Fintech Regulation ApproachesWhat Tech Models Could Be Used to Regulate the Fintech Space?

September 22, 2023 | 8 min read

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Financial technology regulation. What regulatory measure is the best fit for fintech? In the style of red and teal.

Fintech Regulation Approaches

In a Nutshell

The same stringent rules that exist for banks may not fit the specifics of a fintech business. Plus, they're frequently global players right from the get-go, which means they have to juggle a myriad of regulations from different corners of the world. So, how can regulation actually work in the fintech space?

How Should Regulators Approach the Fintech Space? Is Open Banking the Secret?

For a long time, regulators tended to focus their attention on traditional banking systems, while fintech companies operated with relatively limited oversight. This was largely due to the fact that legacy financial rules didn't quite match the unique characteristics of these tech-driven financial companies.

Things have shifted now, though. In most markets, big-time financial watchdogs have fintech firms on their radar. These agencies have even tweaked some rules to better suit the particular needs of the fintech scene.

Regulating fintech firms isn't a walk in the park. In many ways, it's actually more complex than overseeing conventional financial institutions.

The fintech space needs regulation. The real question is what regulatory measure is the best fit for fintech?

Why is Regulation Necessary?

Over the years, regulations have matured to shield banks, their clients, and the broader economy from financial wrongdoing. Rules around Anti-Money Laundering (AML) and Know-Your-Customer (KYC) procedures frequently get tune-ups to stay ahead of evolving scams and criminal tactics.

Fintech encompasses a variety of companies offering banking services, verifying customers, and facilitating transactions. Given the sensitivity of those operations, it's crucial to maintain the same rigorous safety measures that big banks do.

Regulation does more than just protect consumers. When properly devised and implemented, regulation:

Fintech Regulation Approaches Establishes Trust: Trust is everything in the money game, and playing by the rulebook helps fintech build that trust.
Fintech Regulation Approaches Levels the Competitive Field: When regulation is evenly applied, it fosters an environment in which competition is about the best services, not who is most skilled at bending the rules.
Fintech Regulation Approaches Improves Scalability: Compliance can actually help fintechs grow. Whether rolling out new features or crossing borders into new markets, compliance is often the ticket to scaling up.

In other words, without guidelines, fintech companies would find it tough — maybe even unfeasible — to make a big splash in the world of financial services.

Who Currently Regulates Fintech?

The body responsible for crafting and enforcing fintech regulations varies by country or region.

In the UK, for instance, regulatory compliance demands are very stringent. Fintech entities must align their operations with standards set by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA). Additionally, compliance with the Proceeds of Crime Act of 2002 is a statutory requirement.

Here in the United States, the regulatory landscape for fintech is multifaceted. Various agencies oversee different aspects of the sector. For instance:

Fintech Regulation Approaches The Consumer Financial Protection Bureau focuses on consumer protection.
Fintech Regulation Approaches The Financial Crimes Enforcement Network monitors financial transactions to prevent illicit activities.
Fintech Regulation Approaches The Office of the Comptroller of the Currency ensures that fintech activities align with federal regulations. 
Fintech Regulation Approaches The Federal Deposit Insurance Corporation oversees mobile-only banking ventures.
Fintech Regulation Approaches The Securities and Exchange Commission is the regulatory authority for trading platforms.
Fintech Regulation Approaches The Federal Trade Commission establishes general financial market regulations, and also approves new trading technologies.
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Ambitious fintechs planning to scale, whether by acquiring a full banking license or leveraging an e-money license, will encounter regulatory challenges. However, these should be comparable to those of established financial institutions. At least, that’s how it should work in theory.

Is More Regulation Needed?

A recent report from the US Treasury Department reveals that, while the banking sector is becoming more centralized, fintech firms are shaking things up by introducing new business models and increasing competition in key consumer finance areas. That sounds good, but it's not all rosy.

The rise of fintech brings with it a set of challenges, including consumer protection risks and concerns over data privacy and regulatory compliance. To safeguard consumers and promote healthy competition in these fast-evolving markets, the report advises stronger oversight of non-bank entities in the consumer finance sector, among other recommendations.

