Finance in the Fourth Industrial Revolution: Expected Changes and Responses

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1 Finance in the Fourth Industrial Revolution: Expected Changes and Responses Lee, Hyo Seob The Fourth Industrial Revolution is expected to accelerate the shift in the focus of finance from service providers to consumers. The shift is manifested as a new industry landscape arising from artificial intelligence, blockchain, open platforms, and other fintech innovation, each of which will offer financial consumers convenient financial services at lower costs. Beyond fintech innovation itself, its convergence of finance, culture, healthcare, education, and other industries is expected to bring about substantial improvements in consumer benefits. In addition to the positive effects, there have been deep concerns about the Fourth Industrial Revolution. For example, this may cut the number of jobs in the financial industry, and an excessive drive for financial innovation may undermine financial protection and stability. To better cope with the Fourth Industrial Revolution, finance should be capable of giving support to the real sector, e.g., technology finance, while at the same time pushing for creative destruction toward financial innovation. During the progress, caution is necessary to prevent financial innovation from coming at the expense of investor protection and financial stability. The Fourth Industrial Revolution was first introduced by Professor Klaus Schwab, Founder and Executive Chairman of the World Economic Forum to describe the industrial landscape changes arising from AI, big data, Internet of things (IoT), and other technological innovation in ICT. To briefly summarize, the steam engine and machine drove the First Industrial Revolution from All opinions expressed in this paper represent the author s personal views and thus should not be interpreted as Korea Capital Market Institute s official position. Ph.D., Research Fellow, Financial Services Industry Department, Tel: , hslee@kcmi.re.kr 1

2 the end of the 18th century to the beginning of the 19th century; mass production powered by electric energy triggered the Second Industrial Revolution in the end of the 19th century and the early 20th century; and development of ICT such as Internet and semiconductors in the end of 20th century symbolize the Third Industrial Revolution. Whereas the previous three revolutions pursued innovation in production by accumulating capital and labor, the Fourth Industrial Revolution is seeking after further ICT development and its convergence in other industrial technologies so as to bring about innovation in production, distribution, and sales. The Fourth Industrial Revolution has drawn keen attention because of its potency to add value during the ongoing shift in the focus of economic activities from producers to consumers. Under the influence of the Fourth Industrial Revolution, manufacturing, ICT, and all other industries are facing significant changes. For example, the manufacturing sector expects that the convergence of ICT would substantially cut marginal costs in labor and capital, and that innovation in production, distribution, and sales would significantly improve profitability. The ICT industry expects technological convergence and platform innovation to improve consumer convenience. On the other hand, if automated devices such as robots replace the human workforce, this could rapidly cut jobs. Also, the platform provider will enjoy a natural monopoly, which may exacerbate inequality. Another danger is the possibility of social unrest arising from technological errors as a new technology sets in before the previous one fully takes hold. The financial industry is not free from the landscape change brought by the Fourth Industrial Revolution. Fintech, the convergence of ICT and finance, has led innovation in every corner of the financial industry, payment and settlement, asset management, retail lending, InsureTech, etc. Fintech innovation aims to provide low-cost financial services to anyone regardless of wealth. Despite such benefits, fintech innovation also has risks: this may cut the number of jobs in the financial industry, and be vulnerable to errors and hacking attempts that could damage investor protection and financial stability. Against the backdrop, this article explores the impacts of the Fourth Industrial Revolution on the financial industry, and presents the desirable responses for the financial industry to successfully cope with it. Positive changes Fintech, the convergence of finance and technologies, has been leading changes in the financial industry. Development in AI allows all financial consumers to access wealth 2

3 management services at lower costs. Robo-advisors are a case in point of AI-based wealth management. AI is also widely used in distribution channels, beyond wealth management. Furthermore, AI technologies such as deep learning enable a variety of corporate information including disclosures, accounting data, and news to be accurately analyzed and compiled for more meaningful financial information. Also, AI and big data make the assessment of individual credit risks faster and more accurate. Also, AI technologies are widely adopted to monitor the market, detect abnormal financial transactions, and provide mobile-based personal financial secretary services. Blockchain is another area driving innovative changes in the financial industry. Known for its superb efficiency, security, stability, transparency, and scalability as compared to the existing ledger management technology, blockchain is a technology that manages transaction data by distributing them to P2P clients instead of a central server. Thanks to such strengths, blockchain technology is prevalent in every corner of financial transactions ranging from digital money to funds transfers, payment and settlement, OTC securities issuance, trading, and clearing and settlement, electronic registration, electronic votes, auction, collateral management, etc. More recently, blockchain is adopted in IoT that is expected to create value in diverse services such as IoT ownership verification, financial transactions, electronic records, information sharing, charging, etc. For example, a refrigerator can tap into a blockchain service for managing the origins and expiration dates of food products, as well as for recommending and purchasing products optimized for the owner. Lastly, open platforms have grabbed attention as infrastructure technology that makes financial convergence and information sharing much easier. An open platform consists of an open API (a set of program commands open to developers) and the testbed, and serves as infrastructure providing standardized financial services. The UK has built an open data platform under the government leadership since 2010, and began providing a pilot service to retail customers based on its open banking API standard from For example, a financial institution opens its open API for deposits and loans, account balance inquiries and funds transfers, money exchanges, stock orders, giro transfers, etc. Developers then use the open API to provide customized financial services via mobile, SNS, IoT, and other forms. A platform sharing algorithmic trading strategies is recognized as one of the exemplary cases of open platform innovation. In the open platform, global investment strategists freely post their algorithms, from which major 3

