FinTech – Too Big to Stay Unregulated

Financial technology has been growing by leaps and bounds in the last few years – with regard to the technology itself, the discovery of its use cases in making the financial lives of users easier, and in acceptance by users of financial services. Neo-banks have been launched, giving customers an alternative to the traditional ways of banking. There are numerous FinTech solutions offering domestic and international payments and remittance solutions, taking away a part of banks’ most lucrative business away. Cryptocurrency is being touted as the base for all low-cost, high-speed solution for problems created by legacy systems and processes.

The latest kid on the block – ICOs (Initial Coin Offerings) – has been in the news lately for many reasons. From becoming the easy way of raising money (almost $1.3 bn raised globally in the first half of 2017; Tezos raised $232 mn of the digital currencies Bitcoin and Ether in July), to fly-by-night operators who cash out and run, to phishing attempts that redirect investments to alternative accounts ($7 mn worth of cryptocurrency stolen by hacking the CoinDash's website during their ICO), to cryptocurrency balances being stolen from people bragging about their ICO investments on social media; it has already witnessed it all while still being in its infancy.

China, being the center of all FinTech innovation these days, has also witnessed the highest activity around ICOs. Currently, there are 43 platforms providing ICO services in China. The accumulative ICO fundraising value reached RMB2.6 billion (US $420 million), with around 105,000 people participating. Guangdong, Shanghai & Beijing are the three cities with most ICO platforms and together have over 60% of the total platforms. Bitcoin and Ethereum are top two currencies, together accounting for 90% of ICO fundraising. China has also witnessed some of the biggest scams. Hence, it could only be expected to be one of the first ones to react to it. And it did so comprehensively.

On September 12, 2017, People’s Bank of China (PBoC) issued a ban on all ICOs, stating that ICOs are "essentially a form of non-approved illegal public financing behavior and raise suspicions of illegal selling of notes and bills, illegal securities issuance, illegal deposit-taking, financial fraud, illegal direct marketing and related criminal activity." The public notice also made it mandatory for all funds raised through ICOs to be returned to the investors. It further prohibits any entity from dealing as an exchange for any virtual currencies issued in ICOs.

This isn't just related to China; globally, regulators have started reacting to FinTech in general and to ICOs in particular. On July 25, the US SEC had clarified that offers & sales of digital assets are subject to federal securities laws and warned investors about potential scams. The Monetary Authority of Singapore declared in early August 2017 that ICOs that have characteristics of a security will fall under its purview. Canada issued a similar clarification. The very next day, Hong Kong’s securities market regulator, the Securities and Futures Commission, warned that some types of ICOs (the ones where the issued virtual currency represents equity or debt and gives buyer-related rights or dividends, or where the proceeds are invested in return-yielding projects) may be subjected to regulations. Towards the end of August, Israel announced that it would be assessing ICOs. Financial authorities in South Korea threatened to punish ICOs for violating the Capital Market Act. In September 2017, the Financial Conduct Authority (FCA) of UK clarified that depending on how they are structured, some ICOs may involve regulated investments and firms involved in an ICO may be conducting regulated activities. It also warned investors that ICOs are very high-risk, speculative investments, that investors should be conscious of the risks involved, and should only invest in an ICO project if you are an experienced investor prepared to lose your entire stake.

Regulators’ reaction to FinTech, in general, has been more muted and varied. There are some that understand the benefits and are either themselves conducting, or actively encouraging incubation and innovation hubs. Singapore, Hong Kong, Canada, and the UK are providing a nurturing environment for FinTech startups. Others are adopting a wait-and-watch attitude (e.g. India). China has been quite active in this area as well, probably because it has witnessed some really large frauds taking place which could have negative effects on the social front as well as on the financial stability of the system. Some large amounts were siphoned off through a P2P lending platform. Some of these technologies were at times being used in China for transferring large amounts of money out of the country at a time when China was attempting to stabilize a falling currency. These instances have made it somewhat of a leader in coming out with regulations either controlling or banning certain technologies and products.

While the regulations are being announced around the same time, they are quite varied in nature. There is a distinct possibility of this creating a regulatory/jurisdictional arbitrage. Yet, the factors that led China to be ahead of all other countries in this context could prevent these activities from moving to other geographies, especially if those encouraging factors went far deeper than the effect these regulations can have. This might result in a high possibility of these transactions shifting underground, rather than shifting geographies to make use of the arbitrage.

Is there a right time for regulators to step in and start looking at innovation seriously?

The recent spate of regulations seems to have taken the cryptocurrency and FinTech community by surprise (at least parts of it). The question that arises is: is there a right time for regulators to step in and start looking at an innovation seriously? When does it become compelling for a regulator to regulate an activity? Financial products, as they deal with people’s money more directly than any other product, impose a higher responsibility on financial regulators. A number of financial products are launched each year – some of them go on to become highly successful, while most of them just fritter away. It is neither possible, nor justifiable for regulators to try and regulate each new activity/product given this background and their limited resources. However, as something starts gaining traction, it exposes a larger number of users to the consequences of its failure/mismanagement. That is the point where regulators step in.

In effect, FinTech in general, and cryptocurrencies in particular (also online lending) have appeared to have gained enough traction to start worrying regulators. While the regulations per se appear to be worrying the users, this interest is indicative that these technologies and products have achieved the scale the innovators and markets would have hoped them to. An innovation does not become successful until it develops enough use cases and users. Once it does, it comes onto the regulators’ radar and attracts regulations that may stop it in its tracks. As they say, success is a double-edged sword.

Which is the other innovation that may possibly attract regulators’ attention? Would it be the alternative modes of moving remittances across borders? Possibly the ones that use cryptocurrencies to do so? While there is a popular notion that it is the disintermediation of banks in the process that worries regulators, perhaps it is not that; it is rather the disintermediation of regulations that bothers the regulators.