A virtual folder containing financial documents – from insurance policies and credit cards to stock portfolios – that are all matched to one another. Bank advisors and insurance agents could use this image to explain to their customers what the financial industry means by digital ecosystems.

For professionals who deal with financial services as part of their daily work, the term “digital ecosystem” needs no explanation. They no longer confuse it with the concept of sustainable finance. But digital ecosystems and sustainable finance do have one thing in common: neither term has a legal definition. So what are we talking about here?

A simple example of a digital ecosystem would be a map provided by a search engine or other navigation system in which companies can save “points of interest”, such as cash machines or branches. However, as with advertisements, the information provided often directs users to the website of the relevant company and thus away from the original site. The essential characteristic of a more highly developed ecosystem, in contrast, is that it is a self-contained system that functions autonomously – a world unto itself.

Closed systems

Internet platforms and social media are examples of such ecosystems. Their aim is to keep customers on their platform, and they cover all areas of digital life. In addition to allowing users to manage their social contacts, among other things, these platforms also contain news articles, because if a user is able to obtain information within the platform, they will not leave it to visit the news site itself, even if that is where an article was originally published. The idea is that users are able to do everything they want to do online within a digital ecosystem. “And this must at least include convenient payment options as a means of achieving the intended objective: providing a complete and comprehensive customer experience,” said BaFin President Felix Hufeld.

When a customer orders goods (the objective), online payment is one means with which they can receive these goods. Of course, financial services can also be an objective in themselves. This would be the case when, for example, a user within an ecosystem purchases term life insurance. With the help of Big Data and Artificial Intelligence (BDAI) it would theoretically be possible to collate all of the available information on that user, such as data regarding any real estate loans, their marital status and their income, in order to present them with a bespoke insurance solution.

Within such closed systems, the operators can of course also determine which payment means or systems they allow on their platforms. Platform operators can also create conditions which allow them to receive information about the financial transactions conducted by their users, in addition to all of the other user information they collect.

Financial companies are spoilt for choice

Digital ecosystems are not expected to disappear again any time soon. Financial companies must give digital ecosystems careful consideration, weigh up the opportunities and risks, and reach a well-informed decision as to how they intend to respond to them. They are spoilt for choice, and nobody can take this choice away from them – not even BaFin. The authority does not involve itself in the business policy decisions of the companies under its supervision. BaFin is, however, intensively involved in the discussion surrounding the topic, aims to acquire as much knowledge on it as possible, and works to share this knowledge with the market, for example through studies and publications (see issues 1/2018 and 1/2019 of BaFinPerspectives). According to BaFin President Felix Hufeld, supervisors and regulators must reach a decision as to how they intend to deal with new technologies and their implications.

The arrival of bigtech companies on the market

The issue is particularly interesting given the fact that the providers of digital ecosystems are often world-famous and globally-active technology giants who are in possession of vast quantities of data, which they are able to turn into profits in countless industries. These technology companies do not necessarily need to generate income with financial services – they can cross-subsidise such products and, in extreme cases, even provide them free of charge.

BaFin has observed that companies that are not traditional banks or insurers are increasingly moving into the field of financial business with activities that are currently not subject to an authorisation requirement. “The extent to which we will have to react to this through regulatory means, for example by extending the traditional supervisory focus on entities to include specific, clearly defined activities, remains to be seen,” said Hufeld. At the international level, such discussions are well under way among supervisory authorities.

Should bigtech companies ever reach the point at which they require authorisation under section 32 of the German Banking Act (Kreditwesengesetz – KWG), Hufeld has made one thing clear: “In Germany, only those companies that have truly gained the necessary expertise in the field of banking will be granted a licence from us.” Of course, large technology companies can learn how to conduct banking operations – and can learn fast, not to mention the fact that they could cooperate with other companies.

Competition or winner takes it all?

Digital ecosystems as they appear today are set to change the banking landscape, even if bigtech companies do not decide to apply for licences to conduct banking or insurance business. In any case, as gatekeepers, they can take control of the interface between companies and customers. If they choose not to apply for their own licences, these platform providers would have to involve partner companies that hold the necessary authorisation. Nonetheless, they would still be in a position to determine which of these companies could appear within their ecosystems. As such, platform operators will become gatekeepers to customer contact, meaning companies will not be able to reach customers in an ecosystem without them – at least within the framework of the current applicable (competition) law. To an even greater extent than today, many companies will have to settle for the role of mere supplier to such platforms.

This would become truly problematic if no real competition for market share emerges between the various digital ecosystems and only one ecosystem proves to be viable. In this winner takes it all scenario, competition will revolve around the matter of who is and is not able to participate in a digital ecosystem in the first place.

However, in Hufeld’s view, German companies have no reason to be timid. Expertise and customer trust are two areas in which German companies have an advantage over the competition from outside the financial sector, namely the technology and data giants from Silicon Valley. If bigtech companies can acquire expertise in the financial sector, then banks and insurers too can learn the core competences of bigtech companies. Hubs within individual companies are doing this already. There is also further potential for cooperation agreements with fintech and insurtech companies (see expert article on the BaFin website dated 7 March 2019).

Basic principles of supervision

Ecosystems are not just raising questions about classic financial institutions and insurers, they are also challenging the role of state institutions. Blockchains facilitate transactions without intermediaries. According to bank critics, customers should in future place their trust in such technologies rather than in institutions – without banks and insurers. But then who would be supervised? If a major shift towards a blockchain economy really were to take place, resulting in decentralised ecosystems without central institutions and responsibilities, then regulatory and supervisory practice would also need to be updated. “Wherever we ascertain that financial transactions based on blockchain are not subject to existing regulation, we must review whether and to what extend we need to make changes,” explained Hufeld.

As before, this should still be based on the principles of regulation and supervision. For BaFin, these principles include neutrality towards technologies, which means, among other things, that no software solutions are prohibited from the outset; instead, their usage is reviewed with a view to whether they pose a risk to the integrity and stability of the financial market and to collective consumer interests.

Germany’s supervisor is also not influenced by the ages, origins or names of the companies it supervises. For BaFin, these are not the decisive criteria. Instead, its supervisory activities are based on the risk associated with a company’s business activities. BaFin’s supervision is therefore proportional to this risk.

Supervisors will find answers to the challenges posed by innovations in information technology, such as digital ecosystems. The industry is facing the same challenges.