Digitization of Finance | Tracing its Evolution, Importance, and Risks

Traditional Finance (TradFi) is still a mainstream system where transactions are completed with fiat money. People interact face to face and it is heavily regulated by all kinds of authorities. From banking to purchasing, to stock markets, etc. a lot of work is done on paper, which causes delay and increases the chances of discrepancies. 

Digitization of finance can solve all the problems with a traditional approach and make the entire process faster, secure, and more efficient. Digitization involves converting and upgrading the existing systems and formats with modern technologies. 

Where digitization is transforming the financial landscape, it does improve the entire system. At the same time, the evolution of financial technology also brings new challenges, requiring proactive risk mitigation and management. 

Evolution of Digital Finance

Early digitization in finance began with electronic payments when people began using debit cards a.k.a plastic money, Automated Clearing House (ACH) and Electronic Funds Transfer (EFT). This encouraged the shift from cash transactions to digital payments. But this was only the beginning, the financial landscape as we see it today has experienced several upgrades. 

 

Stage of Advancement	Key Technologies and Processes
The Era of Internet	Widespread adoption of the internet led to the development of online banking allowing users to manage their financial accounts of all types from anywhere anytime.  The need for a digital system increased further with the emergence of eCommerce platforms requiring online payment methods. This encouraged the development of making money online gateways and digital wallets.
Mobile Banking and Online Payments	Ushering into a new banking era driven with mobile, the 2000s decade saw a rapid proliferation of  mobile banking solutions. Allowing customers to access their accounts from mobile was considered the apex of accessibility and user-friendliness.  From here, we went to only payments where dedicated bank applications and third-party solutions like PayPal, Stripe, etc. emerged. A notable improvement here was using the NFC technology to allow contactless payments with mobile, one of the important Fintech innovations.
The Era of Blockchain and Cryptocurrencies	With the first cryptocurrency Bitcoin emerging in 2009, the blockchain technology popularized. It was now that the world knew it was possible to run a decentralized finance system.  The success of Bitcoin, blockchain and DeFi led to development of several other cryptocurrencies. The rapid adoption of blockchain and P2P payments paved the way for financial inclusion.
FinTech and InsureTech - Streaming Ahead	Continuing with the expansion of digitization of finance, we are witnessing a rising number of FinTech startups offering innovative financial services.  These include AI-driven solutions, gamified fintech software development services, and much more. Just as financial technology, insurance technology (InsureTech) is up there offering personalized and affordable products related to all types of insurance.

 

This transition from one stage to another is smooth as every stage lays the groundwork for the next one. EFTs, ACH, and ATMs set the stage for electronic transactions. This motivated a move towards online banking services followed by mobile banking. 

 

Given the convenience of mobile banking and its strict regulatory compliance and hidden backend systems inspired the integration of blockchain technology into the financial system. It’s an ongoing process and as long as there’s innovation in digital financial services, new solutions will continue to arrive for the benefit of the end user. 

Importance of Digitization in Finance

Digitization of finance has become a priority investment for businesses and individuals. Those who choose to ignore financial digitization due to security, costs, or any other reason are crippled with inefficiencies, higher operational costs, and lower customer satisfaction. 

• Expanding Access To Financial Services

Digitization of finance will increase financial inclusion. A McKinsey study reveals that mobile-based financial services can add $3.7 trillion to the GDP of emerging economies. 

 

Financial digital transformation can take financial services to earlier underserved and ignored markets. It can help serve the 2.5 billion globally unbanked population who are still slaves to the cash economy. 

 

Digital financial inclusion will take cost-saving digital solutions to the underserved populations according to their requirements. With the right research and effective product development businesses can create winning products harnessing a market need. 

• Reduces the Cost of Transactions and Increases the Speed

At its core financial digitization is about enhancing customer experience through efficiency, better results, and cost reduction associated with financial transactions (monetary and non-monetary). From something as simple as paperless documentation to task automation and improved accessibility, financial institutions experience several benefits with digitization. 

 

Costs are optimized further with the introduction of real-time data analysis powered by advanced technologies like artificial intelligence and machine learning. Operational costs also reduce with the introduction of digital services as it is beneficial for customers and institutions, both. 

• Improvement in Customer Experience With Digitalization

A notable benefit of digitization of finance is customers get quick access to the majority of the services. Successful efforts by banks, FinTech companies, and other financial institutions to deliver comprehensive services to customers has increased customer satisfaction. 

 

Leveraging AI and ML, new products are now customized to match customer behavior and preferences. All of this is done while following regulatory compliance. Integration of AI in finance has proven to be convenient for everyone, including financial institutions and customers. 

• Data-Driven Decision-Making

As financial institutions generate and process tremendous amounts of data everyday, digitalization has helped them not only speed up the process but also ensure better accuracy. Moreover, by digitizing information-intensive processing, financial data analysis costs can be reduced by a whopping 90%. 

