“Responsible Innovation” – What the coming regulation of FinTech will look like

By Christine Duhaime | May 15th, 2016

Financial regulators balance innovation and protection

Financial regulators serve two important functions for the financial system. 1. They support growth and innovation where it could improve access to finance, or the delivery of financial services or grow the economy. 2. At the same time,  they  protect consumers and society at large by supervising the financial services sector actors to ensure that the financial system is sound, risks are identified and mitigated, consumers are protected and financial crime is mitigated. The balancing act requires regulators to take a well-considered approach.

How US, UK and Canada rank in balancing regulation and FinTech

Generally speaking, the US does the best job at balancing these two interests, managing to lead the world both in financial innovation and in the regulation and enforcement of financial crime. The UK is quite strong in both, having recently agreed to adopt the sandbox model invented by Kosta Peric of the Gates Foundation.

The Etherium case

People say that Canada may have a way to go in balancing regulation with innovation but the jury is out. The most prominent example of an unbalanced approach that was likely unintended, is of Etherium, a Canadian Blockchain startup driven by Canadian tech brains which relocated to Switzerland when Canada announced it was implementing the world’s first law to regulate digital currency transactions. Canada was once (in 2013 and 2014), the global leader in Blockchain, now the hottest area of FinTech but no longer, as a result of it being unable to balance the promise of leading in global innovation in FinTech with what it perceived, under a previous government, as an imminent threat to international security from the Blockchain being used to transact with Bitcoin. Canada still has that law on the books but decided not to bring it into force and consequently is viewed as a jurisdiction where there is uncertainty among global investors in respect of FinTech. Sometimes a decision that may seem prudent at the time, tips the scale too much in one direction with unintended and unanticipated consequences.

Bank jobs will be lost with FinTech; different jobs will be gained

We know in the FinTech world that financial services will be delivered almost entirely on a mobile phone in a few short years and while that will substantially drive up the costs for banking in terms of investment in tech, innovation, AI and data centers, it correspondingly will drive down the larger costs of maintaining physical branches, tellers and back office employees. Moreover, banks have hundreds, sometimes thousands of compliance personnel whose jobs will be rendered redundant as banking becomes mobile, saving banks hundreds of millions of dollars per year in compliance personnel. So while innovation will cause mass unemployment  in the financial services sector, it will correspondingly create new employment in FinTech. Wall Street and Bay Street will disappear as we currently know them as financial centers (it will be too expensive to maintain bank towers for tech and AI) but tech centers will pop up all over as banking undergoes fundamental shifts.

Many developed countries have national FinTech strategies (Canada is an anomaly in not having one) to ensure that the tech and AI shifts affecting financial services result in startups being created in, and remaining in, their jurisdictions so that they develop FinTech for export as opposed to being consumers of the tech. With respect to Canada, it is already, for the most part, a consumer of FinTech at the large financial institutional level with banks investing in FinTech expertise in the US, Singapore and UK , and more marginally in Canada. R3CEV, a US based company, is an example of foreign FinTech being invested in by Canadian banks. Ironically, some of R3CEV’s techs are Canadian, despite being in New York.

Some promises and perils

To weigh innovation and regulation, financial regulators look at the promises and the perils of FinTech.

Some of the promises of FinTech are that it will drive down the overall costs of operating a bank and of providing services to consumers, while increasing access to financial services across a broader sector, and potentially solving the growing problem of financial inclusion for small businesses and individuals all around the world. It also promises to make banking more efficient and reduce customer friction.

Some of the perils of FinTech that are of concern to financial regulators will be obvious things like consumer protection and misrepresentations to investors of FinTech startups and of the services they offer and of less obvious things like if analytics and GPS locating are used to exclude people from financial services. For example, an online lender or online bank may make decisions based on demographics or geo-locations to exclude more impoverished sectors of the population.

Another peril is with respect to financial crime mitigation. FinTechs that are front facing, or customer-facing have anti-money laundering and counter-terrorist financing obligations governed by contracts with deposit-taking institutions, rather than imposed as a matter of law. Because they are not directly regulated by prudential regulators or subject to FIU audits, compliance is spotty, non-existent or not uniform. Terrorist financing has occurred through FinTechs, some deliberately and some by accident.

