Developing EU financial regulation and what it means for Fintech

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Winds of change: The European Commission has been progressing a Capital Markets Union (CMU) since 2015. The ambitious aims of this flagship project are to deliver growth and stability through deepening capital markets, enhancing investor choice and diversifying financing opportunities for companies beyond bank finance.

Winds of change

The European Commission  has been progressing a Capital Markets Union (CMU) since 2015. The ambitious aims of this flagship project are to deliver growth and stability through deepening capital markets, enhancing investor choice and diversifying financing opportunities for companies beyond bank finance.

On 20 September 2017 the Commission proposed reforms  to pave the way  for further financial integration and a full CMU.  Jyrki Katainen, Vice-President for Jobs, Growth, Investment and Competitiveness explained the EU’s intention to take “decisive steps to strengthen the European system of financial supervision.

The EU’s supervisory framework was completely overhauled during the financial crisis with the establishment of the European System of Financial Supervision (ESFS) in 2010. ESFS consists of three European Supervisory Agencies (ESAs) which supervise individuals sectors and institutions, and the European Systemic Risk Board , tasked with overseeing the financial system as a whole and coordinating EU policies for financial stability. The three ESAs are the European Banking Authority (EBA), the European Insurance and Occupational Pensions Authority (EIOPA) and the European Securities and Markets Authority (ESMA).    

Importantly, the Commission is committed to ensuring that the framework keeps pace with EU and global developments, and delivers increasing  financial integration. Stronger powers for the ESAs were a priority in the mid-term review of the CMU  Action Plan in June 2017. A core part of the 20 September proposals is a reinforced coordination role for all ESAs and new direct supervisory powers for ESMA. 

ESMA Tasks

New direct supervisory powers for ESMA will be introduced in specific sectors that feature strong integration, important cross-border activities and, that in most cases, are regulated directly by EU law. Integrated supervision at EU level is expected to remove obstacles to financial firms expanding across the EU, enhancing consumer choice and reducing costs for both firms and consumers. The risk of regulatory arbitrage is expected to be reduced. Non-EU firms will benefit from a single point of entry to the EU relying on consistent regulatory standards being applied across all member states.

These direct supervisory powers will apply where (i) critical benchmarks are used to price financial instruments and contracts, or to measure investment fund performance (ii) data-reporting service providers enable the reporting of transactions in financial instruments to regulators and the market (iii) market abuse cases have cross-border implications across the EU and (iv) certain prospectuses are deemed to have an important cross-border dimension and a potential risk of regulatory arbitrage.       

ESA Tasks

ESAs will be equipped with a solid governance structure allowing quick decisions to be made in the EU’s interest.  Within each ESA, national regulators will contribute knowledge and experience through the Board of Supervisors . Newly created Executive Boards will set direction and take charge of case-by-case decisions and certain supervisory matters.

The increased workload will be supported by increased funding. Funding from industry and market participants will replace much of the current public sector funding although EU budgets will continue to fund part. The increased funding from industry reflects the benefits expected from supervisory convergence . Within each sector, firms will contribute in proportion to their size and relevant importance. The Commission argues that these changes should be cost neutral to market participants, on the basis that they typically already finance national regulators who in turn finance the ESAs. The Commission sees national regulators seeking less as workload passes to the ESAs.    

Freeing the ESAs from this funding link to national regulators is expected to support independence within the new executive boards of each ESA, allowing quicker decisions more aligned with the interests of the EU.  Continuing contributions from the EU budget will mean that budgetary oversight and discipline will be provided.

Each ESA will have a stakeholder group. This will include representation from financial institutions , employees, consumers and other users of financial services, SMEs and academia. These stakeholder groups will be able to send a reasoned opinion to the Commission if two-thirds of members consider the ESA has exceeded its competence. This could lead to the withdrawal of the relevant guidelines or recommendations.  

Benefits of ESA reform

The Commission expects the increased role for ESAs to be a win-win for market participants and other stakeholders.  

