Draft for Public Consultation
This consultation takes place between November 6 and November 20, 2017 (11:59 pm Pacific time).Interested parties are invited to provide their feedback on the draft report no later than November 20, 2017 by completing our online form.
This publication is not a legal document. It contains general information and is provided for convenience and guidance in applying the Competition Act.
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Aussi offert en français sous le titre Innovation et services émergents axés sur les technologies dans le secteur canadien des services financiers
Table of Contents
This report provides policymakers and regulators with recommendations to encourage competition and innovation in Canada’s financial services sector.
Role of the Competition Bureau
The Competition Bureau (Bureau) ensures Canadian businesses and consumers prosper in a competitive and innovative marketplace. As an independent law enforcement agency, headed by the Commissioner of Competition, the Bureau is responsible for the administration and enforcement of the Competition Act, Consumer Packaging and Labelling Act (except as it relates to food), Textile Labelling Act and Precious Metals Marking Act.
As part of its mandate, the Bureau participates in a wide range of activities to promote and advocate for the benefits of a competitive marketplace, such as lower prices for consumers as well as increased choice and innovation. Market studies are one of the tools the Bureau uses to advocate for competition. They allow the Bureau to assess an industry through a "competition lens" to highlight issues that may restrict competition and to inform public policy on how markets are regulated.
The Bureau’s basic operating assumption is that competition is good for both business and consumers—and regulation should be minimally intrusive on market forces, allowing competition to drive innovation and improve outcomes for Canadians. At the same time, the Bureau recognizes that market failures do occur. In circumstances where market forces do not adequately correct market failures, regulation can be used to determine outcomes or control market dynamics. Regulation is also used to protect against negative externalities that may be left unaddressed by market forces. But, in some cases, regulation can have unintended consequences, including decreased efficiency and competition in a marketplace. During periods of rapid technological change, regulation can inhibit innovation and new business models from challenging the status quo.
The analysis and recommendations found in this report are made with these assumptions in mind.
Scope and premise of this study
The Bureau decided to study Canada’s financial services sector for three primary reasons. First, during the Bureau’s public consultations in 2013, financial services were identified as an area of focus for potential advocacy initiatives. Second, the sector itself is an important pillar in the Canadian economy, contributing approximately 7% of Canada’s gross domestic product (as of May 2017) and accounting for nearly 800,000 Canadian jobs (2015 figures). Third, it plays a significant role in the day‑to‑day life of most Canadians, whether they are receiving or making payments, borrowing, spending, saving or investing.
While Canada’s financial regulatory system is one of the most well‑respected and sound regimes in the world, the global financial crisis in 2007‑2008 led to a period of economic recession in Canada and around the world. The financial crisis damaged the reputation of the financial services sector and the sector appeared poised for an innovation disruption. A new wave of financial services businesses emerged: start‑ups leveraging the latest technology (in particular the mobile Internet) to launch apps and digital services; seasoned technology companies extending their reach into new parts of the lives of their users; and incumbent institutions seeking to reduce transaction friction to defend and maintain customer relationships.
Today, new entrants and incumbents alike are using technology to innovate and change the way Canadians access and consume financial products and services. The promise of financial technology (FinTech) is that consumers and small‑ and medium‑sized enterprises (SMEs) will benefit from streamlined processes, reduced friction, less need for intermediaries in certain transactions and more choice by unbundling products and services. Ultimately, FinTech’s draw is the potential for a more competitive marketplace, lower prices and increased choice in products and services (as well as more value for money) for consumers and SMEs.
Despite the global attention FinTech is generating, Canada lags behind its peers in its adoption. According to Ernst & Young LLP in 2017, approximately 18% of digitally active consumers in Canada had used at least two FinTech products in the prior six months—roughly half the average (33%) of the other nations surveyed.Footnote 1
The Bureau sought to understand why FinTech adoption appears to be higher in other jurisdictions than in Canada. Commentators attribute Canada’s slow adoption to a number of factors including lack of consumer awareness, lack of trust, consumer demand translating into actual usage and consumer comfort with existing service providers.Footnote 2 Many financial service providers, including FinTech start‑ups, point to regulatory and non‑regulatory barriers as impediments to growth and adoption.
The Bureau’s market study addresses five over‑arching questions:
- What has been the impact of FinTech innovation on the competitive landscape for financial services?
- What are the barriers to entry, expansion or adoption of FinTech in Canada?
- Are the barriers regulatory or non‑regulatory?
- Are changes required to encourage greater competition and innovation in the sector?
- What issues should be considered when developing or amending regulations to ensure competition is not unnecessarily restricted?
To ensure relevance for Canadians, this study focuses on innovations that affect the way Canadian consumers and SMEs commonly encounter financial products and services, with focus on three broad service categories:
- Payments and payment systems: This includes retail payment products and services (e.g. mobile wallets), as well as the infrastructure that supports these products and services (e.g. the clearing and settlement system).
- Lending: This includes consumer and SME lending (e.g. peer‑to‑peer or marketplace lending) and equity crowdfunding.
- Investment dealing and advice: This includes do‑it‑yourself investing and portfolio management through online platforms (e.g. "robo‑advisors").
While the financial services industry is much broader than these three lines of business, they account for a significant amount of FinTech investment by incumbent institutions, entry by start‑ups and growth in the Canadian marketplace. The Bureau did not include the following in its study:
- insurance (property and casualty, travel, health)
- currencies and crypto‑currencies
- accounting, auditing and tax preparation
- corporate, commercial or institutional investing and banking (e.g. pension fund management, mergers and acquisitions)
- payday loans
- loyalty programs
- business‑to‑business services beyond those noted above (e.g. cash handling)
- mortgage lending
For each of the three areas studied—payments and payment systems, lending and investment dealing and advice—the Bureau drew conclusions and formed recommendations for financial sector policymakers, regulators, industry participants, SMEs and consumers.
