin and other virtual and digital currencies creates new concerns for investors. Two bureaus within the Department of the Treasury treat bitcoin in different ways, including the Department of the Treasury Financial Crimes and Enforcement Network (FinCEN), which determined that certain virtual currency businesses would be money transmitters under the Bank Secrecy Act, subject to regulation as money services businesses, and the Internal Revenue Service, which treats bitcoin as property for U.S. federal tax purposes. FTC can apply the Federal Trade Commission Act to combat unfair or deceptive acts or practices in or affecting commerce, which includes virtual currencies. In addition, approximately 44 states have issued licenses to companies that use virtual currency in their business model. The existing regulatory complexity for virtual currencies indicates that regulatory approaches for future applications for DLT will also be complex.

According to interviews we conducted, some agencies and one industry association formed working groups to monitor and understand DLT and virtual currencies. These examples are listed below.

In 2015, CFTC formed a working group on blockchain, distributed ledger technology, and virtual currencies to study their application to the derivatives market and promote understanding and communication across the agency. In 2017, the group broadened its focus to cover other aspects of fintech and changed its name to the FinTech Working Group.

In 2016, the Federal Reserve established a working group that is looking at financial innovation across a broad range of responsibilities, including in payments and market infrastructures, supervision, and financial stability.

In November 2013, SEC formed an internal Digital Currency Working Group to build expertise; identify emerging risk areas for potential regulatory, examination, and enforcement action; and coordinate efforts within SEC in the digital and virtual currency space. In November 2016, the group changed its name to reflect that its efforts had expanded beyond digital and virtual currencies into related distributed ledger technologies and their applications. According to SEC staff, the Distributed Ledger Technology Working Group plans to evaluate when and how distributed ledger technology will be used within the securities market.

In 2016, FDIC established the FinTech wholesale working group of intra- agency experts to monitor work in the areas of DLT, blockchain, and smart contracts.

In 2015, the Chamber of Digital Commerce formed an alliance to provide technical assistance and periodic informational sessions on Bitcoin, other digital currencies, and broader uses of blockchain.

Agency Comments and Our Evaluation

We provided a draft of this report for review and comment to CFPB, CFTC, CSBS, FDIC, the Federal Reserve, FINRA, FTC, NCUA, OCC, SBA, SEC, and Treasury. We incorporated technical comments we received from these agencies, as appropriate. In addition, we received written comments from NCUA and CSBS, which are summarized below and reprinted in appendixes II and III.

In its written comments, NCUA acknowledged that regulators face challenges understanding the risk of the rapidly evolving financial technology industry and the challenge of balancing regulations and guidance to address those risks against stifling innovation. NCUA noted that it continues to evaluate risks and monitor the evolving market impact driven by fintech companies and to indirectly supervise activities through credit unions to the extent possible.

In its written comments, CSBS noted that it had formed a task force to study fintech developments and determine the potential impact on consumer protection, state law, and banks and nonbank entities chartered or licensed by the states. CSBS also provided additional information about the state regulatory system for marketplace lending, mobile payments, and distributed ledger consumer products while noting that the states actively license and supervise companies engaged in these services. CSBS also noted that the states have work under way to improve the Nationwide Multistate Licensing System with a technological overhaul to improve compliance with state licensing requirements.

We are sending copies of this report to the congressional requesters, agencies, and other interested parties. In addition, this report will be available at no charge on our website at http://www.gao.gov.

If you or your staff members have any questions about this report, please contact me at (202) 512-8678 or evansl@gao.gov. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this report. GAO staff who made key contributions to this report are listed in appendix IV.

Appendix I: Agencies with Oversight Responsibilities Related to Financial Technology Firms

Regulation of financial technology (fintech) firms depends on the extent to which the firms provide a regulated service and the format in which the services are provided. Table 3 explains the basic functions of federal and state regulators and agencies with oversight responsibilities related to the following subsectors: marketplace lending, mobile payments, digital wealth management, and distributed ledger technology.

Appendix II: Comments from the National Credit Union Administration

Appendix III: Comments from the Conference of State Bank Supervisors

Appendix IV: GAO Contact and Staff Acknowledgments

GAO Contact

Staff Acknowledgments

GAO staff who made major contributions to this report include Harry Medina (Assistant Director), Lauren Comeau (Analyst in Charge), Namita Bhatia-Sabharwal, Chloe Brown, Pamela Davidson, Janet Eackloff, Cody Goebel, Davis Judson, Silvia Porres, Tovah Rom, Jessica Sandler, and Jena Sinkfield.

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