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Miguel de la Mano Paris, 4 December 2017 OECD - Working Party No.2 on Competition and Regulation Innovative financial products and services (Fintech) A "new" challenge for Finance Regulators and Competition Authorities An economic perspective

Co-operation in the financial sector – DE LA MANO – December 2017 OECD discussion

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Miguel de la Mano

Paris, 4 December 2017

OECD - Working Party No.2 on Competition and Regulation

Innovative financial products and services (Fintech)A "new" challenge for Finance Regulators and Competition Authorities

An economic perspective

COMPASS LEXECON 1

A new wave of technological innovations, often called “fintech”, is accelerating change in the financial sector

� Fintech leverages the explosion of big data on individuals and firms, advances in artificial intelligence,

computing power, cryptography, and the reach of the internet.

� Strong complementarities among technologies > array of new applications touching on services from

payments to financing, asset management, insurance, and advice.

Advantages and risks

� Entities driven by fintech may emerge as competitive alternatives to traditional financial intermediaries,

markets, and infrastructures.

� However, it may also pose risks if its application undermines financial stability or market integrity.

� The challenge is that financial regulation may be too slow to react to new technology — from

cryptocurrencies and blockchain to crowdfunding — in the same way policymakers missed the risks

embedded in the "innovations" in mortgage finance that ultimately fuelled the worst housing bust and

financial crisis in modern history.

� But the regulatory response is important for the results that fintech can obtain. Is Europe ready?

FINTECH

COMPASS LEXECON 2

Fintech firms have attracted substantial investment

in recent years, while public interest has grown

significantly.

� Most firms have remained small––reflecting

their knowledge based business model––but

investment in them has risen substantially.

� Total global investment in fintech companies

reportedly increased from US$9 billion in 2010

to over US$25 billion in 2016.

� Venture capital investment has also risen

steadily, from US$0.8 billion in 2010 to US$13.6

billion in 2016.

� Market valuations of public fintech firms have

quadrupled since the global financial crisis,

outperforming other sectors.

INVESTMENT AND PUBLIC INTEREST IN FINTECH

COMPASS LEXECON 3

� Fintech challengers offer many services traditionally associated with banks (e.g. lending), but most are

not technically banks. Vast majority does not have banking licenses. Any money they hold for consumers

must not be for deposits, but instead for other purposes, e.g. transferring or lending.

Fintech is clouding the very nature of what it means to be a bank.

� PayPal, the biggest fintech challenger focused on financial products, holds enough consumers’ money in

accounts to be about the twentieth largest bank. Yet in the U.S. it is not licensed as one.

– No banking license > no guarantee for consumers to get their money back if PayPal went bankrupt, as the firm

does not have FDIC deposit insurance.

� Four of the ten largest U.S. companies, i.e., Google, Apple, Amazon, and Facebook, all have built

payment systems and made other inroads into finance > these technology giants will likely leave their

mark on finance.

� But the main drivers of fintech innovation are the thousands of startups attracting billions of dollars in

investment each year.

– For peer-to-peer pioneer LendingClub, like numerous other startups, its innovations are more about its superior

analytics or data that it uses to estimate borrowers’ creditworthiness.

– SoFi, a startup in this space, got its start by targeting HENRYs—high earners not yet rich. It realized it could extend

loans to that segment with reduced down payments, believing its carefully selected customers will continue

paying even if the mortgage is worth more than the house.

FINTECH CHALLENGERS

COMPASS LEXECON 4

� The term “fintech” sometimes excludes traditional banks. But this is not accurate. All major financial

institutions have become highly technological. One-third of Goldman Sachs employees are engineers,

more than those at Facebook and Twitter.

– For instance, J.P. Morgan Chase’s Intelligent Solutions Group has over 200 analysts and data scientists that

produced about 50 technologies in 2015 alone.

� Leading banks are purchasing fintech startups, forming strategic partnerships, or internally building

“whiz” teams to design new products.

TRADITIONAL BANKS & FINTECH

COMPASS LEXECON 5

Rapid development of a broad range of advancements in fundamental technologies > new applications in

all functions of finance: e.g. making payments, saving, borrowing, managing risks, getting financial advice.

MAJOR TECHNOLOGIES TRANSFORMING FINANCIAL SERVICES

COMPASS LEXECON 6

Technological innovations can increase competition by removing or mitigating economic barriers to entry.

