Ahead of the changing of the guard, the White House chose financial technology (FinTech) as the subject of one of the Obama administration’s final policy papers.
“A Framework for FinTech” (Paper), released on 13 January 2017, details U.S. national policies on financial innovation and lists ten overarching principles of FinTech. We won’t know their precise application under the new administration for some time. However, the Paper provides an excellent steer on the factors underpinning a successful FinTech model.
This post summarises the key messages from the Paper for those developing or assessing FinTech products.
Principle 1 – Think broadly about the financial ecosystem
Technology is rapidly changing the financial services landscape. This means that a principled approach from a consumer and overall market perspective is essential. In this respect, the Paper suggests that:
“incumbent institutions and new entrants alike should think broadly about this dynamic landscape as they work to ensure that their offerings add value for consumers, investors, and markets, and do so in a manner that is safe, transparent, and sustainable.” (our emphasis)
Thinking broadly also entails thinking about how other innovative industries, such as social media or virtual reality, may interact with the financial ecosystem. For example, we have previously written about the perils of Whatsapp in securities trading. This illustrates that regulatory risk can arise from anywhere.
Principle 2 – Start with the consumer in mind
Making financial services more user-friendly is a key goal for many FinTech companies. Gaining customers’ trust is a harder, but equally important goal. Part of building customer trust is pro-active consumer protection. In this vein, the Paper recommends that:
“Fintech companies … should start with and maintain robust compliance systems to ensure that, as they grow, consumer protection develops as a natural part of their products’ DNA.” (our emphasis)
These compliance systems should also cover marketing. Marketing for FinTech products will often be restricted by both consumer advertising laws and by the laws and regulations that apply to financial advertisements.
Importantly, FinTech companies should avoid giving customers the impression that they are carrying out a regulated activity, such as selling securities or money lending, unless they are in fact licensed or authorised to do so. At an even more basic level, consumers should understand very clearly what they are ‘buying’ and the potential downside risks.
Principle 3 – Promote safe financial inclusion and financial health
FinTech can increase customer choice and expand access to formal financial systems. As the Paper explains:
“[t]echnologically-enabled products and services have the ability to provide broader access to basic financial services, expand access to credit to responsible borrowers, help consumers manage wealth, improve student loan financing, facilitate remittance payments, assist consumers in financial decision-making, and much more.”
Financial inclusion is rapidly becoming a policy priority for governments around the world. For example, Hong Kong Monetary Authority put it squarely on the agenda for banks in its circular on “De-risking and Financial Inclusion” in September 2016.
Accordingly, FinTech products that promote financial inclusion should be well-placed to gain their regulators’ blessings.
Principle 4 – Recognise and overcome potential technological bias
We are already living in the era of big data, and machine learning is rapidly moving from development to deployment. Artificial intelligence mechanisms are already in play. These developments will have a massive impact on financial services. Notwithstanding, as the Paper notes,
“algorithmic systems still rely on inputs and processes informed by the people who design them. Moreover, the information they create still may be subject to human interpretations. Therefore, the underlying algorithms and the decisions they prompt could contain systemic, historical, and cultural biases that potentially may impact consumers unfairly and inequitably.”
The reputational and legal risks that would arise from implementing biased or discriminatory technology are substantial – and the algorithms themselves cannot be blamed. Going forward, we can expect further regulation (and lawsuits) on these issues, akin to what we have seen in many markets on algorithmic trading.
Meeting technological bias head-on requires interrogating the data and examining the assumptions used in the models, as well as monitoring output for patterns and trends.
Principle 5 – Maximise transparency
Transparency is typically vertical in the financial sector. Regulators expect transparency from those whom they regulate, who in turn expect transparency regarding the regulator’s policies and procedures. Equally, customers are required to be transparent regarding their identity, source of wealth and source of funds. As the Paper notes:
“transparency remains at the heart of balancing the mutually reinforcing goals of expanding access to the financial system and protecting the system from abuse.”