It's crucial for regions to offer a transparent and consistently applied set of rules for the relationship between traditional banks and fintech firms. This is vital to ensure the integrity, safety, and reliability of the financial markets. For instance, any consumer financial services facilitated through a partnership between a fintech and an Insured Depository Institution (IDI) should comply with all applicable laws, standards, and regulations that govern the IDI.

Which Regulatory Method is Best for Fintech?

So, which is the best regulatory pathway for fintech? Let's look at three models that are currently up for debate:

Entity-Based Model

This model proposes custom regulations that view fintech firms much like their traditional banking peers. The rationale is simple: if a set of rules works well for traditional financial institutions, it should also work for fintechs.

In some areas like consumer protection or anti-money laundering, focusing on the activity itself might be sufficient. However, for issues like financial stability, an entity-based approach could be crucial. The aim is to mix both activity- and entity-based regulations to cover the unique risks that different players introduce into the financial ecosystem.

It's worth noting that existing regulations sometimes enforce comparable rules differently across entities, even if they offer similar services. A functional organization of financial oversight could potentially eliminate these disparities, leveling the playing field for all.

Segregation Model

Under the segregation model, each financial sector— like banking, securities, or insurance— is governed by its own set of rules and its own supervisory agency. 

In the US, for example, the Federal Reserve and the OCC focus mainly on banks, while the SEC takes care of securities markets. This sector-specific approach allows for tailored regulations and specialized oversight, but also clearly delineates responsibilities if things go awry.

Inclusion Model

Inclusion-based regulation would encourage or even require financial institutions to expand access to financial services. The goal here is to make financial services as inclusive as possible, ensuring they are accessible and affordable to the broadest swath of the population, especially those typically underserved.

While this model can yield economic benefits like reduced income inequality and boosted economic growth, it also presents a unique set of challenges. Loosening regulations to encourage inclusivity shouldn't compromise financial system stability or put consumers at undue risk.

The Role of Inclusion in Open Banking

As we’ve discussed frequently on this blog, open banking could be the key to striking a balance between scalability and regulation. If we consider inclusion as a preferable approach to fintech regulation, financial firms and regulators can benefit in several ways. 

Open banking has the potential to open up a wealth of opportunities in the financial sector. By granting third-party financial service providers access to data from banks via Application Programming Interfaces (APIs), open banking is setting the stage for a host of personalized financial products. Think along the lines of custom-tailored budget apps, innovative loan offerings, and even unique investment avenues.

Not only does open banking pave the way for more innovative products, but it also stirs up some healthy competition among banks and other financial institutions. The result? Better rates and more consumer-friendly products, thanks to collaborations between these institutions and third-party developers.

Open banking has a particularly transformative role to play in financial inclusion. At scale, it would:

#1 Boost Financial Literacy

Open banking offers a platform for educating the public about managing their finances. Third-party providers can offer educational resources that demystify complex financial concepts and inform people about the array of financial products at their disposal.

#2 Expand Credit Access

With open banking, financial institutions can gather richer, more nuanced data about borrowers. This includes transaction histories and varied income streams, allowing lenders to make more educated decisions. This is a win for underserved communities that traditionally face barriers to credit, like those without an established credit history or those with low credit scores.

#3 Pioneer Financial Products

Open banking also gives fintech companies the data they need to develop groundbreaking financial products, particularly for those who are under-banked. For example, they could offer loans with more forgiving interest rates and flexible repayment schedules, tailored to those who might not have easy access to traditional financial services.

#4 Slash Transaction Costs

Collaboration between financial institutions and third-party providers could mean more economical and quicker payment options for consumers. Think mobile payments or digital wallets that could particularly benefit those who don't have ready access to standard banking services.

#5 Streamline Financial Management

Third-party service providers can develop budgeting tools that sift through a user's financial data to offer insightful spending analyses and savings tips. These tools can guide people in setting up a budget, monitoring their expenses, and spotting opportunities to save.

The Future is Uncertain, but Promising

Ultimately, it’s too early to say which regulatory method will pave the way. Still, open banking holds immense promise.

It could enhance financial inclusion and empower individuals and businesses to manage their money better. It could make individuals more able to secure credit and engage more fully in the digital economy.

This financial landscape will continue. to evolve. As it does, the key will be to balance innovation and competition while safeguarding consumer privacy and security.

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