Independent Broker Dealer Consortium

Fintech Firms Race to Innovate, States and Regulators Voice Concerns

The pace of investment and activity in companies providing a technology-based solution to just about every aspect of the financial services industry soared in 2017. Forbes cites a report that $27.4 billion was invested in fintech startups last year, an 18% increase over 2016. Tech firms are scrambling to gain a piece of the 8.5 trillion-dollar financial industry market, and financial institutions are racing to partner with tech firms to create competitive advantage.

Regulators and legislators, mindful of protecting investors and ensuring the integrity of the financial markets, are simultaneously promoting fintech business innovation, issuing enforcement warnings, entering into regulatory collaborations, and looking to regtech to help them adjust to the shifting paradigm (See Bates Group blogs here, here and here). Highlights of federal and state activity over the past few weeks demonstrate this dynamic and their concerns. Here’s a review:

The forces driving both the promise and peril of fintech are made apparent by the activity of state authorities since January. Seven states joined in a compact intended to ease the regulatory burdens for fintech companies to do business in their jurisdictions. In eleven other states, legislation was introduced to either loosen or tighten restrictions on the use of blockchain technology and cryptocurrencies. A “pulse” survey by the North American Securities Administrators Association (“NASAA”) warns of the risks of dealing with rapidly advancing technologies.

Regulators from Georgia, Illinois, Kansas, Massachusetts, Tennessee, Texas, and Washington agreed to join a multistate compact in which each will accept the findings of the others regarding similar money transmitter licensing requirements. State regulators issue these business licenses after review for compliance with IT, cybersecurity, business plan, background check, and Bank Secrecy Act requirements. For now, the compact covers only those requirements that are identical from state to state, although the Conference of State Bank Supervisors (“CSBS”) is working to standardize state regulatory licensing practices for non-bank financial companies. Ostensibly, joining the compact encourages multistate fintech money services operations to open and operate in that state. Joining the compact also addresses a frequent criticism by fintech companies about the cost and labor associated with having to gain licensure approvals in each state. The CSBS is encouraging other states to join.

According to a recent review of state legislative activity, legislators in eleven states introduced bills in January to regulate blockchain-based technologies. One Arizona bill would allow residents to pay their taxes in BitCoin, while another would allow the state to tax capital gains made by cryptocurrency traders. Colorado and Illinois legislators want to combat data breaches of government records by applying blockchain technology to all state agency information. New York, Hawaii and Florida legislators are debating certain statutory definitions to enable the use of smart contracts, blockchain technology and digital signatures. Like Arizona, Vermont is considering taxation of cryptocurrency as well as the creation of a set of new business forms to accommodate fintech startups. Wyoming legislators would create a platform for fintech by allowing LLCs (limited liability companies) to register ownership on blockchain and exempt cryptocurrency token purveyors from securities regulation. States are considered laboratories for innovative policy ideas, and the differing effects of these bills may offer guidance for federal legislators and regulators.

In a recently-released NASAA poll conducted in late 2017, 84% of state securities regulators said that millennials are the most vulnerable to fintech fraud because they are the most likely to use the technology. The survey found that fintech risks vary widely between products. Initial Coin Offerings (“ICOs”) and cryptocurrencies were considered at highest risk for fraud, while robo-advice was considered the lowest risk. The survey also found that perpetrators of fintech fraud were knowledgeable about those risks, implying that they are sophisticated in exploiting them. Three-fourths of respondents felt that preventing fintech fraud is getting more difficult.

The latest CFTC alert warned investors about virtual currency pump-and-dump schemes conducted in unregulated online cash markets. The CFTC advisory reminded customers that pump-and-dump scams are generally anonymous and are enabled by public chat rooms and mobile messaging apps. The targets–particularly millennials–are those who accept tips or rumors over social media regarding virtual currency or tokens, and who do not conduct independent research prior to purchasing. The CTFC advised investors not to purchase virtual currencies, digital coins or tokens based on social media tips and not to believe ads or websites that promise quick wealth by investing in certain digital coins or tokens.

The twin themes of promoting fintech innovation and protecting investors and consumers were on full display at a recent hearing held by the House Financial Services Subcommittee on Financial Institutions and Consumer Credit. A distinguished group of witnesses advocated for varying degrees of support and control over fintech.

The Mercatus Center’s Brian Knight argued for giving more authority to states to allow them to facilitate fintech innovation. For example, he proposed allowing states to establish regulatory “sandboxes” to permit limited product testing. Mr. Knight acknowledged “the risks to both law enforcement and national security by allowing bad actors to move money illegally or avoid sanctions.”

Financial Innovation Now Executive Director Brian Peters argued that regulators need to better coordinate among themselves. He called the current regulatory structure “needlessly fragmented and inconsistent among federal regulators.” Georgetown Law Professor Adam J. Levitin tried to strike a balance. He made a number of specific recommendations including establishing a federal money transmitter license (an alternative approach to the state compact, above), but also urged legislators to require the CFPB to collect data on small business lending. Mr. Levitan urged a slow approach arguing that “Congress should proceed deliberately and carefully in making changes to the fintech regulatory framework, with the first principle being ‘do no harm.’”

In the NASAA survey, one-third of securities regulators said the rapid development of financial technology is a positive development for investors. Twenty percent worried about the potential negative impact of fintech on investors. Almost half acknowledged the benefits but recognized the greater exposure to risk and fraud. As can be seen in the actions above, these competing forces play out in bursts of activity by state and federal legislators and regulators. It is unclear whether Congress will heed Professor Levitan’s words, but the current dynamic seems to be leading regulators toward more collaboration, (e.g., this latest arrangement between the CFTC and the UK’s Financial Conduct Authority), and toward more state experimentation. In the end, it may be up to fintech innovators to solve the regulatory challenges they’re creating. Bates will keep you apprised of ongoing developments.

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