Information gathering and analytical approach
To help inform this study, the Bureau relied on information from a number of different sources. It reviewed public information such as academic literature, media publications, studies and reports from government agencies and other sources. It also leveraged confidential informationFootnote 3 gathered through written and oral submissionsFootnote 4 from marketplace participants (incumbent financial institutions and new start‑ups), industry and consumer associations, industry experts and domestic and foreign government agencies and regulators.
The Bureau thanks all those who took the time and effort to provide information and advance this study to completion.
In total, the Bureau conducted more than 130 interviews or meetings with 118 stakeholders and received 20 written submissions: one from an incumbent financial institution, 12 from FinTech start‑ups, and seven from industry and consumer associations. The Bureau also engaged in significant outreach to various stakeholders including 16 incumbent financial institutions, 35 FinTech start‑ups, 26 domestic agencies and regulators and nine foreign regulatory authorities.
In February 2017, the Bureau hosted a one‑day workshop, inviting FinTech stakeholders to discuss issues surrounding regulation and barriers to entry. The workshop proved to be an important opportunity for the Bureau to advance the discussion of relevant marketplace issues from a variety of perspectives.
The Bureau’s study uses competition principles to identify and analyse barriers to entry, innovation, competition and growth faced by FinTech.
With the current wave of FinTech still in its nascent stage, statistical data from which sound inferences could be made was not readily available. The Bureau relied primarily on submissions from and interviews with industry participants, regulators and industry groups as well as desk research to guide the analysis contained herein. Given the absence, in many cases, of a counter‑factual regulatory environment in Canada (i.e. the emergence of FinTech in an unregulated environment), this study also looks to certain international jurisdictions for insight into different regulatory approaches and their outcomes. Although some of the issues the Bureau learned about pre‑date FinTech and even the Internet, the Bureau gained valuable context from these submissions, interviews and international benchmarking.
The Bureau examined the landscape through a competition lens to assess the likely impact of current regulation on innovation and competition, taking into account the important goals such regulation tries to achieve. From this analysis, the Bureau developed recommendations that focused on reducing or removing barriers to innovation and competition by supporting and encouraging FinTech development and growth.
The speed with which FinTech developments are occurring on a global basis may affect the relevance of some elements of the analysis. Nonetheless, the fundamentals of a competitive marketplace will continue to be relevant into the future and policymakers are encouraged to continuously consider the implications of their frameworks on competition.
Structure of this report
This report is divided into six parts. The introduction provides the competition context, discusses the important role regulation plays in the financial services sector and presents, in brief, recommendations primarily for financial sector policymakers and regulators.
The three chapters that follow discuss each of the highlighted service categories: payments and payment systems, lending and investment dealing and advice. Each chapter is organized to contextualize the marketplace, discuss the potential impact of FinTech innovation in that service category, present existing barriers to entry that may prevent FinTech’s potential from being realised and recommend what policymakers can do to reduce or remove those barriers.
The report then presents global reactions to FinTech and some of the solutions to encourage FinTech innovation being implemented around the world, accompanied by a discussion of the usefulness that such measures could have for Canada.
Finally, the report presents the Bureau’s conclusions.
Competition generally leads to higher levels of efficiency and living standards, helps deal with the unexpected, provides resiliency and stokes innovation.
Why competition is important
The Bureau’s basic operating assumption is that competition is good for both business and consumers and that regulation should be minimally intrusive on market forces, allowing competition to drive innovation and improve outcomes for Canadians. Competitive markets make the economy work more efficiently, strengthening businesses’ ability to adapt and compete globally. They also provide consumers with competitive prices, more product choices and the information needed to make informed purchasing decisions. The Bureau believes that market forces should be relied upon as much as possible to deliver these outcomes.
While rapid technological advancement can accelerate innovation, regulation that does not keep pace can counteract that by impeding market forces from delivering competitive benefits. This can ultimately inhibit innovation and lead to higher prices and less choice for the consumer. In particular, regulatory compliance can act as a significant barrier for new competitors who wish to enter a market or from existing competitors who wish to innovate outside the confines of regulation.
Regulation must strike an appropriate balance between competition and the policy objectives it aims to achieve (e.g. safety, soundness and consumer protection). To take on the challenge will ensure consumers and businesses benefit from a competitive marketplace while market failures are mitigated.
What makes for a competitive market
In a competitive marketplace, companies use different approaches to maximize their profits. Some reduce prices, while others exploit more efficient means of production to increase margins and reduce costs. Still others gain market share through innovation, offering consumers differentiated products and services that deliver more value than those of their competitors. When companies attempt to increase profits by raising prices, they risk losing customers to their competition or attracting new competitors who see the opportunity for profitable market entry.
In markets that lack competition or where the threat of competitive entry is low, firms can maximize profits by increasing prices, without the same risk of lost customers. In these markets, the competitive drive to innovate, improve quality or become more efficient in production is largely lost. Consumers ultimately pay higher prices without a commensurate improvement in value.
Such uncompetitive outcomes are more likely when a market is characterized by a high concentration of suppliers, high barriers to entry and high costs of switching for customers. When a market is effectively composed of a necessary good with very low price‑elasticity (i.e. the rate at which demand decreases when prices increase), even firms with small market share can wield power. It can be argued that the financial services sector has these characteristics.