For consumers, better protection and greater confidence in the consistency of efficient supervision across the EU is expected to support economic growth. The Commission also envisages a key role for the stakeholder groups in the decision making process.

For businesses, the Commission expects improved cross-border and cross-sector supervision to reduce compliance costs. Harmonised standards are expected to remove the need for multiple national authority notifications. The Commission is also optimistic that the stakeholder groups will ensure ESA supervisors are fully versed in market developments. Their view is that this knowledge will encourage supervision which allows financial firms to adjust quickly to new trends. This will include developments in specific areas the ESAs have been tasked with promoting such as Fintech and sustainable finance.

National authorities will continue to supervise all areas not expressly  assigned to ESAs, confident that similar supervisory standards are being applied in all member states. 

Fintech role for ESAs

ESAs will be specifically tasked with promoting sustainable finance and Fintech.

In sustainable finance, the Commission plans to require the ESAs to contribute to more coordinated supervision of environmental, social and governance criteria across the EU financial sector. This is driven in part by the Commission’s view that the financial sector has a vital role to play in reaching the climate change goals of the Paris Agreement and the EU’s 2030 Agenda for sustainable development.  In the absence of coordination from the ESAs, some member states may embrace the benefits of sustainable finance faster than others, leading to financial market fragmentation.

In common with many national authorities the Commission has also proposed that ESAs must take account of and promote developments in Fintech. The CMU proposals describe Fintech as transforming financial services by making access to financial services more convenient, increasing operational efficiency, lowering costs to consumers and increasing market competition by lowering barriers to entry. The existing appetite of supervisors to actively engage in this area was illustrated by the speech of Andrew Hauser, Bank of England Executive Director, Banking, Payments and Financial Resilience on 6 October 2017:

…technological change and innovation, though uncertain in timing, will have profound implications for the nature and range of financial services available to households and firms. Traditional distinctions between regulated and unregulated activities, retail and wholesale, on-shore and off-shore, will blur as conventional models of intermediation are progressively ‘unbundled’ …central banks cannot afford to stand on the sidelines… .

2017 Fintech consultation

Earlier this year the Commission ran a consultation titled “FinTech: a more competitive and innovative European financial sector” (launched on 23 March 2017). The results of this process, available as a published summary of contributions, provide a useful insight into what market participants and other contributors are likely to be hoping for from the ESAs under the current plans for reform.

Contributors included incumbent banks and insurers, incumbent payment infrastructure providers, Fintech industry bodies, Fintech firms, public authorities, technology companies and trade unions.  Interestingly, the vast majority  called for a stronger role for the ESAs in respect of technological innovation. Contributors suggested that ESAs could coordinate the innovation hubs and regulatory sandboxes which have recently been set up by national regulators and ensure best practices are shared  and supervisory convergence is enhanced. This request appears to have been answered since a stated aim of the ESAs is to support national authorities in staying up-to-speed with Fintech whilst reassuring them that similar supervisory standards are applied across the EU.  The new proposals also expressly task the ESAs with coordinating national technological innovation and tools such as innovation hubs or sandboxes.

Contributors also looked for the ESAs to build up competence in a number of areas such as cloud computing, big data and cybersecurity.  The anticipated stakeholder groups will answer this need if they work as the Commission hopes, ensuring ESA supervisors are fully versed on new market developments and encouraging national supervision that allows firms to adjust to new trends. Whether the Commission will go a step further and follow the near universally supported idea of establishing an Innovation Lab to share best practice and regulatory/ supervisory concerns is unclear. Given that most contributors flagged interoperability and standardisation as key for Fintech growth, such an initiative would seem a priority. Contributors were clear that global and not national/regional standards should be promoted.

Automated advice

Contributions in respect of automated advice provide a good illustration of the high level divide on the benefit of common EU rules. Contributors agreed that automated advice was still at an early stage but flagged that development was not spread equally across the EU. Most thought this offered the potential to reach a greater number of customers, enhancing financial inclusion.