 

Cleaner data and detailed analysis offers better insights, helping identify new business opportunities and make improvements in the existing workflows. Access to actionable insights clears the ground for better innovation and also helps reduce digital finance risks.

Risks Associated with Digitization of Finance

Financial institutions while exploiting the benefits of digitization must also know how to manage the risks associated with the process. However, before knowing how to mitigate them, it’s important to understand the risks first. 

• Cybersecurity Threats - Data Breaches and Fraud

Digital transformation at any level means the systems must be connected with the internet, which exposes the entire infrastructure to cybersecurity risks. It goes without saying that any organization connected to the internet may be vulnerable, especially the ones which are dependent on the third-party vendors or use SaaS platforms. 

 

Data privacy breaches and security compromise, especially in a financial institution is detrimental to the organization and its customers. Where the hackers can misuse customer data, they can also access accounts and leak away funds without authorization. 

• Financial Institutions can Access Personal Data

Access to online financial services means customers are creating their digital footprint. As financial institutions can use this data to build customer-centric products, the way organizations use personal data is always a risk. Especially in low-income countries with an inefficient regulatory compliance system, access to personal data can lead to data abuse and cyber crime.  

 

While measures are taken to safeguard customer’s personal data by instructing data collectors to take extra measures, there are several other reasons which financial institutions can exploit. 

• Widespread Failure due to Systemic Risk

Digital systems are interconnected, which is a necessary requirement for them to work together effectively. A systemic risk means when failure in one part of the financial system can cause a breakdown and widespread instability in the entire infrastructure. Given the complexity of financial networks and their interconnectedness increases the occurrence of a systemic risk. 

 

Because some financial systems may rely on centralized platforms and intermediaries like payment processors and data exchanges, a single failure can disrupt a wide range of financial activities. 

• Difficult in Keeping Up with Financial Regulatory Compliance

Integration of new technologies in the financial system requires new compliance requirements. As new technologies tend to change business practices, managing them with updated compliances is essential. 

 

Failure to stay compliant can result in fines and incarceration as well. While compliance risk management is essential, the efforts shouldn’t be limited to your organization's end. Working with third-party vendors and platforms also puts your organization at noncompliance risk. 

Risk Mitigation and How to Embrace New Opportunities

As we have discussed above there are several risks associated with digital transformation in finance. The moment an organization’s digitalization begins, they must also lay out the building blocks for digital risk management and mitigation. 

• Robust Cybersecurity Infrastructure

Work on creating a cyber resilience framework with the right tools (hardware and software) while implementing them through a comprehensive approach. To manage cybersecurity risk means deploying a zero trust approach against cyber threats and responding to all security threats. A robust cybersecurity infrastructure includes the framework, a risk analysis report, and a Security Information and Event Management (SIEM) provider. 

• Data Privacy and Protection Measures

Starting from network security measures like setting up firewalls, intrusion detection system (IDS), and VPNs financial institutions must also integrate data encryption systems. Encrypting data at rest and during transit will eliminate the risk of data theft and eavesdropping. For the best cybersecurity in finance, the organizations must set role-based access control (RBAC) measures and multi-factor authentication (MFA). 

• Risk Management Frameworks

A risk management framework must include risk identification, assessment, treatment, monitoring, and governance.

 

Risk Identification	Identify potential threats and conduct vulnerability assessment.
Risk Assessment	Use quantitative methods to assess the likelihood of security risks and assign a score to each risk.
Risk Treatment	Eliminate or avoid the risks while implementing preventive measures.
Risk Monitoring	Set up continuous risk monitoring measures to identify emerging threats and take preventive actions.
Governance	Establish an in-house risk committee to oversee the implemented measures and conduct regular reviews to assess their effectiveness.

 

• Collaboration Between Regulators and Industry

Financial institutions must work with industry experts and regulators to set up joint working groups for policy making and execution purposes. The purpose is to build risk management strategies which ensure consumer and organizational protection. The JWGs must also work on integrating AI in finance ensuring the right usage of technology while setting up compliance measures. 

• Fostering Innovation and Education

With rapid digitalization in the financial sector ensuring digital literacy among professionals and consumers is essential. The right education will empower everyone to hone digital skills required to conduct business safely. Moreover, education also includes knowing about the emerging technologies like blockchain, cybersecurity awareness, and cryptocurrency. 

Conclusion

Digitization of finance has become crucial for success in the financial sector. From banking to stock markets, to all sorts of financial institutions, adapting new technologies is essential to improve customer experience. Where customers now get remote access to personalized banking services 24/7, institutions benefit from automation and reduced costs. 

 

With Helius, banking institutions can embrace digital transformation while focusing on risk management and prevention. However, it remains to be seen how the industry reacts to the emerging trends and technologies as a part of the digital transformation process.