There are a few key elements that create an environment in which competition can flourish: low barriers to entry; low costs of switching for customers; complete and accurate information; and a sufficient number of effective competitors. Without these elements, markets are likely to tend away from competitive outcomes.
Low barriers to entry
In markets with low barriers to entry, incumbent firms must keep prices low, exploit efficiencies and continuously innovate. If they do not, they face the risk of new entrants with better prices, more efficient production, more innovative offerings or some other value proposition for consumers coming into the market and taking away their profits. In contrast, when barriers to entry are high, incumbent firms are less likely to face the threat of competitive entry and can more easily earn profits in excess of what a competitive firm would earn. High barriers to entry effectively protect incumbent firms from future competition—and the innovation that may come with it.
Competitive entry can take different forms: a completely new firm (e.g. a start‑up) entering with new products or services; an existing firm expanding the scope of its product or service offering (e.g. a mortgage lender that begins giving business loans); an existing firm expanding the geographic area in which it operates (e.g. a small bank that opens a new branch in a different town); or an existing firm increasing production or supply. Barriers to entry affect the timeliness, likelihood and sufficiency of competitive entry.
Whether they take the form of absolute restrictions on entry or individually small (but cumulatively large) deterrents, barriers to entry deter competition by making it too costly or risky to enter the market profitably.
They can include: regulatory barriers, high sunk costs (e.g. costs that cannot be recovered if the entrant later exits the market), economies of scale, network advantages, market maturity and incumbent control over key inputs.
Low costs of switching for customers
When consumers of a good or service can switch between suppliers easily and for low or no cost, firms have the incentive to keep prices low or otherwise maintain value for their customers. If not, they risk losing those customers to a competing firm. When it is difficult for customers to switch between suppliers (or when doing so does not generate enough benefits to outweigh the costs of switching), customers are less likely to switch even if prices increase. Firms that have more of these so‑called "sticky" customers may have less incentive to compete vigorously.
Information and price transparency
To help customers make switching decisions and indeed purchasing decisions generally, complete and accurate information—presented in a manner that is easily understood by consumers— is needed. Where pricing and related information is opaque, confusing, false or misleading (e.g. where the general impression is contradicted by disclaimers) or the promise of responsive and reliable service is unclear, consumers find it more difficult to properly assess the costs and benefits of switching. As a result, businesses do not have to compete as vigorously to keep customers as they would have to in competitive market.
Finally, a competitive market needs competitors. Often, mature industries with high barriers to entry and sticky customers result in concentrated marketplaces with a few large suppliers and potentially a competitive fringe. As time passes, the incumbent firms, protected by the barriers to competition, tend toward oligopoly or in the extreme, monopoly—which can create anti‑competitive outcomes.
Key barriers to entry and growth facing FinTech
As the Internet and mobile computing have become ubiquitous, consumer demand for new ways to deliver financial services has increased. Rather than visiting a branch to receive financial services, consumers are now looking for more on‑demand, digital transactions that can be conducted at their leisure.
Widespread use of the Internet would be expected to increase competition, given that one of the largest barriers to entry—the need for a branch network—is reduced.
However, many other barriers to entry remain in the way of FinTech delivering on the promise of a more competitive financial services marketplace. The key barriers facing FinTech include:
- consumer awareness and demand for products
- start‑up capital
- trust in incumbent institutions
- access to basic services and processes
- market maturity and reputation
- customer stickiness
- economies of scale and scope
- regulation (relating to the safety, soundness and security of the financial system)
- ensuring risks are mitigated (e.g. cybersecurity, privacy)
Consumer awareness and demand for products are barriers that all new businesses face. As consumers learn more about FinTech and begin to demand more innovative solutions in financial services, one would expect these barriers will be more easily overcome.
The lack of access to capital for FinTech start‑ups is often cited as a significant barrier to entry in Canada—this was highlighted at the Bureau’s FinTech workshop with some stakeholders suggesting that the dearth of investment focused on FinTech companies is contributing to the exodus of financial sector innovators seeking more FinTech friendly jurisdictions and putting Canada’s global competitiveness at risk.
Consumers of financial services want to ensure their money is safe, their investments grow and their payments are made on time. Many of Canada’s financial service providers have been in business for more than a century, with some dating back to before Confederation. As a result, new entrants find it particularly challenging to win the trust of consumers and build reputations as safe and reliable service providers. On top of that, this is a marketplace where most of the target market is already served in some capacity by seemingly similar services (e.g. from their current service providers)—making market maturity, reputation and trust significant barriers to entry that new entrants will need to overcome.
"Customer stickiness" refers to the willingness and ease with which customers can switch between service providers. The integration of financial services in our daily lives heightens the risks associated with the uncertainties inherent in trying a new product. Additionally, fees and penalties for switching increase the costs and difficulty for consumers, which makes adoption of new services or products less likely to happen quickly. FinTech entrants may find consumers’ inability to easily switch to be a barrier to entry.
Related to customer stickiness, building "economies of scale" refers to the ability of FinTech companies to gain the necessary critical mass of users on all sides of transactions to make their services profitable and maintain the cost advantages expected from avoiding costly branch networks. Incumbent financial service providers have an advantage in that they have the customer base and capital to experiment with new offerings without the same consequences of failure. "Economies of scope" refers to the ability of firms that bundle a wide variety of services or products to enjoy a cost advantage over firms that offer a narrower set of services or products.