Contributors were divided on common rules for oversight. Some felt these could resolve issues around regulatory arbitrage  and discrimination risks. But others thought that existing regulations were sufficient and acting too soon might stifle innovation. This represents the conflict faced by ESAs in trying to promote the constant improvement of markets through Fintech innovation, whilst ensuring it is not achieved at the expense of strong and consistent regulation.

Crowdfunding

The contributions on crowdfunding provide a great example of the need for the ESA to take a lead in supervisory coordination across the EU. Most argued that national regulatory regimes actively hindered cross-border crowdfunding activity and EU-level harmonisation was needed. Areas cited for harmonisation were platform disclosure requirements, registration requirements and consumer and investor protection rules. Some dissenting voices argued that existing regulations such as MiFID were sufficient. But a large majority proposed a pan-European framework balancing the needs of industry and the protection of investors. Many argued this should be supported by regulatory sandboxes with harmonised criteria, allowing solutions developed in one member state to be passported across the EU.

RegTech

The key response in this area involved public authorities looking for an open dialogue with industry. If the stakeholder groups proposed by the ESA reforms work as intended these could provide the ideal forum for such interaction and the ability for industry stakeholders to contribute directly to regulation and compliance.

Cloud services

Concerns were expressed around the lack of clarity regarding the use of cloud services in financial services, a lack of harmonisation between national rules and the inconsistent interpretation of EU rules by national supervisors. This would therefore seem an area ripe for ESA input as many felt that adoption was being held back by cloud providers failing to adapt their offer to the specific constraints of financial institutions.

Opinion was divided though on whether the solution was limited intervention at EU level with guidance from national supervisors or stronger intervention at EU level with harmonised rules. The success of the ESAs ambitions in Fintech generally is likely to depend on their ability to appease both these camps with a balanced approach built on strong stakeholder engagement.

DLT

Given that most Distributed Ledger Technology (DLT) offerings are still at proof-of-concept stage it is not surprising that respondents largely argued that bespoke regulation on DLT would be premature. Some stakeholders referred to regulatory sandboxes as a useful way for regulators to keep up with change. If the proposed stakeholder groups function as planned this will be another way for knowledge transfer on current trends allowing regulators to make an informed decision as to when to act.

Contributors thought that DLT would ultimately require the amendment of existing EU Financial Services legislation and not new regulation. The ESAs could take a key role in this once they consider the timing right.  

Regulatory approach to Fintech

On the role of regulation generally, the vast majority of contributors agreed that technological neutrality, proportionality and integrity were the right principles to guide EU policy and the regulatory approach to Fintech activities. Most demanded a level playing field for all market participants whether a new technology solution or a traditional incumbent. Encouragingly for the ESAs plans, open discussion and collaboration between the industry and regulators were seen as essential to support an uptake in Fintech.

Some specific obstacles to cross-border scaling were raised. Among these were varied KYC requirements, non-technologically neutral provisions (eg, disclosures only being permitted on paper), national restrictions on data movement and the complex combination of national and EU legislation in areas such as crowdfunding and peer to peer. Encouragingly the increased role for the ESAs may allow them to take a significant role in addressing these.

Conclusions

If the CMU proposals work as well as the Commission expects, they will address many of the concerns raised in the recent Fintech consultation. This is important- almost half of contributors foresaw Fintech having a huge impact on the entire financial services value chain, improving efficiency in almost every area.

As with any initiative though there are concerns that it may not work as planned. Active industry participation through the stakeholder groups is only likely to last for as long as it is clearly providing industry with a voice.

As always there will be some suggesting a land grab by the Commission. Some national authorities stressed the need to inspire innovation through regulatory arbitrage. The ultimate manifestation of this is Brexit with some arguing it calls into question the value of the CMU.  Allowing more European firms to access the ready capital markets of the City of London was a key driver of the CMU that is now likely to be lost.

First published in Payments & FinTech Lawyer, A Cecile Park Media Publication, November 2017

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