There are also privacy law, consumer protection, securities law and prudential concerns with FinTechs in the sense that most FinTechs plow ahead without considering what is required, legally speaking, to provide financial services in a regulated environment. Global banks in the UK routinely say that they are frequently pitched to by FinTechs who have developed great tech but the tech is completely useless to financial institutions because it does not comport with the law and is built on wrong assumptions on the law, or without considering, legal requirements of financial institutions.

AML & CTF law is rocket science

The anti-money laundering regime is particularly problematic with FinTechs, and often raised by global banks as an area where FinTechs are venturing without background knowledge or legal expertise to understand the regulatory landscape.

While analytics and AI can be used to improve processes for anti-money laundering law and counter-terrorist financing legal compliance, and undoubtedly will in time, we are facing a tech and knowledge gap in the sense that there is no existing technology that can deliver counter-terrorist financing or anti-money laundering legal compliance at any standard or level that is acceptable to a responsible regulator, or that any financial crime lawyer could sign off on.

I enormously respect FinTech startups and the work they do, but the truth is that FinTechs are just not there yet in this space and the jury is out among counter-terrorist financing and anti-money laundering professionals as to whether a FinTech could ever get there. One needs only to ask a FinTech in this space to describe how their systems deal with legal versus beneficial ownership at on-boarding; how their systems detect a politically exposed person from Vietnam, Austria, Russia, Brunei, or any other country; or to identify which terrorists lists they are using for their warning system. Most can’t have that conversation because anti-money laundering and counter-terrorist financing law is rocket science.

A financial institution using a system created without expertise in anti-money laundering and counter-terrorist financing detection, mitigation, reporting or terrorist property asset freezing, poses a security risk to everybody.

Bar associations may move into FinTech & LawTech regulation

It is likely that other regulators will emerge as well to have their say on the debate on innovation versus regulation and I suspect it will be the law societies and bar associations, especially on financial crime and increasingly on LawTech.

By law, only lawyers are permitted by state, federal and provincial legislation, to practice law, give legal advice or provide legal services, including in anti-money laundering and counter-terrorist financing law, even if it involves just the provision of tech for legal solutions.

A law firm owned by a lawyer licensed to provide services to the public (ergo, not one in-house) can create and sell tech that provides legal solutions such as compliance or legal forms, or auto-divorces, let’s say, but not a startup that is not owned by a licensed lawyer. FinTechs need to be cognizant of where they can go, and cannot go, in tech that is legal. The same is true for accounting services. FinTechs need to be careful to not be providing services that are accounting in nature.

LegalZoom, a tech company that sold online legal solutions and was not a licensed law firm, was required to hire lawyers to vet and approve all of its legal solutions in order to avoid protracted litigation over allegations that it was engaged in the unauthorized practice of law. A few months ago, LegalZoom, bought a law firm to acquire a license to sell legal solutions to the public without running into issues of the unauthorized practice of law. In time, we are likely to see more tech companies buying law firms in order to enter into the field of anti-money laundering and counter-terrorist financing legal tech compliance to avoid being sued by bar associations.

The direction financial regulators are likely headed in a few years on the financial crime front is to require that anti-money laundering law and counter-terrorist financing systems be tested and licensed to preserve the integrity of the financial system in the same was as we require gambling systems to be tested and licensed to preserve the integrity of gambling. A financial crime system that is tested and licensed balances innovation with regulation.

New era of  “responsible innovation”

Generally, we are heading into an interesting phase with FinTech. Financial regulator have taken a fairly hands off approach with FinTechs around the world, allowing them to grow to support innovation but there are signs that that is about to change. The mood seems to be swinging towards light regulation with a sandbox and in some cases, heavy regulation. The SEC is now looking at P2P lending and other FinTechs from the perspective of whether or not the disclosures to consumer are adequate and to investors.

The new buzz word for FinTech from regulators will be “responsible innovation” and that will mean that FinTechs will be regulated on a sliding scale depending upon the services rendered to the public and the risks involved.

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