Finally, regulation may present a barrier to market entry and success for FinTech companies. The financial services and banking sectors are heavily regulated at the federal and provincial levels. The regulatory frameworks in place today are unquestionably important in safeguarding consumers and mitigating internal and external risks to the financial system as a whole. When they do not keep pace with technology, regulations can inadvertently deter innovation and the competitive benefits that follow.
Given the impact regulation can have on entry and competition in the marketplace, the primary focus of this study is on the regulatory barriers to entry faced by FinTech. Throughout this study, the Bureau heard from many stakeholders about the issues different regulations pose for FinTech. The majority of regulatory barriers can be divided into four categories: anti‑money laundering regulations; securities regulations; payments regulations; and other broadly applicable laws that may inhibit certain FinTech activities (such as the Personal Information Protection and Electronic Documents Act).
The role of regulation and regulators
The goal of most regulation is to correct for negative externalities that will not be corrected by market forces alone. Regulation also plays a role in mitigating risks that may be ignored when companies pursue higher profitability. Risks that regulation in financial services aims to mitigate include systemic risk (i.e. risk of financial system failure), prudential risk, institutional governance, risks to consumers and investors, asymmetry of information (between financial services consumers and suppliers) and financial illiteracy, counterparty risks in payments, privacy risk, and abuse of the financial system to hide or facilitate criminal activity. In this context, financial services regulations exist to both protect the systems in place and to govern the conduct of those who provide services in the marketplace.
Regulation at the federal level
The Minister of Finance and the Department of Finance Canada are responsible for fiscal policy and financial sector regulatory policy and legislation. The Minister of Finance oversees a number of agencies and Crown corporations in the finance portfolio, including the Office of the Superintendent of Financial Institutions (OSFI), the Financial Consumer Agency of Canada (FCAC), the Financial Transactions and Reports Analysis Centre of Canada (FINTRAC) and Canadian Deposit Insurance Corporation (CDIC). While the Minister of Finance sets policy and creates legislation, these agencies and corporations carry out the administration or enforcement of that legislation. Key statutes under the Minister of Finance's purview include the Bank Act, Payment Card Networks Act, Proceeds of Crime (Money Laundering) and Terrorist Financing Act and Canadian Payments Act.
The Bank of Canada is responsible for setting monetary policy in Canada, targeting inflation through manipulation of overnight interest rates (i.e. the rate at which financial institutions borrow from each other). It oversees major clearing and settlement systems, providing those systems with banking services (pursuant to the Payment Clearing and Settlement Act); promotes financial stability globally with international bodies; and provides liquidity to the financial system. The Bank of Canada is also responsible for issuing currency. Some of the primary risks concerning the Bank of Canada include the safety, soundness, stability and efficiency of the financial system.
OSFI regulates and supervises more than 400 federally regulated financial institutions (FRFIs) and 1,200 pension plans to determine the soundness of their financial condition and whether they are meeting their obligations as set out in legislation. FRFIs include all banks in Canada as well as all federally incorporated or registered trust and loan companies, insurance companies, cooperative credit associations, fraternal benefit societies and private pension plans. OSFI’s mandate is to protect depositors, policyholders and other creditors, while allowing financial institutions to compete and take reasonable risks.
The FCAC ensures that federally regulated financial institutions (i.e. those overseen by OSFI and the Department of Finance) comply with consumer protection measures set out in legislation and regulation. It also conducts research and promotes financial education and awareness of consumer rights and responsibilities.
FINTRAC is Canada’s financial intelligence unit, assisting in the detection, prevention and deterrence of money laundering and terrorist activity financing. It provides a unique contribution to the safety of Canadians and the protection of the integrity of Canada’s financial system through the enforcement of the Proceeds of Crime (Money Laundering) and Terrorist Financing Act.
The CDIC is a federal Crown corporation that contributes to the stability of the financial system by providing deposit insurance against the loss of eligible deposits at member institutions in the event of their failure. Premiums for deposit insurance are paid by member institutions.
In addition to direct government involvement, Payments CanadaFootnote 5 has a legislative mandate and is responsible for the clearing and settlement infrastructure, processes and rules that are essential to the exchange of billions of dollars each day (i.e. interbank payments). Payments Canada operates three payments systems: the Large Value Transfer System, the Automated Clearing Settlement System and the US Dollar Bulk Exchange. The organization also oversees the rules for this key payments infrastructure and ensures its smooth and efficient operation.
Regulation at the provincial and territorial level
Provincial and territorial governments are responsible for policy and regulatory development related to provincially‑ or territorially‑regulated financial institutions (such as most credit unions) and securities. Securities are regulated through 13 distinct provincial and territorial authorities, each administering separate laws and regulations. Alberta, British Columbia, Ontario and Québec are the four largest provincial regulators, supervising the vast majority of the securities market.Footnote 6 Most provinces and territories also have consumer protection legislation, some of which deals with financial transactions and agreements.
In relation to the three areas of study that are the focus of this report—payments and payment systems, lending and investment dealing and advice—securities laws have a significant impact on the entry and growth of FinTech. The goal of securities legislation is to foster fair and efficient capital markets and protect investors. Securities rules include regulation of the conduct of securities issuers and dealers as well as their reporting requirements and business structures. To harmonize, improve and coordinate securities legislation and regulation across jurisdictions, each of the provincial and territorial securities regulators have combined to create the Canadian Securities Administrators (CSA) umbrella organization.
In addition to provincial securities authorities, two self‑regulating organizations, the Investment Industry Regulatory Organization of Canada (IIROC) and the Mutual Fund Dealers Association of Canada (MFDA), have oversight authority regarding the conduct of investment and mutual fund dealers.
