Fintech and Regulation
The global financial crisis of 2008-2009 has drastically modified the landscape – present and future - of the financial services industry, both through the crunch of credit markets resulting in dramatically lower lending levels to consumers and corporations, and in parallel, through the rapid emergence of compliance and regulatory issues as key industry parameters.
Jointly, these forces have resulted in the onset of an ever changing landscape of financial regulations over the recent years, which combined with the advancement of technologies such as mobile and wireless communications, data mining analysis and machine learning, have created opportunities for entrepreneurial financial technology businesses to develop innovative products and services to both complement and compete with industry incumbents. And indeed it is fair to say that even when compared to other industries, the long established quasi-monopoly of traditional banks in financial services has created the ideal conditions for a mature ready-to-be-disrupted environment for entrepreneurs.
The emergence of Fintech
It is precisely in this context that the financial technology (fintech) industry has emerged as a virgin territory for the parallel forces of technology and restructuring to create innovative services and products at the hands of a new generation of visionary entrepreneurs. In the space of just a few years, a new generation of fintech companies has emerged so rapidly as to succeed in breaking down the doors of the traditional banking business by benefiting countless underserved small business owners who would otherwise not have received funding capital.
Across disparate services, ranging from facilitating loans to wealth management to mobile payments, fintech companies pose a serious threat to traditional practices that due to their inefficiency have shut out as many as two billion consumers globally from the provision of most basic financial services. Fundamentally, the onset of the fintech has democraticized the way consumers and small business owners borrow money, lessening the age-old dependency on banks. Unsurprisingly, the growth of fintech start-ups is nothing short of impressive: in data collected by KPMG, thirteen fintech startups are valued at over USD 1 billion, and in a recent study published by Goldman Sachs, it is estimated that fintech upstarts could steal up to USD 4.7 trillion in annual revenues from incumbent banks.
Yet the growth of the sector and its progressive establishment as part of the mainstream landscape of financial services has been hampered by a generalized lack of a systemic approach to regulation across different jurisdictions, the absence of clarity regarding regulatory requirements and standards, and a lengthy and costly approval process. Collectively, these factors have caused many start-ups in the field to employ a shoot-first, field-questions-from-regulators-later approach that has confused consumers and in many cases drawn harsher regulatory scrutiny, in essence a loss-loss situation.
The case for managing and balancing risk across the competing forces of compliance and innovation: a dualistic approach.
Getting the right balance
At the present time, uncertainty seems to be the operative characteristic in the fintech ecosystem, as exemplified by the repercussions of the July 2015 U.S. Treasury Department issuance of a Request For Information (RFI) for online marketplaces, with the stated goal of allowing policymakers “to study the various business models and products offered by online marketplace lenders, the potential for online marketing lending to expand access to credit to historically underserved borrowers, and how the financial regulatory framework should evolve to support the safe growth of this industry.” This call for information has spurred much buzz from industry participants about what the regulation will look like, as well as how it may affect the pass-through structures of the marketplaces – in sum, about the very core direction of this industry in the coming years.
As key stakeholders in the system, financial institutions should learn to understand and embrace the need to deal with regulation and compliance requirements as a leverage to foster critical mass and momentum to create new, innovative technologies that can be deployed as enablers to better analyze and understand industry dynamics and processes that are critical to their competitiveness. For example, the simplification of incumbent banking systems and increased data automation will eventually lead to increased avenues for ‘collaboration’ and innovation; intuitive database applications could then be deployed to analyze and contextualize regulatory information, allowing fintech firms a greater depth of insight and information leverage.
Managing corporate governance in a Fintech industry
In parallel, regulators should work for the benefit of fintech in a collaborative process of consultation, addressing key questions such as what should compliance look like for the fintech industry, and what specific requirements across domains such as financing, operational and management risk, data security, monetization, and infrastructure will need to be dealt with to establish a robust and sustainable fintech regulatory framework.
