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Banking Act. 18 Aug 2017

Types of fintech regulation: active, passive and restrictive

fintech-regulation-bbva

European regulators want to create a fertile framework for the growth of the fintech sector. The rise in financing requires regulation and there are three routes to choose from: active, passive and restrictive approach. Specifically, the European Union, especially the UK, has opted for a proactive approach in order to promote growth, as highlighted in this report Business Insider "The fintech regulation report".

Data from KPMG highlighted that investment in fintechs backed by venture capital firms grew by 106% to 13.8 billion dollars in 2015. Even though in Europe only $1.5 billion of this total was invested - 11% of global funding-,  it is becoming a fintech powerhouse with a 30% annual increase in activity.

The governments of various countries have adopted different approaches to regulate the fintech industry. Regulation can determine where to locate businesses, how fast the industry grows and how startups can escalate in those countries. Three categories define these approaches:

Active approach

Regulators work closely with startups to understand new fintech developments and upcoming obstacles and to help startups to address these challenges. This is an effective way to nurture the growth of fintechs, although it is a focus of intensive use of resources, which always carries the risk of regulatory capture, when the regulator sets the specific interest of companies ahead of public interest. The FCA, the financial services regulator in the UK, is an example of how the regulatory body carries out an active approach.

The FCA allows companies affected by regulation to offer proposals at the earliest stages of drafting new regulations. Consequently, companies find it easier to comply with it because they know the requirements in advance. The FCA also provides  public feedback at each stage, and explains its decisions, so it is a easy model to follow for other countries that want to build a similar model. For example, Australia has launched an Innovation Center and works in collaboration with the FCA. A good example of an initiative of the FCA that has followed this approach is Project Innovate.

The FCA allows companies affected by regulation to offer proposals at the earliest stages of drafting new regulations

A project that was initiated to help startups to comply with regulations while allowing the FCA to keep abreast of the latest fintech developments. Companies can apply to be part of the project and, if their application is approved, have access to support and guidance on the regulations. To date, 177 companies have participated. Project Innovate aims to allow the FCA to better understand the impact of regulations and be aware of the British and European standards that restrict or encourage innovation in financial services. It also allows the agency to keep abreast of the latest fintech technology and advances.

The FCA works with  startups to help them develop their product aligned with the regulation, so as not to have to go back later and change their business model. Project Innovate has also announced plans to make it easier for  fintechs established in the UK to venture abroad, and vice versa, with Australia the first country to be considered. Investors like well-regulated environments, and companies with a large market potential see the FCA as an important factor in keeping the UK  fintechs at the cutting edge.

Problems? Some. There is some concern that the FCA is going to become overloaded. In order to keep abreast of the rapid advances of fintechs, the FCA needs to have good resources and support of government departments and third parties. Finally, the FCA refuses to give preference to participating companies. The Innovation Center accepts only companies whose business models are new and are not covered by the existing regulations. Since the Innovation Center helps define the process on the regulation, companies that come after must follow the same rules and therefore there shouldn't be any problems of preferential treatment.

Example of active regulation is IFISA -a savings account developed through the collaboration between the UK government and the P2P lending industry-. IFISA, a new savings product available to British consumers from April 2016, has been developed by several ministerial departments and the FCA, who consulted the P2P lending industry. IFISA will allow consumers to invest up to $21,692 in P2P lenders like Funding Cirle, RateSetter and LendInvest without paying taxes on any interest earned. It is the government that promotes IFISA, which should help increase consumer confidence in the product, and could have a domino effect on the impact on consumer confidence in all fintechs in general.

The potential impact of IFISA is significant. It is likely to lead consumers to invest more. European consumers spend most of what they earn. In the UK, 49% have no savings or investments, or those that have them are worth less than £1,500. One reason is the low interest rates offered by existing products which average 2.6%. IFISA, however, can offer much higher rates of interest -to about 7% -, which encourages consumers.

The more people who invest, the more funds P2P lenders will have to lend. The government is particularly interested in the fact that these funds can help SMEs.  Fifty-seven percent of SMEs have no money and are unable to invest in staff and equipment. Most also still go to banks for loans or overdrafts. IFISA increases the funds available to SMEs through P2P companies, by providing an alternative to traditional lenders.

Passive approach

National regulators do not play an active role in trying to make  fintechs succeed, but they don't stand in their way either. The German regulator, BaFin, has historically taken this approach, although there are signs that things are starting to change. It has recently launched an internal group whose project focuses on fintechs, but it did so only after banks and other traditional operators had begun to partner with fintech companies. This suggests that Germany is moving towards an active approach, although it is early to talk about an active regulatory environment as exists in the UK.

Restrictive approach

Governments can take this approach because they are risk averse, loaded with a lot of bureaucracy, or fear regulatory capture by the holders of the financial services industry. The United States, for example, has different regulatory bodies in each state, which means that compliance is difficult and expensive. In addition, despite the booming fintech industry  in California, and that which is emerging in New York, the commitment of regulators is still very limited. However the United States is beginning to recognize that the industry is too important and the regulations are too outdated. Recently, the OCC (Office of the Comptroller of the Currency)  started an investigation into how to regulate  fintechs to foster innovation.

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