Each of these regulatory or oversight authorities has an important role to play in ensuring that financial markets are safe, secure, efficient and useful to Canadians. They promote confidence in the financial system through consumer protection and literacy, while mitigating exposure to unnecessary risks. There is no doubt they are important and necessary to the operation of our financial system.
Summary of key recommendations
Throughout this study, the Bureau heard from a wide variety of stakeholders regarding innovation and competition in the financial services sector. Given the barriers identified in this report, the Bureau recommends the following be adopted by financial sector regulatory authorities and policymakers to ensure that, wherever possible, regulatory responses to FinTech balance the need for protection against risk with competition and innovation:
- Regulation should be technology‑neutral and device‑agnostic. Prescriptive rules regarding how a firm must comply with a regulation are often written with the technology of the day in mind. For example, consumers may still face instances where services providers require a ‘wet’ signature, verification of identification or collection of personal information in person or through a face‑to‑face conversation. These rules and policies may have made sense when transactions occurred in person at a branch, but the Internet and mobile computing have changed how consumers wish to consume services—and how providers provide them. Rules that can accommodate and encourage new (and yet‑to‑be developed) technologies open the door to more innovative offers down the road.
- To the extent possible, regulation should be principles‑based. Policymakers should aim to create regulation based on expected outcomes rather than on strict rules of how to achieve those outcomes. A regulation that prescribes exactly how an identity must be verified, for instance, can potentially limit an innovative service from using new, more effective ways of verifying customer identity such as biometrics or remote identity verification through third‑party sources. If this same regulation was based on the notion that the service provider must verify the identity of a customer using sufficiently robust means or demonstrated diligence, it could encourage innovation in the marketplace. Principles‑based regulation has the added benefit of allowing regulators the flexibility to issue guidance and be more flexible in their approach to enforcement as technology changes.
- Regulation should be based on the function an entity carries out. Current regulations at the federal level apply only to certain entities defined within legislation. For example, regulations enforced by the FCAC apply only to FRFIs. Many FinTech entrants, that may do similar activities but are not included in the list of FRFIs, do not fall under the same regulatory umbrella. As a result, there are varying levels of regulation for the same activity or function performed by different entities. This contributes to the potential imbalance created as entities have different standards to which they must adhere. Function‑based regulation ensures that all entities have the same regulatory burden and consumers have the same protections when dealing with competing service providers.
- Regulators and policymakers should ensure regulation is proportional to the risks that the regulation aims to mitigate. Deposit‑takers who lend on fractional reserve, for example, may require more emphasis on prudential regulation than a payment app that allows users to store money to pre‑order and pay for coffee and collect reward points. Similarly, within the same functional area (e.g. payments), regulations could be tiered such that functions whose failure poses lower risks to the system (e.g. paying for coffee) do not necessarily face the same strict oversight as functions whose failure poses higher risks the system (e.g. interbank settlement). Together with function‑based, principles‑based and technology‑neutral regulations, proportional regulation ensures that FinTech entrants will compete on a level playing field with incumbent service providers offering the same types of services. At the same time, it will reduce the risk of regulatory arbitrage.
- Regulators should continue their efforts to harmonize regulation. Much work has been done to harmonize regulations across Canada regarding securities; however, differences still exist that can unnecessarily lead to increased compliance burden. As an example, provincial regulators have introduced three different equity crowdfunding exemptions—and the rules and requirements to take advantage of each are different across jurisdictions. Regulators and policymakers should make best efforts to harmonize regulation across geographic boundaries.
- Policymakers should encourage collaboration throughout the sector. More collaboration among regulators at all levels would enable a clear and unified approach to risk, innovation and competition. Greater collaboration among the public and private sector more broadly would foster greater understanding among regulators of the latest services—and of the regulatory framework among FinTech firms. Finally, pro‑competitive collaboration between industry participants would help bring more products and services to market, while recognizing the potential for anti‑competitive collaborations. Other jurisdictions (such as the UK, Australia, and Hong Kong) have established regulatory sandboxes and innovation hubs, accelerators and precincts to facilitate such collaboration. Policymakers in Canada appear to be following suit (e.g. with regulatory sandboxes and concierge services in the securities space) and should continue to do so.
- Policymakers should identify a clear and unified FinTech policy lead for Canada with federal, provincial and territorial expertise to facilitate FinTech development. Some jurisdictions, like Singapore and Switzerland, have created new offices to facilitate FinTech, while others have clearly identified policy leads. In Canada, such a body could serve as a gateway to other agencies, giving FinTech firms a one‑stop resource for information and encouraging public and private investment in innovative businesses and technologies in the financial services sector.
- Regulators should promote greater access to core infrastructure and services to facilitate the development of innovative FinTech services under the appropriate risk‑management framework. Access to core infrastructure, such as the payments system, would enable more market participants to deliver new overlay services to payments customers (e.g. bill payment applications, international remittances, foreign exchange services). Access to core services, such as bank accounts, is often a necessary input for FinTech firms to operate their services. When regulation is cited as the reason for denying such services, competition and innovation may be lessened.
- Policymakers should embrace broader "open" access to systems and data through application programming interfaces. With more open access to consumers’ data (obtained through informed consent and under an appropriate risk‑management framework), FinTech can help consumers overcome their inability or unwillingness to shop around by paving the way for the development of bespoke price‑comparison tools,Footnote 7 and other applications that facilitate competitive switching. This is the approach taken by the UK Competition and Markets Authority (CMA) in its "open banking" initiative to promote more competition in the banking sector. Clarifying the conditions under which access is granted would support greater clarity of liability for consumer redress. And, by enabling more financial processes to be conducted without the need for a bricks‑and‑mortar branch network, customers in regions with little competition may see their options improve.
