As we did in 2021 and 2022, we’ve crowdsourced some fintech predictions for the coming year from the Freshfields Fintech team, with a couple of long-term trends thrown in for fun. So you can skip ahead (if you choose), the topics of these predictions are:
- Regulation of crypto assets
- AML – increasing focus on fintechs
- Regulation of BNPL
- Tokenization
- DeFi
- AI in fintech is finally delivering
- Serving financial institutions – regulation in itself?
- A future beyond stablecoins?
- Central Bank Digital Currency (CBDCs)
- The Metaverse
Regulation of crypto assets
After a turbulent year for crypto-assets, we expect lawmakers around the world to reconsider their approach to businesses operating in this space. In the EU, MiCA is expected to be adopted in the first half of 2023, establishing a harmonized set of rules for cryptoassets. The question for 2023 is whether other regulators will follow suit, and if so, how will that affect their relative attractiveness to the industry.
We also believe that 2023 will see an increasing pace of legislative reform, as legislators finally understand the difficulty of fitting digital assets into existing legal frameworks. For example, in the United States, the Uniform Commercial Code may be amended to address issues of ownership of digital assets and the creation and perfection of security interests. In the UK, consultation continues on a third type of property (“data objects”), and a consultation is underway on the legal characterization of decentralized autonomous organizations (DAOs). Finally, the taxation of crypto assets remains complicated – our snapshot from earlier this year describes some of the complexities.
AML – increasing focus on fintechs
AML has been a priority for financial authorities for the past decade, and scrutiny of fintech businesses in this area is likely to increase. The range of AML risks expands to include criminal enforcement and a potential tsunami of third-party follow-on litigation. We expect regulators to flex their muscles in this area, for example by restricting fintechs and challenger banks from taking on new clients where they see weaknesses and appointing special auditors to monitor AML implementation in the most serious cases.
Crypto in particular will be subject to significant scrutiny in this area. Over the past few years, we have seen tightening of AML rules in the UK, EU and across Asia, bringing crypto-asset service providers into the scope of the AML regime, and this trend is set to continue.
Regulation of BNPL
With the cost of living crisis affecting more and more people, and the increasing use and availability of ‘buy now, pay later’ (BNPL) (eg to buy takeaways and groceries), we predict that 2023 will be the year when lawmakers and regulators clamp down on BNPL. In the UK, many providers are currently not regulated due to an exemption from the consumer credit regime. However, this exception will be narrowed and many providers will have to be authorized and comply with extensive requirements. BNPL products are also included within the scope of the EU’s updated Consumer Credit Directive which we expect will become law in the first half of 2023 (for more information, see our podcast).
It will be particularly interesting how lawmakers balance the availability of credit with ensuring that consumers are appropriately protected, and how debt management will work at a time when defaults are expected to increase. We will also watch how the industry reacts – some BNPL companies may need to consolidate to survive.
Tokenization
If 2022 was a challenging year for cryptoassets, it also saw a growing consensus that the underlying distributed ledger technology works and is undeniably useful. Most news outlets reported Jamie Dimon’s description of Bitcoin as “a hyped scam,” but only a few mentioned his next statement that DLT and tokenization have clearly proven their usefulness. But as confidence in the technology has grown, confidence in the cryptonative users of the technology has fallen as concerns persist about the governance behind even the biggest fintechs. We believe this opens the door for traditional banks and broker-dealers to offer their existing clients the opportunity to tokenize their current fixed income and equity holdings. By doing this, they will be able to offer their customers efficiency. For example, when it comes to coupon payments, settlement times and corporate actions that can be streamlined using smart contracts. In addition, tokenization will provide access to new revenue streams available in the cryptosphere and, more specifically, enable customers’ tokenized assets to be used as collateral or for staking in DeFi transactions.