Questions arise in respect of horizontal transparency. Can FinTech companies pool data without breaching competition laws? Should regulators around the world be able to share confidential information with one another? Policymakers and regulators will have to tackle these questions over the coming years.
In the meantime, for anyone designing a FinTech product, think hard about what information that product needs to be successful and make sure that you understand the legal implications of accessing and using that information.
Principle 6 – Strive for interoperability and harmonise technical standards
As a means of ensuring interoperability across many different platforms, internet technologies are increasingly standardised and open-source. Similarly, the Paper recommends that,
“[a]s financial services continue to disintermediate and consumers seek increasingly personalized and flexible financial solutions, fintech companies and financial institutions should embed a presumption of interoperability and harmonized (or harmonizable) technical standards in their products and services.” (our emphasis)
A laudable goal, but adoption of new technical standards entails strategic risk (what if the wrong standard is backed?), operational risk (what if the standard fails?), as well as reputational and legal risk (what if the standard is hacked?).
One way that FinTech companies are managing these risks is by pooling their resources and expertise. For example, the Linux Foundation’s Hyperledger project benefits from substantial industry involvement and backing as it develops a standard, cross-industry blockchain platform.
Principle 7 – Build in cybersecurity, data security, and privacy protections from the start
Providing financial services no longer means just holding money. We have previously written about the global effort to combat money laundering and terrorist financing. Complying with these regulations means that financial services companies are increasingly holding large amounts of personal and proprietary customer data. Accordingly, the Paper recommends that
“fintech companies must incorporate robust cybersecurity, data security, and privacy safeguards at the beginning of, and throughout, product and service lifecycles.” (our emphasis)
The importance of these issues is impossible to overstate. As we have previously analysed, potential fines in some jurisdictions for data protection compliance infringement now rival competition enforcement penalties.
Going forward, cybersecurity, data security and privacy protections should be core functions for all financial services providers. The key message? Understand what the legal implications are and make sure that the product design pays more than lip-service to them. There is only so much you can get away with using fine print.
Principle 8 – Increase efficiency and effectiveness in financial infrastructure
Financial infrastructure is a major focus of many FinTech firms. As the Paper notes:
“[w]hether faster payments, auditable processes, or compliance systems, these innovations have tremendous potential to positively impact the financial services sector.”
FinTech companies engaged in infrastructure-level innovation should make responsible use of the inevitable time lag between innovation and regulation. In the absence of clear guidance on topics such as blockchain, a cautious and step-by-step approach may be warranted – particularly in order to avoid reactionary regulation down the road.
Principle 9 – Protect financial stability
FinTech is a disruptive force within finance. But regulators rarely like to hear the words “financial” and “disruption” in the same sentence. As the Paper comments:
“[w]hile new and untested innovations may increase efficiency and have economic benefits, they potentially could pose risks to the existing financial infrastructure and be detrimental to financial stability if their risks are not understood and proactively managed.”
Managing these risks proactively may entail voluntarily placing transaction limits in a service, or only selling a product to professional investors. Going forward, the responsibility of the FinTech sector for maintaining financial stability will increase in proportion to its share of the financial market.
Principle 10 – Continue and strengthen cross-sector engagement
Pro-active engagement can help mitigate regulatory risks. To this end, the Paper recommends that
“[f]intech companies, financial institutions, and government authorities should consistently engage with one another. Whether the company is a new entrant or a mature institution, it must seek to develop consistent and ongoing relationships with policymakers and regulators.”
Ideally, mature institutions should already have these relationships in place, either themselves or through their legal advisors. For new entrants, the advent of regulatory sandboxes, such as Hong Kong’s Fintech Supervisory Sandbox, is a great way to kick-start regulator engagement.
We continue to see fantastic new FinTech products test the market. But many, if not most, struggle to get off the ground because they fail to fully appreciate one or more of the above principles. So, when developing or assessing FinTech products, consider the Paper’s framework as a pre-launch checklist.