- Industry participants and regulators should explore the potential of digital identification to facilitate client identification processes. Many services currently rely on verification of one’s identity based on passwords and personal identifying information presented without a physical presence. Some Government of Canada services, for example, allow users to verify their identity using SecureKey or their existing banking credentials, relying on the fact that the user’s bank has already verified their identity and the log‑in credentials are unique to that person. Digital identification could help reduce the cost of customer acquisition for new entrants and incumbent service providers alike, while reducing the costs of switching for consumers and facilitating regulatory compliance where identity verification is needed.
- Policymakers should continue to review their regulatory frameworks frequently and adapt regulation to changing market dynamics (e.g. consumer demand and advances in technology). Reviewing regulatory frameworks ensures they remain relevant in the context of future innovation and can achieve their objectives in a way that does not unnecessarily inhibit competition. When consumers are faced with new products and services that they may not fully understand, they may be left exposed to harmful outcomes. Updating regulations to reflect new market dynamics can better ensure consumers are protected when using new or innovative financial products or services and technologies to access those services. Extending consumer protection principles to services enabled by FinTech can help reduce barriers to entry and at the same time ensure that all consumers, regardless of technology, enjoy the same level of protections. Indeed, FinTech products can help promote greater financial literacy among consumers. Policymakers should explore ways to leverage technology to achieve these objectives.
The Bureau is confident that these recommendations, if adopted, would facilitate competition through innovation to the benefit of Canadians. Policymakers are encouraged to consider stakeholder involvement in the policy‑ and regulatory‑development process to ensure the right risks are mitigated and competitors are not unduly excluded from participating in markets.
Retail payments and the retail payments system
If given the opportunity, FinTech innovation in retail payments will deliver consumer and business products and services that go beyond just finding a new way to tap the same credit card.
In 2015, more than 20 billion transactions worth almost $9 trillion in retail payments were made in Canada. A payments system that is safe, secure and efficient is the backbone of our financial system. Payments are critical to Canada’s economic activity and the daily lives of Canadians, with consumers and businesses making millions of retail payments each day via cash, cheques, debit and credit cards, electronic funds transfers, wire transfers and email money transfers.
Retail payments are the low-value, high-volume payments consumers and businesses make on a daily basis to purchase goods and services, make financial investments, pay wages and send money to one another. Most of these transfers require an underlying infrastructure with accompanying instruments, technical arrangements, procedures and rules to facilitate the exchange of value between the party making the payment (the payer) and the party receiving the payment (the payee). All combined, these elements make up the retail payments system.
At a high level, the retail payments sector is composed of two key pieces: the infrastructure that ensures payments are cleared and settled (specifically, the Automated Clearing Settlement System [ACSS] and Large Value Transfer System [LVTS]) along with the various payment schemes and services (e.g. credit card networks, electronic transfers).
Given the critical importance of the payments system, a strong regulatory framework is needed to ensure payments are made and received in a safe, secure and expedient way. Yet, these important regulatory constructs can sometimes have unintended consequences that slow innovation and reduce competition.
Retail payments ecosystem
Retail payment systems are a combination of interrelated processes and networks. These networks have a vertical relationship, moving from downstream services to upstream payments infrastructure for clearing and settlement. For these systems to operate effectively and efficiently, they are bound by rules that all participants must follow.
How payments are madeFootnote 8
Different payment schemes use different processes, infrastructure and rules to effect payments.
Cheques are demands on a payer’s account initiated by a payee. Upon deposit, the payee’s financial institution submits a request for payment from the payer’s financial institution through the ACSS, which is operated by Payments Canada. The payer’s financial institution verifies the availability of funds in the payer’s account and makes the payment; if sufficient funds are not available, the payer’s institution returns the cheque and the payment will not be made. The risk of non‑payment (counterparty risk) is borne by the payee.
Electronic point of sale (POS) debit transactions are demands from the financial institution of a payee (typically a merchant with a POS device) on the payer’s institution. Unlike cheques, electronic debit transactions are considered "good funds" transactions, where the debit network (e.g. Interac®) provides the software that enables the payer’s institution to authenticate and authorize the transaction at the point of sale, suspending the required funds from the payer’s account and ensuring the payment will clear and settle through the ACSS. The debit network also eliminates the risk of double‑spending by a debit card user by "earmarking" the required funds immediately. The counterparty risk of cheques is eliminated. Email money transfers operate in the same general way as payments using debit cards but they operate a proprietary network for clearing payments before being settled through the LVTS.
Electronic funds transfers (e.g. direct deposits, pre‑authorized debit) are completed in a similar way to debit transactions. In the case of direct deposit, the payment is initiated by the payer and funds are immediately "withdrawn" from the payer’s account. For a pre‑authorized debit (e.g. automatic bill payments), the payee initiates a request to the payer’s financial institution and funds are withdrawn, if available. In a payer‑initiated electronic funds transfer, counterparty risk is eliminated; however, in a payee‑initiated request, the payment will fail if funds are not available in the payer’s account and counterparty risk is borne by the payee.
Cheques, debit transactions and electronic funds transfers through financial institutions are all cleared and settled through the ACSS.
Credit card transactions are requests from a payee’s institution to the payer’s issuing institution. As the funds are provided by the payer’s financial institution (i.e. the card issuer), counterparty risk is all but eliminated.Footnote 9 The payer’s institution then collects the outstanding debt from the payer, typically at a later date.