4 institutional investors select and implement a highly-rated one. If a fund selecting the strategy generates profits, the institutional investor and the algorithm owner share those profits. Fintech is not the only channel via which the financial industry would face changes under the Fourth Industrial Revolution. Financial innovation is pursued by convergence between the industry and other service sectors such as healthcare, culture, education, etc. For example, InsureTech converging insurance and technology tries to re-converge with the healthcare industry with the aim to address the insurance industry s deep-rooted problems of moral hazard and adverse selection. More specifically, a hospital may share the result of healthcare services with an insurance company that will charge differentiated premiums depending on the result. Crowdfunding is evolving into a convergence model between finance and culture while being used as a popular financing tool for production and distribution of cultural contents, such as films, albums, soap operas, musicals, etc. Finance is also expected to converge with education, e.g., a mock trading system using AI, investor education based on augmented reality, etc. Concerns in the financial industry Unlike the positive impacts the Fourth Industrial Revolution would have on the financial industry, some have raised deep concerns. First and foremost, robots and other automated devices are expected to replace human jobs in production, distribution, back office infrastructure, and almost all areas, which is likely to cut the overall number of jobs in the financial industry going forward. Indeed, the number of staff at major commercial and investment banks in the US has been rapidly decreasing. As of 2015, Citigroup and JPMorgan Chase employed 231,000 and 235,000 staff, respectively, a 13% and 10% decrease from 266,000 and 259,000 in As AI and other automated devices are rapidly replacing banks product manufacturing, prop trading, and distribution functions amid the worsening bank profitability, jobs in the traditional financial industry are projected to dwindle further. What is intriguing is that the number of employees is increasing at Goldman Sachs after its announcement to shift toward a tech company. As of 2015, Goldman Sachs employed 37,000 staff, an 11% increase from 33,000 in Although Goldman Sachs cut jobs in prop trading and distribution as did other commercial and investment banks, its substantial increase in its recruitment of quant staff appears to be a major contributor. 4

5 Figure 1. Number of staff at US banks Source: Statista Another concern is that an excessive drive for financial innovation may undermine investor protection. For example, it is hard to tell whether a consumer solicited via a non-face-to-face, online channel properly understands product risks or not, which may compromise the duty to explain or the suitability test. Furthermore, an AI-based online platform may recommend consumers to buy high-fee financial products. Also worrisome is the uncertainty in legal liabilities when there is a financial dispute. New payment and settlement tools and retail lending products could be either misused to circumvent the existing regulatory regime or maliciously used by perpetrators. Lastly, the Fourth Industrial Revolution may possibly undermine financial stability. For example, when multiple AI services in the financial markets make the same investment decision, herding or sophisticated forms of unfair trade practices may occur. If financial services are concentrated in a certain platform, e.g., a blockchain, an open platform, etc., it is hard to rule out the possibility that any unexpected hacking attack or program error will inflict damage on a great number of financial consumers. The market has already observed such cases: a hacker attack on the bitcoin exchange caused damages on many investors, and advanced algorithmic trading such as high frequency trading substantially pushed up capital market volatility. Desirable directions As the Fourth Industrial Revolution is currently in progress, every industrial sector is gearing up to successfully complete it. What are the roles finance should undertake in the era of the 5

6 Fourth Industrial Revolution? First, finance should continue to promote its function to support the real sector via the capital markets and banks. For a successful Fourth Industrial Revolution, innovators pursuing creative destruction should be able to put their ideas into action by starting their own business. In particular, facilitating youth startups is a precondition to job creation. Financing is the biggest obstacle to youth startups. Startups with superb technology should receive risk capital. In the past, policy financing used to play a role of technology financing, but the private sector should now increase risky investments in new growth industries. For example, it is worth exploring overseas technology financing cases to review whether to introduce new investment methods such as private debt/equity fund portfolios. This refers to a scheme where private debt/equity funds simultaneously invest in a startup as they increase equity investment in, instead of lending to, a risky startup while they decrease investment and increase lending to a firm in the stable phase. Second, financial innovation should be pursued via creative destruction. Learning from Goldman Sach s success, financial firms should hire and expand their quant workforce for their prop trading, wealth management, risk management, research, distribution, etc. Also necessary is the need to expand the range of their open data and open APIs so that developers can easily access and utilize financial services. In the same vein, it is worth considering establishing a market to trade open APIs and applications. In addition, the convergence of finance should go beyond technology to innovation in other areas such as culture, healthcare, education, tourism, etc. Also necessary is to pursue financial innovation in a persistent manner via overseas expansion to overcome Korea s small market size. Third, investor protection and financial stability should receive continuous attention. An excessive drive for financial innovation in the name of the Fourth Industrial Revolution may come at the expense of investor protection and financial stability. There have been many regretful cases of financial innovation that put the interests of financial firms ahead of client interests. To prevent this, it is required to disclose fees of financial products in a transparent manner, and to facilitate online advisory and distribution infrastructure. Both the government and financial institutions should increase investments in financial security infrastructure, and aggressively develop AI-based systems to monitor the market and detect abnormal financial transactions. Another risk factor is that a new set of technologies emerge even before the previous technology fully takes hold. Learning from the UK case to facilitate RegTech that helps address challenges of internal controls and compliance would be a good idea. Without financial 6

7 backing, the past three industrial revolutions could have never achieved anything. For the Fourth Industrial Revolution to bear fruit, finance should faithfully carry out its intrinsic functions to support the real sector, while pushing for financial innovation via convergence in other industries. During the process, it is important to bear in mind that financial innovation should not come at the expense of investor protection or financial stability. 7