How will Fintech Regulators Protect the Financial Markets?
It is no secret that Fintech developments are rapidly changing the traditional structure of our economy. Fintech companies offer a wide range of niche services, and the industry is constantly expanding to include more offerings, resulting in a high value and market potential. In 2022, the Fintech industry grossed a total revenue of $166.3 billion, with a projected revenue of $183.1 billion for 2023. The rapid advancement of technology and constant influx of startup companies leaves policymakers struggling to protect the financial system, without stunting the growth of the high-value Fintech industry. In an attempt to regulate Fintech, experts have identified four regulatory approach categories. Some important regulation questions facing the Fintech world today: What does each approach entail? How have they been implemented? Which appears to be the most efficient?
Figure 1: Fintech Industry Size
Fintech Regulation Approaches:
Wait-and-See: Observe Innovation Trends Over Time Before Taking Regulatory Action
When executing the wait-and-see approach, policymakers work to understand innovations before developing and implementing restrictions, in order to better accommodate risks and protect the industry. This approach often comes into play when there is uncertainty regarding whether an activity falls under the jurisdiction of an existing government agency or corporation, or when policymakers are unsure of how much regulation is necessary.
The Central Bank of Ireland manages cryptocurrency activity and investment in crypto-assets using a wait-and-see approach. Since the Irish Government does not back any cryptocurrencies, the Central Bank does not currently believe cryptocurrencies require government regulation. Therefore, rather than implementing regulations or prohibitions, the Central Bank has released a formal warning to consumers about the potential risks of engaging with cryptocurrency.
Continuing to use the wait-and-see approach, Ireland’s Department of Finance has created a blockchain working group, which has researched approaches to Fintech regulation and published a paper on their findings, entitled “Ireland’s Blockchain, Crypto & Web3 Future: A Vision to Establish Ireland as a Global Web3 Hub”. However, a 2019 study conducted by this group showed that this hands-off approach boosted the popularity of cryptocurrency throughout the country, despite government warnings.
Test-and-Learn: Regulators Grant Restricted Licenses or Partial Exemptions for New-Entrants
The test-and-learn approach creates specific testing frameworks on a case-by-case basis for companies and their products. This regulation system is implemented in real-world settings with a “No-Objection”, a letter to companies that gives formal allowance for testing from government regulators. Depending on the geographic area, the level of oversight permitted by a “No-Objection” letter ranges from minimal supervision to strict supervision. This approach is designed to be flexible and ensure that existing regulations can be configured to cover new Fintech ecosystems and accommodate the needs of each specific company.
Kenya has successfully implemented the test-and-learn approach with one product, M-PESA, which was developed by a telecommunication service named Safaricom. While Safaricom consists of various product segments, M-PESA, specifically, allows users to complete money transfers via mobile devices. The Central Bank of Kenya permitted Safaricom to launch the product while following a set of conditions, concerning proper record maintenance and measures to guard against fraud and money laundering. M-PESA proved to be immensely successful, now contributing to 5% of the country’s overall GDP.
Innovation Facilitators: Structured Frameworks Created by Regulators to Guide Experimentation
Innovation facilitators help regulators understand the Fintech market by guiding experimental oversight of products and trends. Both innovation facilitators and the “test-and-learn” approach create a structured environment for experimentation. However, while the “test-and-learn” approach creates and adapts existing frameworks to follow industry developments and market demand, adaptation using innovation facilitators is more preemptive and is initiated by regulators. Innovation facilitators invite companies and researchers to participate in experiments with market development and do not wait for products to have a noticeable effect on the market before taking action. Two common types of innovation facilitators are innovation hubs and regulatory sandboxes.
Innovation hubs are easy to access points for financial market participants, where they can receive guidance and ask for clarification on regulations or expectations. These hubs are less resource intensive than other facilitators. Still, they support continued technological innovation in financial markets by providing support, advice, and guidance for Fintech ecosystems.
Regulatory sandboxes allow for the live testing of innovations, under the oversight of financial regulators. The “sandboxes” serve as a period of trial and error, in which selected financial market participants are granted temporary licensing relief and can test solutions in a controlled, real-world environment. Regulatory sandboxes contain risk but they allow regulators to learn more about the application and implementation of technologies. Unlike other approaches, this provides an opportunity to contain potential risks and strongly support further innovation.
Figure 2: A Typical Sandbox Lifestyle
At the end of 2022, The Central Bank of the Philippines (BSP) switched from a “test-and-learn” approach to a regulatory sandbox framework. While a typical sandbox lifecycle includes six stages (eligibility, evaluation, test design, test, monitor, and exit), the BSP assigns an oversight team for evaluating each of the four stages in their sandbox, which include application, evaluation, testing, and an exit stage that determines whether the tested product is fit for consumers.
Regulatory Laws and Reforms: Introducing New Laws in Direct Response to Companies and Business Models
Regulatory laws and reforms are implemented after a new company or product is developed, and they can be overarching across the industry or address specific product developments. However, reform for regulatory laws differs from the other methods in that it may be more time-consuming. These laws are implemented before testing and understanding a product’s effect on the market. After implementation, regulators will often reevaluate and reform the laws based on the results thus far. All-encompassing laws and laws with immediate implementation are easier to develop than multiple specific regulations, which typically makes this method popular with policymakers.
In 2018, Mexico implemented the Financial Technology Institutions Law, a regulatory umbrella law for Fintech that restricts payments, crowdfunding, and business models that involve virtual assets. The law was structured to be adaptable to the sector, while allowing for the development of future regulations to provide specified implementation details. Under the law, electronic payment institutions (EPIs) and crowdfunding institutions are permitted to handle virtual assets that are approved by the Bank of Mexico. The law also establishes a regulatory framework for open banking, a system that allows financial service providers to easily access consumer banking and other financial data from banks and financial institutions through application programming interfaces (APIs).
Figure 3: Process for Applying an Approach To Fintech
As Fintech is rapidly evolving and becoming implemented into the structure of established markets, countries across the globe are facing unprecedented challenges regulating Fintech in a way that protects the stability of financial markets. Governments of countries around the world–such as those of Kenya, the Philippines, and Mexico–have explored different options for managing the rapid advancement of technology such that both the financial market and consumers are protected. Each regulation method provides positive and negative features, and to evaluate the right approach, several factors must be considered, such as the resource availability, market conditions, and legal framework of a country.
With consideration of these factors, the most viable option for regulation appears to be the test-and-learn approach. This approach, unlike the wait-and-see approach, not only focuses on consumer protection, but it allows for regulation that is less labor-intensive and costly than innovation hubs in a way that still avoids the misguidance and error that often comes with regulatory laws and reforms. While the test-and-learn approach is effective in regulating Fintech, this method still may result in failures, and therefore, regulators continue to search for methods of control for Fintech developments that protect market participants, while still allowing the technology to evolve and reach its full potential.