While the volume of transactions made with cash, debit and credit cards accounted for 75% of retail payments in 2015, these methods accounted for less than 10% of the value of all retail payments. Cheques and other paper instruments make up the largest proportion of the value of retail payments, with electronic funds transfers following closely behind. The general trend, however, is toward less reliance on cash and cheques in favour of credit cards and electronic funds transfers.
Open‑ and closed‑loop payment schemes
Generally, there are two types of front‑end payment schemes available to end users. Open-loop systems facilitate transactions between different account‑holding institutions. The Interac® network operates an open‑loop scheme cleared through the ACSS, while credit card networks (e.g. Visa, MasterCard) operate their own proprietary open‑loop schemes. Closed‑loop systems involve schemes where a payment service provider (PSP) holds all funds from both payers and payees at one institution. Payments between users of closed‑loop networks (e.g. gift cards) are recorded as "book entry" transfers between payer and payee, without the use of a payments system like the ACSS.Footnote 10 Closed‑loop schemes do not require the use of the ACSS to clear and settle transactions within the scheme, but require its use to bring funds into and out of the scheme.
Competition in retail payments
As payments move away from costly instruments such as cash and cheques, demands for payment services are changing. The demand for seamless, instant, convenient and around‑the‑clock payments is largely being influenced by the mobile and online experience of consumers in many other sectors. New PSPs are entering the market, using technology and innovative business models to meet these demands.
In terms of the FinTech ecosystem, this entry is significant—the retail payments industry has attracted the most new entry from FinTech companies both in Canada and globally. These new entrants have the opportunity to increase competition in the retail payments marketplace. The Department of Finance Canada, for example, has noted that "the prominence of traditional providers of payment services, such as banks and debit and credit card networks, is being challenged by non‑traditional providers."
To understand the potential of FinTech to provide effective competition in the retail payments sector, it is important to understand how competition happens in the market today.
Given the complexity of retail payments, competition occurs in a number of ways at various points along a payment journey: from the service that allows initiation of the payment, to the network used to facilitate the payment, to the institutions that process and clear transactions. At each stage of a payment, there is opportunity for innovation and competition to deliver better results for Canadians.
There are two key types of competition in the payments system: inter‑network and intra‑network competition.
Intra‑network competition occurs between members within a particular system (e.g. the Interac® network). In many cases, PSPs share upstream clearing and settlement infrastructure but compete downstream by offering payment services directly to end users (e.g. through cardholder benefits like insurance or cashback privileges). Members of a clearing and settlement system, such as the ACSS, may also compete with each other to provide clearing and settlement services to smaller members who may not be able to afford to clear and settle directly with the ACSS or to institutions that are excluded from the ACSS.
Downstream competitors provide an interface between the users of payment services and the clearing and settlement process and offer a wide range of services to both consumers and businesses. The majority of competition in the retail payments sector is in this downstream market, with both new entrants and incumbents competing on price and service levels.
Despite a relatively high degree of consolidation, competition is generally strong in the "merchant acquiring" marketplace. Merchant acquirers provide the infrastructure and services merchants use to accept and process retail payments. While some merchant acquirers are owned by financial institutions, non‑financial institutions have entered this market in the past decade to provide merchant acquiring services. Given the large number of financial institutions that offer Interac® debit as well as Visa and MasterCard, non‑financial institution merchant acquirers generally have a competitive choice for banking service partners.
Inter‑network competition occurs between payment systems as a whole, including the entire vertical chain of exchange, clearing and settlements functions. Payment systems often offer different features or qualities, including security, convenience, reliability, timeliness, convenience, cost, the ability to draw on a credit facility and on the ubiquity of users on both sides of the transaction (i.e. the payers and payees using that network).Footnote 11 End users can choose between payment instruments that meet their specific needs but often have to accept a trade‑off between features. Because no two retail payment instruments are seen as being perfect substitutes, the retail payments marketplace has several competing payment systems. Given the features of a certain payment instrument, however, end users can typically be serviced by multiple competing providers. Both facets of inter‑network competition are important; research has shown that some payment systems take intensity of competition with similar systems and with other payment instruments into account when setting prices.
FinTech enters the payments space
The potential for FinTech in the payments space to circumvent traditional institutions is real. But to be successful, PSPs need to bring enough users on both sides of a payment to their service to offer a truly competitive option.
Downstream intra-network competition has seen a number of FinTech firms enter the market. Mobile payments, for example, are an innovation through which new competitors have managed to enter the market. Many PSPs, including financial institutions, have developed their own mobile wallet applications and technology companies such as Apple (though iOS) and Google (through Android) have introduced mobile wallets that allow end users to make retail payments with their mobile phones at physical POS terminals. Mobile payments can reduce or eliminate the physical limitations on the number of cards that can be carried or used feasibly by end users, increasing competition from new entrants.
Recent innovations driven by competition from new players on the merchant acquiring side of the transaction include low-cost POS terminals and innovative business models that reduce payment processing costs. Square’s mobile credit card processing products, for example, allow merchants who may have historically relied on cash or cheques to accept a wider variety of payment methods,Footnote 12 reducing counterparty risk for merchants and improving convenience for consumers.
Other FinTech innovators are offering products that combine payments with back‑office features for merchants, such as inventory management, bill collection or accounting integration; along with features that help consumers better track and manage spending or access ways of paying that are otherwise more convenient.