� Technology can undermine the need for

– intermediaries by lowering asymmetric information (automated credit scoring), or

– transaction costs (online payments), or

– allowing for a more efficient matching of savers and borrowers (peer-to-peer lending platforms, or crowd-

sourcing).

� Technology could also lower barriers to entry by

– decreasing fixed costs of operation (back-office automation), or

– lowering network externalities (internet operability).

� The degree of horizontal and vertical integration will change if technology affects economies of scope.

E.g., social media platforms could cross-sell financial services based on their knowledge of user

behaviour).

� Technology challengers are already providing digital alternatives to traditional financial institutions. For

instance:

– Instead of borrowers labouring to compare and fill out multi-page loan applications, a RocketMortgage app

promises that they can “press a button, get a mortgage”.

– Automated assistants such as Credit Karma can, with access to consumers’ personal data, recommend a tailored

credit card, bank account, or loan with lower rates.

COMPETITIVE IMPACT ON FINANCIAL MARKETS AND BANKING

COMPASS LEXECON 7

� Other consumer industries, such as electronics, music, and books, have seen Fortune 500 companies

dissolve and profits fall in the face of digital upstarts.

� In contrast, banks have steadily gained customers in the midst of technological innovation.

� There are many possible explanations for this outcome, but the two most plausible are:

1. TBTF Banks continue to benefit from implicit subsidies and remain partially insulated from competition.

2. Traditional banks have erected obstacles to data sharing with Fintechs. For example, they have blocked automated

financial assistants from accessing customers’ account information even when customers approve.

RESPONSE FROM INCUMBENTS

COMPASS LEXECON 8

� Unregulated banking is prone to instability: e.g., depositor panics, domino-like collapses, asset price

spirals.

� Governments provide a financial safety net to protect against this instability. Unfortunately, the safety

net creates moral hazard.

� As of 2014, the (contingent) taxpayer support to date that benefit the EU banking sector amounts to

40% of EU GDP (€5.1 trillion in parliamentary committed aid measures) and undermined the solidity of

several countries' public finances.

� As a result of their TBTF status, certain banks have an implicit government guarantee. Bond investors are

willing to lend them money at lower interest rates than their smaller competitors.

– This is why large banks could pay 3/4 percentage points less for money than small banks in the wake of the

financial crisis, giving them a huge competitive advantage.

� In the long run TBTF increases systemic risk and restricts competition, but in the short-run, from the

perspective of a micro-prudential regulator, only the impact on financial stability is of relevance in

practice.

TBTF

COMPASS LEXECON 9

COMPASS LEXECON 10

� The TBTF problem has not been resolved. In the aftermath of the financial crisis regulators considered three

responses:

1. higher capital requirements

2. structural reform and

3. resolution regimes

� Resolution: surely an improvement on bankruptcy regimes that are ill suited to handle bank failures, limiting

contagion and panics by ensuring continuity of essential services. But they do not actually solve the moral hazard

problem. It is difficult for shareholders/other creditors to monitor and discipline the management of the bank even

under the threat of bail-in.

� Structural reform: only being implemented in the UK. Remarkably little serious structural reform anywhere else.

� Higher capital requirements: The general (ditto) opinion among economists is that banks should be required to have

at least twice as much equity capital relative to their exposures as the prevailing regulatory settlement. To say twice is

indeed to understate things.

– A truly formidable group of economists with great expertise in finance, Nobel laureates included, wrote to the Financial Times in

2010 to criticise Basel III (Admati et al 2010). For them, at least 15% of bank assets should be funded by equity – “the social

benefits would be substantial … and the social costs would be minimal, if any”.

– On that view, Basel III allows four times too much leverage.

� It follows that Antitrust enforcement in the case of TBTF banks should be strict. If the special responsibility doctrine

under EU antitrust enforcement means anything it should certainly apply to firms that are implicitly shielded from

failure.

TBTF SOLUTIONS?

COMPASS LEXECON 11

� Besides the large amount of regulation, fintech challengers have faced two other types of entry barriers:

1. incumbents’ ability to block market access, and

2. the difficulty in obtaining a special purpose license.

1. Incumbent’s blocking market access

� For example, credit card networks engage in exclusionary conduct, through clauses that prevent

merchants from using other payment methods.

