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Is Regulation Slowing Down the FinTech Revolution?

The financial industry has been and is still in the midst of a gigantic technology overhaul – led by the fearless FinTechs of today. Even some of the most old-school and stuck-in-the-past banks have slowly but surely began the journey of digitising their operations. The current environment of lockdowns where profits are heavily reliant on online channels has pushed these digitalisation plans even higher up on everyone’s agenda.    

The financial services digital transformation has led to a flood of new providers entering the market, giving rise to new competition characterised first by the unbundling of services by FinTechs and increasingly by the re-bundling inside tech giants’ digital ecosystems. With BigTechs like Google, Apple, Amazon and Facebook also bravely entering the digital payments sector, policymakers have, as a response, introduced regulations to prevent and manage new risks while promoting innovation-stimulating competition. Due to BigTech’s size and power, including the large volumes of data they have access to, policymakers are increasingly questioning their practices, which has, in turn, led to tighter regulations in the FinTech world.  

How is this regulation overload harming the FinTech sector?

For many FinTech startups, profits are still a mirage. And although they have been on a roll, with generous amounts of venture capital funding being injected into the sector before the pandemic began, many FinTechs are still not profitable and have a continuous need for capital in order to complete their innovation cycle of attracting new customers, enhancing their propositions and eventually monetising their scale to turn a profit. While many believe that FinTech companies fall somehow outside the regulatory radar, the truth is that today, FinTechs face more regulatory challenges and higher costs than ever before.

Despite the initial difficulties surrounding regulating the sector, policymakers are now working hard to ensure that FinTechs are compliant in a financial regulatory framework. As demand for digital tech continues to grow and more and more players enter the sector, regulators seem to be on a mission to issue guidance and pay closer attention to FinTechs, with an extensive list of new regulations for strong client authentication and transaction monitoring being issued. Regulatory compliance has now become a competitive advantage and a key differentiation for successful FinTechs, who use any opportunity to show their potential clients that they are compliant with both old and new regulations – whilst paying the price it comes at.

The EU is one of the fastest-growing FinTech regions in the world and regulators such as the European Commission (EC) and Parliament, ECB, EBA and ESMA have started a number of initiatives to regulate the sector in an attempt to strengthen efficiency, innovation and financial integration. Indisputably PSD2 is the biggest and most monumental legislative update in the EU banking and FinTech arena in recent years. And although its aim is to help FinTechs build all kinds of new services, powered by bank data they previously didn’t have access to, it also comes with its challenges. While the regulation is indeed driving innovation across the sector, it’s also created this fear in FinTechs that if they don’t innovate constantly, they may quickly become irrelevant.

In addition to PSD2 and as a response to the rapidly developing FinTech sector, EU regulators have also resorted to numerous approaches including piloting schemes, setting up of innovation offices and hubs, regulatory sandboxes and innovation accelerators and more recently, RegTech and SupTech initiatives. From the Fifth Anti-Money Laundering Directive, through to the recently unveiled FinTech Action Plan 2.0, there is a lot to keep up with. Devising a framework which provides necessary safeguards, while at the same time acting as a facilitator for innovation is certainly not an easy task, but what policymakers need to do is ensure that their constantly updated regulations are not becoming a hindrance which confuses companies and slows down innovation and evolution in the world of FinTech.

But it’s not just regulatory compliance that’s harming the FinTech industry. The emergence and spread of COVID-19 has also had a negative effect on the sector. As McKinsey reports, venture capital funding has slowed, business model vulnerabilities have been exposed and competitive dynamics are shifting, which has brought the industry’s underlying profitability and long-term business model sustainability to the fore and to a point where “the path to profitable scale for many FinTechs has been structurally altered”.

The pandemic is expected to have a significant negative impact on the sector’s profitability – as household incomes decline and discretionary spending drops, European transaction volumes and value could drop by 10% for domestic transactions and by 25% for cross-border transactions. As the broader economy is experiencing a slow-down, loan volumes are also feeling the pressure, which could result in a slump in Western European retail banking revenues by 35-40% as risk costs are up by 4-6 times and net interest margins decrease due to persistently low-interest rates.

However, this does not mean that there’s no light at the end of the tunnel. FinTechs’ digital origin, efficient cost structures, organisational agility and impressive customer loyalty will most likely help the sector weather the storm and overcome both the impact of the regulatory pressures they’re faced with and the COVID-19 pandemic.