Recently, the International Organization of Securities Commissions (IOSCO) released its Research Report on Financial Technologies (Fintech). IOSCO is an international body comprised of the world’s securities regulators including some Canadian securities commissions. Fintech is disintermediating and re-intermediating securities businesses. The Report studies the evolution of Fintech and its intersection with securities market regulation in the categories described below.

Alternative Financing Platforms

The Report examines peer-to-peer lending (P2P lending) and equity crowdfunding (ECF), noting that the significant growth of each is attributable to a series of supply and demand factors, including the current low-interest rate environment, which has driven investors to look for alternative investments (e.g. in the case of ECF, the ability to make early stage equity investments).

The risks and regulatory responses associated with P2P lending and ECF include the following:

  • Disclosure Risks. These may exist because investment proposals on these platforms may lack standardization. Potential regulatory responses include: the requirement that only qualified investors can participate in ECF offers; the imposition of caps on the maximum investment that can be made per year/platform; and the imposition of mandatory investor education requirements.
  • Credit Risk / Investment Risk. This can be higher in P2P lending when, for example, interest rates rise, and risk can be higher for ECFs, because start-ups, lack a track record of revenue and income and may be more susceptible to failure. Potential regulatory responses include the imposition of caps on maximum investment; the imposition of caps on the maximum amount of capital a borrower or an issuer can raise during a particular period; the requirement that a platform conduct due diligence on a borrower or an issuer; and the imposition of an “all-or-nothing” funding model whereby funds raised only get released to a borrower or an issuer if the entire target amount of funds is raised.
  • Liquidity Risks exist as a result of the want of secondary markets for the loan or equity purchased on the platform. In response to these risks, regulators in some jurisdictions have adopted initiatives to foster a secondary market.

Retail Trading and Investment Platforms

The Report focuses on online trading and investment platforms as well as technologies that support retail investor decision-making on such platforms, and identifies six categories of new Fintech business models: comparison websites, financial aggregator platforms, robo-advisors, social trading and investing platforms, social media sentiment analysis, research and networking platforms and other innovative business models.

With respect to robo-advisors, the risks noted were risks of errors in algorithms, risks of overly complex or overly simplistic algorithms and risks of static client information. Most of the regulators surveyed by IOSCO rely on general suitability, know-your-customer, registration, training, disclosure, record-keeping, compliance and supervision rules to address robo-advice, or other forms of automated and digital advice. Some jurisdictions have introduced additional regulatory measures and tailored guidance to the automated advice industry.

With respect to social trading and investing platforms, and social media sentiment, research and networking platforms, risks are noted as including advice potentially not being suitable for, or in the best interests of, all investors, and a lack of investor understanding of potential conflicts, fees / incentive structures and of product and service related risks. Certain regulators issue alerts that are intended to highlight the risks posed by certain types of social trading.

Institutional Trading Platforms

The Report reviews the evolution in fixed income platforms. The Report notes that regulators are faced with the challenge of enhancing monitoring and suggests that regulators can leverage data to evaluate compliance with regulatory requirements and can explore leveraging new compliance software and surveillance tools to monitor trading and detect misconduct.

Distributed Ledger Technologies (Blockchain)

The Report examines, at a high level, permissioned and permissionless distributed ledger technologies (DLT), which include blockchain technology and shared ledgers, and smart contracts that leverage DLT.

Noteworthy applications of DLT are (a) keeping corporate records, making corporate actions (e.g. dividends, consolidations, share repurchases) more efficient, (b) revamping post-trading processes for exchange-trade equities, (c) trading and settling OTC derivatives, (d) facilitating loan syndication, (e) tracking repo transactions, (f) trading short-term debt, (g) automating KYC and AML compliance processes, and (h) alternative financing. These applications present opportunities to reduce cost and increase efficiencies, accuracy and reliability, transparency, security and regulatory oversight.

However, the foregoing applications face regulatory challenges before they can be implemented in the securities industry such as:

  • Assets such as securities will be “tokenized” (digitally represented), and the “tokens” would have to be recognized by law to constitute valid proof of ownership of the underlying asset.
  • Smart contracts allow pre-written logic to modify a ledger based on data in that ledger or external sources (another ledger, Internet of Things, centralized database, etc.), but the finality of any ledger entry would have to be recognized by law and in certain circumstances, revocable.
  • Privacy issues would have to be addressed when personal data is stored, even if the ledger is permissioned.
  • Supervisory and jurisdictional issues abound in permissionless applications of DLT.

In addition to observing developments in DLT, many regulatory authorities are familiarizing themselves with DLT through research, labs, innovation hubs and proof-of-concept projects.

Fintech Developments in Emerging Markets

In emerging markets, due to the lack of legacy infrastructure, Fintech is often able to leapfrog current technology and bring about greater financial inclusion, access to capital and economic growth. The Report summarizes several developments in mobile-based innovations, P2P lending and ECF platforms, investment platforms such as robo-advisors, and DLT in emerging markets. Due to the nascent nature of business models in such markets, there is little consistency in the regulatory approaches.

Miscellaneous Regulatory Considerations

The Report also provides an overview of the following miscellaneous regulatory considerations:

  • Regulatory complexity: Novel technology utilized in delivering financial services may increase the complexity of supervision, surveillance and enforcement.
  • International regulatory cooperation: Fintech with cross-border applications has the potential to raise jurisdictional challenges to securities regulation. Addressing such challenges requires multilateral cooperation and the exchange of information between regulators.
  • National cooperation: Even within a jurisdiction, Fintech may engage the jurisdiction of multiple regulators, requiring greater national regulatory coordination.
  • Onboarding requirements: With Fintech enabling digital onboarding, market participants must be cognizant of jurisdictional difference, particularly as they relate to non-face-to-face customer identification/verification and AML/CFT safeguards.
  • Investor awareness and literacy: Most regulators view transparency and disclosure of information as critical to facilitate informed assessment and decision making by investors. Some regulators may impose specific requirements aimed at slowing down online decision-making to avoid the risk of “too-fast-click-decisions”.
  • Cybersecurity risks: Regulators are looking at strengthening regulatory preparedness for cyber-incidents, and market participants are reminded to invest in cyber security and data protection.
  • Dialogue with innovators: Several regulators have established dedicated Fintech offices to promote dialogue between regulators and the industry. While some regulators are considering sandbox frameworks, allowing Fintech companies to offer services subject to regulatory flexibilities in narrow circumstances, other regulators consider such an approach as encouraging an uneven playing field between innovative firms and incumbents.