� More subtle, traditional financial institutions can limit or shape entrants through control of data.

� For instance, one class of fintech challengers relies on data access to improve customer switching.

� The goal of automated financial assistants such as NerdWallet, Credit Karma, Mint, and MagnifyMoney is for

people to make all of their financial decisions through a single app.

� These companies learn about consumers—with permission—by accessing personal bank accounts, credit scores,

credit card records, tax returns, and other similar sources of financial information. The users receive

recommendations about credit cards or mortgages with lower fees, savings accounts that pay rates, and other

products that better meet their needs.

� >> Established financial institutions’ response has been to seek technological ways to block or limit automated

adviser access to customer information.

� In contrast, Amazon did not need help from Walmart, Target, and other retailers to sell directly to

consumers. Uber did not need existing taxi companies, nor did Airbnb need existing hotels, to operate.

ENDOGENOUS OR CONDUCT-DRIVEN ENTRY BARRIERS

COMPASS LEXECON 12

COMPASS LEXECON 13

2. Difficulty in obtaining a special purpose license

� Another entry barrier comes from the difficulty in obtaining licensing or registration necessary to

operate.

Why regulate the financial sector?

� Financial regulation seeks to address vulnerabilities and imperfections in financial markets that weaken

financial stability, undermine market efficiency, and expose consumers to risks.

� Financial regulation should:

– provide incentives for institutions to take into account systemic risk;

– protect consumers from conflicts of interest and where information is hard or costly to obtain; and

– support competition and prevent oligopolistic behavior.

� In pursuing these objectives, regulation should be proportional to the contribution of entities and

activities to systemic risk.

WHY REGULATE THE FINANCIAL SECTOR?

COMPASS LEXECON 14

� Nobel Laureate Jan Tinbergen stated the rule “for each policy objective, at least one policy instrument is

needed”.

� I would extend the rule further. For each policy objective a different competent authority is needed.

� Consider the attitude of a prudential regulator towards fintech startups:

� The prudential regulator primary mission is preserving the stability of the financial system.

� This revolves around preventing large financial institutions from failing.

� But allowing new fintech startups to compete fully could significantly increase the chances that

traditional financial institutions fail.

� In contrast, competition decisions—blocking mergers, and analyzing obstacles to data sharing—are less

visible. The effects of such decisions unfold over many years, and it is difficult enough to identify an

anticompetitive outcome, let alone trace its causes.

� Similar arguments can be made regarding a prudential authority’s incentive to reign in conflicts of

interest, or prevent financial institutions from developing and commercialising profitable products, for

example CDO or CDOs squared.

INSTITUTIONAL CHALLENGES

COMPASS LEXECON 15

� More recently, misselling of bank bonds – that can be bailed in – to retail consumers has highlighted the

need for a strong conduct-of-business supervisor for banking and other retail financial services, separate

from prudential supervision to ensure a strong focus on the interests of consumers

� Prudential supervision and conduct-of-business supervision (including markets supervision) require

different mind-sets, skills and approaches:

� Prudential supervision requires staff trained in economics, finance and/or accountancy

� Conduct-of-business supervision is more behavioural and legalistic. It involves policing the conduct of

financial institutions in the markets (insider trading, market abuse, disclosure, etc.) and towards

clients (adequate information provision, duty of care, know your customer, etc.).

� Long and sometimes painful experience demonstrates that prudential supervisors often prioritise the

interests of supervised entities over those of their customers.

� Extending licenses to new fintechs is a risk because it creates an additional threat to any particular

bank’s profitability.

� Additionally, designing a new licensing scheme takes resources away from a higher priority mission

and makes the prudential regulator responsible for unfamiliar business models.

INSTITUTIONAL CHALLENGES (II)

COMPASS LEXECON 16

1.Competition enforcement (EC-DG COMP)

2.Ensuring financial stability (Single Supervisory Mechanism (SSM))

3.Consumer protection in financial markets (reinforced and

revamped European Securities and Markets Authority (ESMA))

SEPARATION OF POWERS

COMPASS LEXECON 17

1. Competition enforcement

� In the EU, DG COMP has revamped its antitrust and merger enforcement in financial services.

