CHAPTER 1
Regulatory Strategy for Fintech Companies

The Fintech space-like the overall tech space a few years earlier-is evolving at breakneck speed, even though from a low base when compared to the incumbents currently present in the market. Financial services is a highly regulated industry-and for good reasons, as it is the lifeblood of a modern economy, and because it deals with people's live savings. Because of the lack of scale, Fintech has thus far mostly escaped regulation. However, this is coming to an end: as Fintech grows up and moves into the mainstream of finance, regulation on a par with that applied to other financial services is unavoidable.

Many people, especially in the tech world, see regulation as a nuisance, and something that at best needs to be reluctantly complied with. This is partially true-compliance with applicable regulations is tedious and a lot of work. However, from a strategic point of view this is not necessarily a bad thing: to the extent that a company is better able to navigate the regulatory environment than others, this can and will provide a competitive advantage.

This competitive advantage can be particularly important for tech companies because of way they slice up the underlying market: the current banking system is mostly designed on the assumption that customers want a one-stop-shop for all their banking needs, or even for all their financial needs, with most major banking groups now also sporting associated insurance and asset management divisions. Tech companies tend to have a very narrow focus in terms of the services they provide, and often even in terms of the segment of customers they target. They also understand the importance that scaling has for them: for many tech business models the first player who can reach significant scale in its segment can reach a position that is difficult to attack for followers, so being able to scale quickly and efficiently is a key part of a tech company's strategy.

There are very few national markets in the world-and especially in the Western world-that provide sufficient scale for a tech company that wants to play in the major league. This means that tech companies have to think about international expansion early on. For Fintech in particular this means that they will always have to deal with regulatory compliance in each and every market in which they operate. Compliance being costly is one thing, but from a scaling point of view more important is that regulatory compliance means delays: even before the first customer interaction takes place, a company has to ensure that it can comply with the applicable requirements, document this, and then seek authorisation or registration in the relevant jurisdiction. This process can be very time-consuming, especially if approached the wrong way, and more regulatorily nimble competitors can leapfrog Fintech companies that are seeing regulatory compliance as an afterthought rather than a core strategic skill.

The purpose of this book is to allow senior executives-especially those that come from a technical and single-product-focus background-to get to a point that allows them to understand the overall regulatory environment they are facing and to formulate a regulatory strategy, in particular during the scaling phase.

The financial markets are a highly connected system, and it is not possible to understand financial services regulation without a high-level understanding of the entire financial services space, and the range of products and services it offers. A big part of this book therefore is a description of the financial services space, intertwined with applicable regulation.

The first part of the book provides the main narrative. It is split into the following chapters:

1. a general introduction to regulations and their purpose, and how they impact a company's strategic planning (this chapter)
2. an overview of financial services regulations, looking at the types of regulations (ie, grouped by purpose), as well as their strands (ie, grouped by the way they are organised in reality)
3. a more detailed description of the regulations in place, looking at the sources from which they flow, then at various regulatory models, and finally a discussion of the areas most important for Fintech companies
4. an overview of the financial services industry split along the classic sectorial lines, interspersed with discussions about key applicable regulations
5. an overview of the key products offered by the financial services industry offered in the retail space, interspersed with discussions about key applicable regulations
6. an overview of the key products offered by the financial services industry offered in the wholesale space, interspersed with discussions about key applicable regulations.

The second part consists of tear sheets covering in more detail the most important regulations applicable to Fintech companies. A quick summary of each of those regulations is provided, and there is a discussion of the strategic importance of that particular regulation within the Fintech space. The tear sheets are cross-referenced against the regulatory text so that it is quick and easy to look at the exact regulatory requirements. All regulatory texts are linked on the companion site for easy access. In order to avoid duplication I had to choose a jurisdiction for which to provide those regulations, with the choice being between the US and the EU. I ultimately chose the EU because the regulatory structure is clearer. However, the large majority of rules and regulations will be very similar in the US, just with different references where to find the respective legislation.

1.1 Regulation

Whilst there is a general belief that markets work well in many instances, there is also an understanding that there are market failures, and that markets left to themselves can lead to suboptimal or bad outcomes. In many cases, market failures can be traced back to the fact that one party is better informed than the other one-not because they have failed to do their homework, but because structurally one party to the transaction finds it impossible or at least very expensive to acquire information that the other side has.

1.1.1 An Example for Beneficial Regulation: Taxis

Financial services are complex, so I want to start with an example where the market failure is very obvious: taxi services. First let's define the service, the classic street-hailed taxi service where a customer-possibly someone not living in that particular city-must go from point A to point B within that city, and where this is not a regular trip. Being at point A they'd therefore go to the closest busy street, or to the next taxi stand, and take a taxi to point B. What the customer wants is to get there (a) unharmed, (b) reasonably fast, and (c) at a reasonable and predictable cost. Unfortunately, if the customer just stands next to road waving his hand and a car stops, he will not have the information that would allow him to assess the points (a)-(c) above. For example, he'd like to know that the driver is sufficiently capable and not a psychopath, and that the car is safe in order to assert (a). To assert (b) he'd want to driver to be sufficiently skilled in navigating the city, and to assert (c) he'd either need to know that the driver is honest, or would need a benchmark to assess what the fair price should be.

It is interesting that technology changes how those constraints can be addressed. For example, since GPS units have become ubiquitous, being able to navigate the city is no longer a big issue, and even non-residents can assess the length of a trip, and whether or not the price demanded is fair. However, ignoring the fact that nowadays it is possible to quasi-street-hail taxis using a smartphone app, the issue of the honest and skilled driver with the sufficiently safe car remains: when a car pulls up at the kerb or waits at the taxi stand, the potential passenger has no means of getting all the information he needs. That is the fundamental market failure in taxi services, and in in absence of a mechanism to address this, potential customers might find it too dangerous to take a taxi, and therefore a mutually beneficial deal would not happen.

There are fundamentally two different ways in which this can be addressed: regulation and reputation. Let's start with reputation. In countries where taxis are not well regulated one tends to have large taxi companies that dominate the market. For example, when I was in Jakarta a while ago, I was strongly advised to only use cars of a specific company, and to always order a car by phone, lest rogue drivers manage to get hold of a car of that company. One impact of this was that it was rather difficult to get a cab when not in a location where some trusted friend or an honest concierge could order a car, and the company was able to charge premium prices because they had a quasi-monopoly on vetting reliable drivers.

In most cities, taxis are regulated. They are easily identifiable as taxis, and both the car and the driver must be in possession of a valid licence. Licensed taxis are equipped with an official meter that both the customer and the driver can see, and that is the sole basis for the fare that will be due at the end of the ride. The meter is regularly verified to ensure that it works correctly, and police makes spot checks on taxis in operation and fines offenders who do not comply with the aforementioned requirements. In this environment, customers do not have...