What is the Best Regulatory Response to Fintech?

Over the last decade, “Fintech” — broadly defined as the use of new technology and innovation to compete in the marketplace of financial institutions and intermediaries — has disrupted or is disrupting the financial services sector in at least three ways.

New technologies have allowed incumbent financial service providers to offer a range of new services that remove intermediaries and administrative layers to make transactions more effective and less prone to error. In this way, financial services are “decentralized” and made flatter.

Most obviously, there is the growth of mobile banking that allows customers to perform a wide range of transactions online. Networked access to financial services facilitates quicker access to all manner of transactions from checking financial status, making payments, and withdrawing and transferring funds.

“Behind the scenes” activities of financial institutions are similarly transformed. In part, this involves the use of Big Data to deliver a more efficient service, but it also allows firms to use technology to manage legal risk more effectively.

The fallout from the 2008 financial crisis resulted in vast swaths of new banking regulation. One consequence has been the increased use of technology to help banks comply with the new regulatory requirements. Sometimes referred to as “Regtech”, this involves using new technologies to meet regulatory and compliance requirements.

There are a number of areas of compliance and reporting where technology can have a significant benefit, such as risk data aggregation, modeling and real-time transactions monitoring. Machine learning, artificial intelligence, and biometrics have been particularly promising in tackling compliance challenges.

Fintech has also facilitated the emergence of startups that offer an alternative source of financial services. In particular, “app-based” companies are emerging everywhere. They challenge and disrupt incumbents, such as traditional banks, by supporting a wide range of financial services, namely marketplace lending platforms, equity crowdfunding platforms, insurance services, algorithm-driven “robo-advisors” offering smarter more personalized financial advice and blockchain-based crypto-currency and payment systems.

Different Type of Fintech Companies

For Millennial consumers, in particular, these alternative service providers are very attractive. Banks have traditionally failed to cater to three generational characteristics of Millennials, namely the perception that banks are (i) not to be trusted; (ii) profit driven corporate machines disengaged from the needs and values of ordinary people; and, (iii) bureaucratic organizations associated with the values of an older more selfish version of capitalism.

The desire for instant gratification and the expectation of a more thoughtful and transparent service means that if traditional financial institutions don’t satisfy these needs the Millennial consumer simply moves to new providers that will. Ironically, automation and technology can provide a more personalized experience than traditional “human” customer service.

Finally, Fintech leverages technology to improve the quality of, and access to, financial services for individuals that have traditionally been excluded from such opportunities, in particular in emerging economies.

Driving this change is the global proliferation in smartphones. Smartphone penetration is expanding quickly around the world with 6.1 billion users expected by 2020. A number of startups are leveraging that reach and providing access to credit in markets in Africa, South America and South-East Asia.

The range of services is rapidly expanding. Examples include providing an easier way to maintain land rights data which can then serve as collateral for accessing credit or verifying identities which is often a challenging and prohibitive requirement for accessing both financial and non-financial services.

The conclusion? Despite the risks or fluctuating interest, Fintech cannot be ignored.

This trend is borne out by the investment data. Since around 2010, more and more investment is being made into Fintech. And even though there is evidence that deal activity has slowed over the last year, there is little evidence to suggest that the growth of Fintech is likely to permanently stall or collapse.

Global “Venture Capital” Investments in Fintech Startups (Source: PitchBook)

Given this disruption — a trend that seems set to continue — regulators are obliged to respond to Fintech.

So, what are the options?

Broadly speaking, if we look around the world today we can distinguish between two broad categories of response — “reactive” and “proactive” — each of which has a number of sub-categories.

1 — “Reactive”

The first group includes countries in which nothing is being done. There is “No Regulatory Talk or Action”.

The second group consists of countries in which there is partial or “Fragmented Regulation” of Fintech. Certain institutions, such as the Consumer Financial Protection Bureau (CFPB) in the United States, may offer certain safe harbor provisions for certain type of Fintech companies. Yet, there appears little willingness to genuinely embrace the technology and its regulatory implications, nor is there any comprehensive plan as to how Fintech can or should be regulated.