2. Ensuring financial stability

� All euro-area banks are now supervised on the prudential side by the European Central Bank (ECB)

which was granted the Single Supervisory Mechanism (SSM): directly for the larger ones and indirectly

for the smaller ones. This minimises the possibilities of regulatory arbitrage and of a concentration of

systemic risk in a given country.

� However, the ECB has no jurisdiction on important arenas of market activity and regulation. These

include securities firms (also known as broker-dealers), asset managers and financial infrastructure such

as central counterparties (CCPs, also known as clearing houses). The ECB also does not cover the

conduct-of-business oversight of banks themselves.

3. Consumer protection in financial markets

� ESMA was created in 2011 to help foster “supervisory convergence” and mitigate the vast existing

differences of approaches, experience, and effectiveness between individual MS’ national authorities.

� ESMA also has some direct supervisory authority, but only over comparatively tiny market segments,

namely credit rating agencies and trade repositories.

� ESMA has built up a decent track record, but its current mandate is not sufficient to integrate EU-27

capital markets and ensure high standards of compliance with EU regulations.

SEPARATION OF POWERS (II)

COMPASS LEXECON 18

� The obvious solution is to enhance ESMA’s responsibilities, such as:

– authorisation of significant investment intermediaries (for example banks and securities firms) under

the EU Markets in Financial Instruments Directive and Regulation (MiFID/MiFIR);

– An extended consumer protection mandate, allowing ESMA to conduct market investigations and

directly impose sanctions at EU level, for example in cases of market manipulation (e.g. LIBOR or

Forex), data access restrictions or deliberate degradation of interoperability.

– registration, supervision, and resolution of Central CounterParties (CCPs), at least those that serve

international clients and have a potentially systemic importance from an EU perspective;

– supervision of audit firms;

– the enforcement of International Financial Reporting Standards; and

– Direct consumer protection powers

– Powers to use regulatory sandboxes at EU level.

� Significantly, the influential German Council of Economic Advisors (Sachverständigenrat) indicated in its

latest annual report that “organising the supervision of banks, insurance companies and financial

markets at [the] European level is the right approach.”

SEPARATION OF POWERS (III)

COMPASS LEXECON 19

Sandboxes have been developed by regulators and supervisors in a few jurisdictions to provide a controlled

and contained environment in which firms can conduct pilot trials of innovative financial services and

products in a timely and cost-effective manner before these are launched on a larger-scale.

� Objectives: strike a balance between promoting innovation and preserving financial stability and

consumer protection.

� The sandbox approach proposes to achieve this by lowering barriers to testing innovative financial

products and services while at the same time ensuring that adequate safeguards are in place to mitigate

risks and protect consumers.

� Some sandboxes also provide greater clarity on regulatory expectations and applicable rules for products

or services that do not easily fit within existing regulatory frameworks.

THE SANDBOX APPROACH

COMPASS LEXECON 20

� Regulations: Depending on the particular sandbox, certain regulatory or licensing requirements can be

relaxed, adapted or waved on a case-by-case basis, to allow firms to test innovative services and

products without incurring the full cost of compliance with licensing and regulatory requirements, and

reducing the time needed to get these services and products to markets.

� This will often be limited to the regulations and licensing regimes within the purview of the relevant

supervisory or regulatory agency responsible for the sandbox, and will at times expressly exclude certain

regulations that cannot be waived like anti-money laundering (AML) and combating the financing of

terrorism (CFT), fit and proper requirements and tax legislation.

THE SANDBOX APPROACH (II)

COMPASS LEXECON 21

� Eligibility criteria: To qualify for most sandboxes, the financial product or service to be tested must

involve genuine innovation, for instance, by using new or emerging technologies or using existing

technologies in an innovative way, and must either have the potential to address a problem or bring

benefits to consumers or to the industry.

� Other criteria include having the necessary resources, a thorough business plan, and a test-ready

product or service. The intent to deploy the product or service in the jurisdiction of the sandbox is often

included as a requirement.

� Safeguards: All sandboxes include some form of safeguards to mitigate the risks and contain the

potential consequences of the live tests. Safeguards typically include restrictions on the scope of the live

test, including on the number and type of customers, the duration, the total value and, in more

prescriptive frameworks, on the specific products and services that can be tested.

THE SANDBOX APPROACH (III)

COMPASS LEXECON 22

THE SANDBOX APPROACH IN SELECTED JURISDICTIONS

COMPASS LEXECON 23

Thank you for your time!