This article provides Fintech startups and investors with an overview of the regulatory framework that applies to the Fintech industry and the issues that they need to be aware of as they navigate the shifting regulatory landscape and manage risks.
What is driving Fintech?
The financial technology (Fintech) industry, driven primarily by innovative technology companies and startups, is transforming the financial services and banking sector. New Fintech products and services, such as crowdfunding, peer-to-peer lending platforms, online lenders, algorithm-based wealth management and advisory services (robo-advisors), online money transfer services, e-wallets, digital currencies and distributed ledger technology, have taken advantage of powerful computing resources, cloud-computing technologies, mobile devices, artificial intelligence, machine learning and big data analytics to reduce transaction costs, increase speed and efficiency, and improve the consumer experience.
Impact of Fintech
These new technologies are already transforming the way consumers, companies and institutions, including large financial institutions, banks and insurance companies, invest and raise money, transfer and settle payments, exchange financial assets and financial instruments, and issue, trade and settle debt instruments. The new products and services are creating opportunities for unbanked and underbanked individuals and entrepreneurs to access once out-of-reach financial services and participate in the global financial system.
The excitement around Fintech has been accompanied by concerns that the industry is unregulated or less regulated than the traditional banking and financial services industry. Regulatory gaps and risks certainly do exist, but the Fintech industry is not necessarily the Wild West. Federally-regulated financial institutions and intermediaries in Canada have adopted and embraced Fintech to improve back-office functions, such as settlement and clearing and loan approvals, and have partnered with Fintech companies to provide customers with more convenient products and services. Fintech companies that operate outside of existing regulatory frameworks and allow consumers to bypass traditional financial institutions and intermediaries altogether may be subject to less-direct regulation and oversight, but nevertheless need to comply with certain federal and provincial regulations that apply to various Fintech-related activities. Regulators are also quickly moving to fill the gaps and manage risks to protect consumers and investors.
The regulation of financial services in Canada is fragmented, uneven, overlapping and complex. Both the federal and provincial governments share jurisdiction for regulating financial services. As such, various regulators and government agencies are responsible for overseeing the regulation of different aspects of the industry, including investor protection and securities law, consumer protection, anti-money laundering, privacy and data security, and payment processing. The rules and regulations in these areas may apply to certain Fintech-related activities.
Investor protection and securities regulation
Securities law regulates the issuance, sale and trading of securities. The term ”securities” broadly captures various types of investments, such as debt (e.g., loans or portions of loans), equity (e.g., common and preferred shares, options and warrants), asset-backed securities, investment funds and derivatives.
Given the broad definition of securities, Fintech companies that engage in any of the following activities may have to comply with securities law:
- Crowdfunding platforms that connect investors with companies or individuals looking to raise capital;
- Peer-to-peer lending platforms that allow lenders (investors) to fund loans or portions of loans (securities);
- Robo-advisors that recommend and/or facilitate investments (e.g., Exchange Traded Funds).
Under provincial securities laws, Fintech companies that offer securities for sale to the public are required to comply with registration, prospectus and disclosure requirements to ensure that investors have adequate information to make investment decisions. In addition, Fintech firms that are in the business of trading, underwriting or advising in securities are subject to specific registration and licensing requirements.
Securities regulators though, have demonstrated flexibility in addressing the challenges posed by Fintech. For example, a number of provincial securities regulators have introduced crowdfunding regulations that allow certain crowdfunding platforms to distribute securities through a registered funding portal without a prospectus, subject to certain conditions (the Crowdfunding Prospectus Exemption).
Securities and financial markets regulators, such as the Ontario Securities Commission (OSC LaunchPad) and Québec’s Autorité des marchées financiers, are willing to work closely with the Fintech community to help innovative Fintech businesses enter the marketplace, including creating sandboxes to allow these businesses to engage in regulated activities for a test period without having to comply with certain securities requirements.
Provincial consumer protection legislation regulates various aspects of the commercial relationship between Fintech companies and their customers, including rules regarding online contracting, false, misleading or deceptive representations and unfair practices. In particular, consumer protection legislation regulates credit agreements and imposes specific financial and cost of credit disclosure obligations on lenders for fixed credit, open credit and credit cards.
Provinces have also implemented regulations to govern payday loans, which are typically short-term, single-payment unsecured loans where a lender agrees to lend the borrower a small amount of money in return for the promise of future payment and certain fees. The regulations impose licensing and disclosure requirements on payday lenders and price caps on the fees that payday lenders can charge borrowers.
Online lenders offering innovative credit solutions to consumers must be aware of consumer protection requirements regulating their lending practices, credit disclosure requirements, as well as caps on interest rates and fees that they can charge to borrowers.