2 — “Proactive”

On the other hand, are those countries that take a more a proactive approach.

In the first group we find those countries that make Fintech a “Priority”. In such countries, there is a lot of regulatory attention paid to Fintech. Such “attention” can take the form of consultation papers, White Papers, or conferences. But action is limited and there is a risk that “prioritizing” Fintech can slide into an empty “lip service” aimed at projecting an image of regulatory action when, in reality, action is limited.

A second group of countries engage in what we might characterize as “Regulatory Guidance”. Regulators provide advice to Fintech startups and incumbents in order to help navigate them through the regulatory system. This does not necessarily entail changes in regulatory structure, but it does promote a collaborative dialogue between regulators, traditional service providers and Fintech companies.

A final group of countries have embraced the possibilities of Fintech by creating a so-called “regulatory sandbox”. We characterize this approach as “Regulatory Experimentation”.

Regulators create a regulatory sandbox in which they facilitate and encourage a space to experiment. This allows the testing of new technology-driven services, under the supervision of regulators. This ensures that meaningful data can be gathered for the evaluation of risk in a safe environment. Such data can then facilitate “evidence-based regulatory reform”.

A key point about this last approach is that it is collaborative and dialogical, in the sense that regulators, incumbents and new service providers are engaged in an on-going dialogue about the most effective means to gather relevant information and to identify the most appropriate regulatory model.

In order to better understand, the effects, risks and opportunities associated with these regulatory choices my colleague Mark Fenwick and I conducted an empirical study of regulatory responses to Fintech in seventeen jurisdictions.

In particular, we looked at first time “venture capital” investments in Fintech companies. The intention was to see whether there was a meaningful connection between levels of investment and regulatory choice.

Overview of the Countries in our Study

Five jurisdictions were cut due to a lack of enough reliable data. For instance, we didn’t find a sufficient number of companies receiving investment; or there were doubts about the veracity of the data and it was difficult to independently verify; or there was conflicting information.

The twelve remaining jurisdictions were examined. When we look at the results of Year-on Year %-growth of first time “venture capital” backed companies we get the following Figure.

YoY %-Growth of “First-time” Venture Capital-Backed Fintech Companies (Country)

In many cases, this data confirms anecdotal evidence of a slow-down of interest in Fintech. But interestingly, in sixof the twelve jurisdictions there was an increase in investment activity in 2016.

The question this data raises is whether there are any signals as to a correlation between regulatory initiative and increased activity in the Fintech sector?

YoY %-Growth of “First-time” Venture Capital-Backed Fintech Companies (Regulatory Approached)

In those countries in which the response was reactive, there seems to be clear evidence of a slowdown. In contrast, in those countries with a more proactive response — particularly involving Regulatory Guidance or Regulatory Experimentation — there is evidence that this proactive approach makes the jurisdiction more attractive as a potential location for starting Fintech operations.

This suggests that the regulatory environment does affect the degree of investment and — perhaps as importantly — affects the willingness of companies to start operations in one jurisdiction, rather than another.

Regulation matters, but we have to realize that there are other components that make up an attractive ecosystem for Fintech.

Consider Israel. A market known for its venture capital industry, a strong R&D focus and large multinationals that are open to Fintech. These ingredients play a crucial role in making Israel an attractive site for investing.

But the evidence does suggest that collaborative regulation that facilitates experimentation is key. For now, policy experimentation seems to be the way to go for regulators. It is, therefore, crucial that we track the effectiveness of regulatory sandboxes in 2017. After all, they are relatively new and we need to build a better understanding of their effectiveness in order to improve their design.

Such knowledge will show whether other countries can follow this more proactive and experimental model and whether it might also work in other industries that have a tradition of being heavily regulated, such as “MedTech”, “CleanTech”, or “LegalTech”.

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