The computers upon which we work all have operating systems that we generally ignore. We mainly deal with the apps that run on these systems. Email, ubiquitous as it is, is merely an app. Nothing works without the system in the background, and because it works so well, we tend to neglect it.
The same can be said of the financial system, particularly the funds management and investment industries in the US. The operating system upon which the entire industry depends in the U.S. is Aladdin by Blackrock. In China, prior to 2021, it was mainly provided by the Alibaba affiliate, Ant Financial. Large U.S. financial and tech firms, including Facebook, Apple, and Google, are working hard to emulate Ant’s scale and scope. The end result we foresee is the market dominance of a small number of digital finance platforms (DFPs).
Our neglect of computer operating systems is benign. The neglect by scholars of financial operating systems may well not be. The $50 trillion asset management industry in the U.S. has far more funds under management than the banking system, and it depends almost entirely on Aladdin. Aladdin has been described as the oxygen necessary for the entire industry’s operation.
In our recent article, “Digital Finance Platforms,” we seek to redress this neglect. We explore the rise of such platforms developed by large, established financial institutions and trace their remarkable growth in global asset management. We analyze how DFPs are crucial infrastructure for financial markets and provide massive cost savings for investors and examine the extraordinary challenge their rise poses to financial regulation.
Digital Finance Platforms as Drivers of Industry Concentration
We argue that DFPs are central to the extraordinary growth of asset and fund conglomerates, including Vanguard, Blackrock, and Fidelity, and broker-dealers like Charles Schwab. We examine the reasons for the massive growth of these platforms, and the policy implications of their possible failures and successes. Their extraordinary growth can be seen as arising from economies of scope and scale, network efforts, and efficiency, which combine to produce major competitive advantages for these massive institutions.
Since the COVID-19 pandemic began, these platforms have grown ever larger. This further increases our regulatory concerns. While DFPs are not exposed to financial risk in the same sense as banks and hence have been regulated differently, such platforms generate a substantial degree of operational risk, particularly risks that arise for human or, increasingly, technical reasons. Moreover, we show how technology and platform concentration challenges the traditional regulatory paradigm for asset management, raising concerns about the potential for such platforms to escape regulation while simultaneously stifling innovation and competition.
From Front-end to Back-end to Financial Ecosystems
In the asset management industry, DFPs are evolving into comprehensive, front-to-back financial ecosystems. For example, Ant Financial which, at its height just before its cancelled listing in October 2020, provided a single financial ecosystem linking more than 1.2 billion clients through its payments services, also offered (1) a money market fund with over 300 million investors, (2) the largest fund brokerage platform in China, and (3) a sizable insurance business. DFPs are driving a similar trend towards concentration in the U.S., where they provide the technological infrastructure that underpins the entire funds industry.
Notwithstanding this substantial size and scope, DFPs are still developing swiftly and often remain overlooked. In our article, we examine the evolution of DFPs in large asset management houses—and increasingly in the large banks as well. Goldman Sachs, for example, announced in 2019 its intention to develop a digital finance platform to provide “a full range of services across the wealth spectrum.” Their potential is enormous, but the scope, scale, network effects, and efficiencies of DFPs drives consolidation and potentially winner-take-all or oligopolistic outcomes.
Risks from Digital Finance Platforms
We argue that ever-more parts of the asset management value chain will be integrated in ever-fewer dominant platform ecosystems. The fewer asset management providers that compete, the fewer incentives for innovation and the greater the potential systemic risks from size (“too-big-to-fail”) or interconnection (“too-connected-to-fail”).
While we focus on the growth of DFPs in the asset management industry, similar developments are occurring across the financial sector, as DFPs are increasingly driven by efforts to build full financial services ecosystems (such as Ant Financial). This evolution could well be beneficial. However, the economic pressure that DFPs generate from their access to data and liquidity will likely squeeze profits out of the rest of the financial system, leading to fewer and larger service providers—and generate the winner-takes-all outcomes often seen in platform industries. Societies—and their financial regulators—must promote innovation and competition, and balance innovation against risk. This has become the core focus in China since October 2020, as it seeks to build systems to balance the opportunities of platforms with their risks in terms of concentration and dominance.
The Case for Regulating DFPs
Considering the risks posed by DFPs for investors, market structures, national security, and financial stability, our paper explores possible avenues for regulating DFPs. On the light end of the spectrum are wait-and-see approaches that foster innovation; in the middle are moderate regulatory interventions which encourage competition; and at the extreme end are strong interventionist approaches akin to the regulation of public utilities or even—in the extreme case—breakup or nationalization.
The approach taken by regulators will depend on the stage of development of a particular DFP, and its market share, dominance, and the significance of the functions it performs. Regulators must be prepared to act quickly to curtail the significant risks posed by such platforms, which are already so integral to the asset management industry that the biggest are far too big to fail.
We cannot yet determine whether the greatest threat from DFPs will emerge from their domineering success or catastrophic failure but, either way, now is the time for sober legislative and regulatory scrutiny.
Ross P Buckley is a Scientia Professor of Law at the University of New South Wales
Dirk A. Zetzsche is a Professor of Financial Law at the Universite de Luxembourg
William A. Birdthistle is a Professor of Law at Chicago-Kent College of Law
Douglas W Arner is a Professor of Law at the University of Hong Kong
This post is adapted from their article in the University of Pennsylvania Journal of Business Law, available on SSRN: Digital Finance Platforms: Toward a New Regulatory Paradigm by Dirk A. Zetzsche, William A. Birdthistle, Douglas W. Arner, Ross P. Buckley :: SSRN