The regulation of payment processing in Canada is fragmented and many rules that apply to traditional financial institutions do not necessarily apply to other entities, such as Fintech companies, engaged in payment processing activities.
In Canada, federally-regulated financial institutions (FRFIs) must adhere to payment rules and standards established under the Bank Act and are subject to oversight by the Office of the Superintendent of Financial Institutions (OSFI). Since OSFI regulates FRFIs and not the services that they provide, other entities that provide payment processing services, such as Fintech mobile payment providers, are not subject to OSFI oversight.
Fintech companies, though, must consider compliance with various codes of conduct and standards in the payment industry, particularly if their products and services intersect with or utilize existing payment infrastructure. This includes the Code of Conduct for the Credit and Debit Card Industry in Canada and the Canadian NFC Mobile Payments Reference Model.
In particular, Fintech companies should be aware of the standards established by Payments Canada when utilizing or interacting with its payment clearing and settlement systems, and infrastructure and other arrangements for the making or exchange of payments.
The speed and convenience of many Fintech products and services are based on the remote and non-face-to-face nature of transactions. This runs straight into know-your-customer (KYC) requirements imposed on the banking and financial services industry to protect against money laundering, criminal activity and terrorist financing.
The Proceeds of Crime (Money Laundering) and Terrorist Financing Act, requires certain entities, including provincially-regulated loan companies, entities engaged in the business of foreign exchange dealing and the remitting or transmitting of funds (Money Service Business or MSB), securities dealers, portfolio managers and investment advisors to verify their clients’ identities, keep records on their clients and report suspicious transactions to the regulator—Financial Transactions and Reports Analysis Centre of Canada (FINTRAC). MSBs must also register with FINTRAC.
Online money transfer services, robo-advisors, crowdfunding platforms, peer-to-peer lending platforms online lenders and digital currency MSBs may have to adhere to these KYC requirements.
Fintech technologies are, in part, driven by Big Data—the processing and analysis of large quantities of data to provide insights, identify patterns and trends, and predict events and behavior. The information collected and analyzed by Fintech companies is invaluable for creating credit risk profiles, predicting customer preferences, addressing financial fraud, identifying and measuring financial risk, and developing new products and services. Biometrics, such as fingerprints and facial recognition, are increasingly being used for authentication purposes, as interactions between Fintechs and their customers primarily take place online and on mobile devices.
This means that Fintech companies are collecting detailed information from their customers, including sensitive personal information about their finances, assets, credit history, spending habits, and even location information.
In Canada, the Personal Information Protection and Electronic Documents Act (PIPEDA) establishes rules on how private-sector organizations, including Fintech companies, may collect, use and disclose personal information in the course of commercial activities. Under PIPEDA, knowledge and consent are required for the collection, use and disclosure of personal information. The form of consent (i.e., opt-in / opt-out consent) depends on the sensitivity of the information (on its own and in combination with other information) and the legitimate expectations of individuals. Organizations also remain accountable for information transferred to third-parties for storage or processing in Canada or in a foreign jurisdiction. Importantly, organizations must ensure that they protect personal information with security safeguards appropriate to the sensitivity of the information against loss or theft, as well as unauthorized access.
A notable privacy issue for Fintech platforms is data security. Canada’s Federal Government, in mid-2015, introduced new rules and requirements regarding data breaches. When these provisions come into force, organizations will be required to report any breach of security safeguards involving personal information under their control, such as financial information, to the Office of the Privacy Commissioner if the breach creates a real risk of significant harm to an individual. Organizations will also have to notify individuals that are victims of the breach. Organizations that fail to comply with the breach reporting requirements will be subject to monetary penalties.
While the regulatory environment for Canada’s Fintech industry is fragmented and complex, Fintech companies must be aware of the need for compliance or potential compliance as follows:
- Provincial securities laws, specifically registration, prospectus, licensing, and disclosure requirements;
- Provincial consumer protection legislation, including pay-day loans regulations with disclosure and licensing requirements, and price, interest rates and fee caps;
- Payment processing regulations under the Bank Act; the Code of Conduct for the Credit and Debit Card Industry in Canada; the Canadian NFC Mobile Payments Reference Model; and Payment Canada standards;
- Proceeds of Crime (Money Laundering) and Terrorist Financing Act, regarding verification of clients’ identities, record keeping, registration with and reporting requirement to FINTRAC;
- Personal Information Protection and Electronic Documents Act (PIPEDA) rules regarding the collection, use and disclosure of personal information; and the reporting of data breaches to individuals and the Office of the Privacy Commissioner.
As there are many and still evolving regulations with which Fintech companies must comply, it is wise to seek advice from legal counsel experienced in Fintech.