DeFi
Which brings us nicely on to our next prediction for 2023, and that is the growth of DeFi. If you are less familiar with DeFi, you may want to read our insight article. Initiated readers will know that DeFi at its simplest essentially describes the financial transactions that are carried out solely on the Blockchain without a central intermediary. DeFi did not escape the difficulties of 2022. Genesis, which was one of the largest DeFi lenders and had gained membership in ISDA, was very publicly pulled down among the FTX wreckage, filing for insolvency earlier this year. Others had similar but less high-profile fates. Questions about circular collateral (loaning to a fintech and holding coins issued by that fintech as collateral) and concerns over AML and KYC checks remain, and some hard lessons need to be learned quickly. If they are, the benefits of the technology remain, and growth in DeFi will be driven by the twin forces of challenging traditional debt markets and the rise of tokenization of assets.
AI in fintech is finally delivering
As discussed in our recent blog post, the insurance industry should be a natural fit for AI, but the big breakthrough has yet to happen. We predict that 2023 will change that. As insurers battle the cost-of-living crisis to deliver competitive rates, AI can be used to reduce costs, streamline the customer experience (e.g. reduce claim times) and increase the efficiency and accuracy of risk assessments. We may also see the increased use of automated services, such as further automation of the insurance and claims processing process. Implementing AI solutions is not without challenges, and much will depend on the age-old balancing act that regulators face between innovation and customer protection.
On AI more generally, we expect to see increased regulation in the UK, as foreshadowed by the Digital Markets, Competition and Consumer Bill, due to be published in Q1 2023 and expected to include new powers for the CMA to test and verify companies’ use of algorithms is in accordance with competition legislation.
Serving financial institutions – regulation in itself?
Legislators and regulators have recognized that financial institutions are becoming increasingly dependent on third parties to provide services that are critical to the stability of the financial system. Given the increasing number of partnerships between established institutions and BigTech (eg LSEG-Microsoft) and the proliferation of ‘banking as a service’ providers, these new regimes will have a significant impact on a previously unregulated area.
The EU is certainly leading the way, having published the Digital Operational Resilience Act (DORA) towards the end of 2022, although its provisions will not apply until January 2025. So the trend for 2023 is for businesses and service providers to digest the impact and start preparations for potentially significant changes. Other jurisdictions may be a little behind but are moving in the same direction – for example, the UK has published a discussion paper outlining a “critical third party” regime that would similarly apply to significant service providers.
Any service provider that meets the criteria to be designated under DORA or the UK proposal will be subject to supervision by one or more financial authorities – which can be quite daunting for those who are not ready for it.
A future beyond stablecoins?
It seems clear that 2023 is the year when activities related to stablecoins will be regulated in many jurisdictions. At the time of writing, stablecoins are the only new type of crypto-asset that the UK government plans to bring into its regulatory scope, and there are no remaining plans to regulate crypto-assets such as bitcoin or ether. The HKMA consulted on stablecoins in early 2022 and the Singapore MAS consulted on a specific regulatory regime for stablecoin-related activities towards the end of 2022.
The political justification for regulating stablecoins was that these types of cryptoassets were seen as the most likely to become a widespread means of payment, including by retail customers. In our view, this has not happened and appears as an example of how it is difficult to regulate in such a rapidly moving area. If anything, the events of 2022 have raised more questions about the viability of stablecoins, and at the time of writing it feels like we are a long way from a stablecoin sufficiently trusted to be used as a daily means of payment.
In a world where CBDCs are likely to be introduced in the next few years, we question the relevance of stablecoins and whether regulatory time could be better spent on a wider range of crypto-assets. Given the risks of investing in cryptocurrencies where the get-rich-quick lure remains strong and the recent failures of crypto-asset companies, it suggests to us that regulators may have backed the wrong horse in trying to protect consumers.
CBDCs and Metaverse
Finally, we will give you two long-term trends that we will undoubtedly hear more about in 2023.
Central banks will continue to explore and develop their CBDC solutions, and we expect more public announcements in the coming year. We can also see some central banks piloting their solutions, and others rolling out theirs for wider use.
As for Metaverse, we believe this will be the year when lawmakers begin to grapple with new (and existing) legal issues arising from new applications. By 2023, the European Commission is expected to take steps to ensure that virtual worlds are developed in a human-centric way (similar to the goals of its recent regulatory intervention on AI) and that European industries and citizens can benefit from the associated opportunities.
