John C. Williams, president and CEO of the Federal Reserve Bank of San Francisco, Calif., sees fintech as holding great promise for the financial system, but he also believes regulation plays an important role in allowing fintech to fulfill its potential.

Speaking to the LendIt USA 2016 conference in San Francisco, Williams said there are potential risks involved with new advances that regulators have to consider. LendIt USA is an online lending platform.

During his presentation [PDF], he cited the possibility that digital currency can be used to support criminal and terrorist activity.

[L]eft unbridled, the ease and anonymity of some types of fintech, such as digital currencies, have the potential to make criminal and terrorist activity even easier.

As a representative of the Fed District that is home to a technology hub that is considered the center of the tech universe, Williams said he is compelled to consider future obstacles.

Financial System Fundamentals

He began by reviewing how the financial system should serve the economy and society. The financial system’s goal is to facilitate payments among buyers and sellers, as well as direct homes’ and businesses’ savings to their best uses.

These “best uses” include building homes and businesses, achieving an education or creating infrastructure. The system is also tasked with being resilient and efficient.

Williams said fintech holds great promise, but he sees potential risks. He said regulators often don’t highlight risks since they know they are perceived as pessimists, but they are nonetheless required to consider unintended consequences.

Williams made what he called a standard disclaimer, meaning the views he expressed were his alone and don’t necessarily reflect others in the Federal Reserve system He also noted that as president of the San Francisco Fed, he does not write regulations directly. He did not wish to discuss specific regulations as they apply to fintech.

Williams said his goal was to present questions that should be considered in how fintech can make the financial system and the economy successful in achieving fundamental goals.

Opportunity Brings Risks

Innovation’s laws often reflect those of physics; every stride carries a risk. Technology brings great opportunities to improve financial performance. It includes products addressing all parts of the consumer wallet: saving, borrowing, spending and planning. Fintech products use platforms that increase the customer base and allow more people access to credit.

One of fintech’s most game-changing benefits is being able to reach economically disadvantaged and underserved communities. This is true in mature economies like the U.S. where access to financial services is a perennial issue, as well as in emerging economies.

“Fintech can lower costs and improve services, particularly for lower-income families and small businesses,” he said. “Meaning fintech can help more people get access to credit at reasonable terms, better manage their finances, and keep more money in their pockets.” Fintech can help rebuild poor neighborhoods by enabling small businesses that are shut out of the formal financial sector to grow.

Helping The Unbanked

Payment systems are emerging via mobile phones in regions where most people are unbanked or underbanked but have cell phones, he said. These people don’t have to pay big fees for banking services.

“This has made its mark in some areas, is starting to gain a foothold in others, and even has potential here.”

The problem is these same people could become even more marginalized, Williams said. In the past, portions of the population did not receive services based on where they lived, an exclusionary practice in lending called redlining.

Lending metrics resulted in the disenfranchisement of ethnic and racial groups, even when laws prohibited discrimination.

Unintended Consequences

“It would be a travesty if, despite the best intentions in the world, new technologies designed to improve the availability of credit instead ended up reintroducing that kind of exclusion, by, say, basing decisions on zip codes or other demographic metrics.”

Fintech’s novel approaches to intermediate savings and investments could reduce costs and increase access to the unbanked and underserved, but based on historical precedent, “the unscrupulous will prey on the vulnerable,” whether through irresponsible payday loans, predatory lending, fraud and more.

Williams said he does not want to see fintech’s positive potential hijacked by becoming a source of more powerful platforms to prey on consumers.

The leveraging of data analytics to improve risk management, decision making and operational efficiency offers great potential. Algorithms can help overcome obstacles to preventing money laundering and funding of criminal and terrorist groups. Know-your-customer rules mandate that financial institutions verify customer identity.

Also read: VC fintech funding sets record in 2015, fueling bitcoin and blockchain growth

Digital Currency’s Role

At the same time, the anonymity and ease of certain types of fintech like digital currency can make terrorist and criminal activity easier, Williams said. While fintech can improve the ability to manage and assess risk, it is important to protect the privacy of consumer data.

The resilience of the financial system as a whole must be considered. As fintech expands, risks to the system and the economy also expand. For the financial system to be efficient, a level playing field is also important regardless of how institutions describe themselves or what type of charter they hold.

Williams insisted he was not suggesting innovation’s spirit is nefarious or that people have not considered risks on their own. But he said it is important to consider unintended consequences.

“I am excited for the changes to come, and I see the potency of the possible. But for fintech’s potential to be met, we need to make sure we don’t reinvent or exacerbate shortcomings that have plagued our financial system thus far.”

He said well-designed regulation that fosters inclusionary practices and protects the consumer should help rather than hinder fintech’s contribution to a better financial system.

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