There is a powerful case for regulators to adopt a progressive mindset and bring more clarity in this space by fostering innovation and focusing on the issues at the core of the broader societal application of fintech, chiefly amongst them the process of promoting credit access for small businesses, which despite the pickup in overall economic activity remains significantly below pre-recession levels. Importantly, this does require a radical revision and rethinking from the traditional and all too well established practices of the incumbent banking system, practices that over time have been stifled by a void of technology innovation and the inability to properly evaluate the creditworthiness of a small business. If regulators were to succeed in imposing less stringent standards, the fintech industry as a whole would be positioned to keep growing organically and keep serving consumers and small business owners, as well as to allow fintech companies to continue to forge strategic partnerships with the banks that are now seeing the enormous value fintech can bring to their own operations.
The key industry challenges and threats faced by the fintech industry, all of which have a critical regulatory component, can be summarized as follows:
1. Regulatory burdens becoming regulatory barriers: traditional financial services companies have been adept at turning regulations slowing their own innovation into effective barriers of entry blocking fintech companies from launching new products and services.
2. Lack of global standards: until now, laws regulating lending practices have remained generally both fiercely local and complex, causing lending and fundraising efforts by fintech startups to be hampered while trying to navigate the maze of regulations. It is safe to conclude that until banking regulations are rationalized across borders, incumbents’ lenders will likely maintain a distinct advantage, even despite their inefficient practices and lower quality products and services.
3. Government monopolies on currency: whilst much of the financial system has already migrated to all-electronic formats, the production of cash remains a government monopoly in much of the world. In this context, the rapid emergence of bitcoin and other digital currencies is proving a test to the possibility of establishing financial exchanges based on innovative forms of trust and legal underpinnings. Should digital currencies achieve the critical mass and security needed to become a more established medium of money exchange, several stakeholders will need to adapt, including the banking system as a whole, governments and other para-governmental entities.
4. Technology as a challenge to the need for additional regulators in the system: as proven by countless examples of e-commerce platforms, one of the factors that make disruptive technologies so powerful is their ability to break down conventional wisdom on how industries are organized and how they are most effectively regulated. In this perspective, while it is certainly the case that the banking system as a whole will continue to require strong oversight to function effectively at the benefit of the broader society, there is no reason to believe that regulation will always have to be managed by often inefficient and corrupt governmental bodies; there is indeed a call for exploring the benefits of establishing some form of self-regulation by fintech companies, or alternatively for assessing the merits of an innovative type of rating methodology to be built in new lending, banking and investment platforms that would in turn enable consumers to establish general oversight, as already proven by the automated safeguards in place with digital currencies, which are recognized as a superior means of currency risk management.
While the above reflects a broader pattern being played out across several disruptive industries, more so than in any others, the winners and losers in the disruption of financial services will be determined by how regulators across different jurisdictions apply laws that may be well over a century old. On the one hand, such regulations impose costs and innovation delays from which the start-ups are largely immune, yet on the other, the same rules can also provide undue protection for incumbents, keeping start-ups outside of markets requiring licensing and other types of approvals.
Dealing with complex layers of regulatory oversight
In sum, it remains a fact that even fintech startups trying to play by the rules are undone by the complexity and expense of multiple layers of conflicting regulatory oversight. Given the likelihood that this reality will remain unchanged over the short to medium term, it is fair to assess that the ability to navigate such waters will be the key distinguishing factor for those startups able to compete successfully in an industry still dominated by incumbent financial services companies. Yet, despite the fundamental challenge involved in successfully unsettling the established mainstream and getting the regulatory equation right, fintech startups that will be successful in appealing to the universal consumer demand for value creating disruption are altogether poised to leverage innovation and operational dexterity and create a new trajectory for the industry as a whole.
To learn more about how Crestbridge can help you handle your corporate governance requirements for your Fintech fund structure, call George Bashforth on +352 26 215 420 or email firstname.lastname@example.org to arrange a telephone or video call.