Unlike downstream intra‑network competition, new entrants launching closed‑loop systems compete as vertically‑integrated PSPs. These entrants are increasingly providing competition for the initiation of payments, eliminating the visibility of financial institutions to end users. For example, PayPal operates a closed-loop system where payers and payees can transfer funds between themselves and make purchases from merchants who also use PayPal, without the use of a financial institution.Footnote 13 Only when a user decides to withdraw funds from their PayPal account (or load funds into their account) do financial institutions become a part of the payment journey. Similarly, some FinTech entrants providing international money transfer services use closed‑loop models. Payments between two parties seeking to send and receive money in different countries are in effect made through two domestic transfers. The PSP transfers funds between the payer and itself in one country and, at the same time, transfers the reciprocal amount between itself and the payee in the other country. Again, this process avoids the need for a financial institution to initiate the exchange of funds.
Closed‑loop systems, like e‑walletsFootnote 14 and international remittance services, can provide enhanced convenience to end users by improving transaction speeds and providing a more customized, flexible payment experience (e.g. through loyalty and rewards programs).Footnote 15 Competition between payment systems can also reduce the overall price level for payment services, with new players offering systems that leverage technology and innovation to provide these services at lower prices than existing systems. In addition, the entry of FinTech can lead to lower prices on goods and services currently purchased through high‑cost payment systems by reducing how much it costs merchants to accept payments.
Canadians are increasingly using credit cards as a payment method rather than a source of financial credit. This can be attributed to the features many credit card issuers provide on their cards: insurance, zero‑liability, "delayed" payment, security, the ability to conduct transactions online or over the phone, rewards programs and more. The funding for these services and features comes from part of the fee levied on merchants for all purchases made using credit cards.Footnote 16 Credit cards that provide "premium" benefits often carry a higher fee. If they are given the opportunity to develop the necessary scale, new FinTech entrants offering alternative payment methods may put downward pressure on these fees or provide better value in other dimensions (e.g. rewards or budgeting). To achieve that scale, short of direct price regulation, merchants must have the ability to adequately incentivize consumers to adopt alternative, less costly, payment methods.
FinTech entrants in the retail payments space, however, face significant barriers to entry that may slow innovation and, in the extreme, prevent these benefits from being achieved. Some of these barriers are directly attributable to regulation—that is, the regulations themselves may create barriers to entry. In other cases, the barriers are not attributable to regulation but may indeed benefit from a regulated solution.
Barriers to entry not directly attributable to regulation
The Bureau conducted extensive stakeholder engagement over the course of this study to identify the barriers to entry and growth facing new firms entering the market as well as incumbent firms seeking to expand or compete with new entrants. These barriers include consumer behaviour and market maturity, the impact of network effects and the need for economies of scale and access to core banking services that are needed to underpin a FinTech product or service. Some of these barriers must be overcome by the firms wishing to enter on their own, while others may require regulatory intervention as the market has somehow failed.
A key to success for a new PSP is penetration and adoption rates by both consumers and businesses. While innovations such as mobile payments are relatively new, early estimates suggest adoption and usage rates have been lower than initially estimated. The Canadian Bankers Association reported that in 2016 approximately 8% of Canadians used mobile payments in the past to make a purchase, with more than 70% believing they will still be using cards and cash 10 years from now.
Industry participants told the Bureau that consumers have a high degree of trust in the existing payment card infrastructure and believe that they are well serviced by it.Footnote 17 As a result, consumers’ willingness to switch to a mobile wallet is currently limited. One industry participant suggested it will take years, rather than months, to change consumer behaviour. Some participants suggested that creating a digital copy of a user’s credit or debit card on their mobile phone was not enough of an incentive to drive adoption. Research on mobile payment adoption in Canada has cited similar barriers.
Additionally, countries where mobile payments have grown significantly are relatively more cash‑oriented than Canada and have "underbanked" populations driving adoption. Canadian consumers have generally enjoyed faster innovation in card‑based products from incumbent institutions, including chip‑and‑pin and tap‑and‑pay functions, compared to other jurisdictions.
Aside from mobile devices, FinTech entrants are finding new ways for consumers to make payments online and for merchants to improve their e‑commerce offerings by allowing more flexibility in payment options. PayPal is one such innovation that has arguably revolutionized e‑commerce for SMEs and consumers. There is broad consensus that e‑commerce can drive innovation and competition from new entrants. For example, several innovative payment services have emerged over the last number of years in Europe, facilitating growth in e‑commerce—often as a cheaper alternative to card-based payments.
Consumer adoption of these services, however, is only one side of this two‑sided market. Merchants in Canada have also been relatively slow to adopt new forms of payments or even e‑commerce functionality. One merchant association told the Bureau that the number of members accepting electronic payments through mobile and e‑commerce platforms is still relatively low: less than 20% of its members offered such platforms, with little growth in the last five years. Another merchant association indicated that, while there had been some uptake, there had also been a "fair bit of reluctance" from some merchants to enable online payments. Other studies offer similar statistics.
The data on retail e-commerce sales paints a surprising picture. As a percentage of sales by Canadian retailers, e-commerce accounted for only 3.5% of total sales at its peak in December 2016. As a result, demand for new forms of payments may not be sufficiently significant to attract new entry. As for why this may be the case, merchant associations noted that control of consumers’ payment data and related concerns such as security and liability were not adequately understood by or clear to merchants. Cost was also a key concern for merchant adoption of mobile and e‑commerce platforms. Merchant concerns over the potential for penetration pricingFootnote 18 have also caused some delay in adoption.
To overcome this barrier, FinTech entrants will need to prove the utility of their product or service to a wide range of users on both sides of a transaction.
Incentives for competitive switching
There are also barriers to consumers and merchants switching between payment services driven largely by the distinct economic characteristics of retail payments.
Most payment-related innovations in the market today are built on top of existing payment networks. For example, credit cards accounted for 96% of the value of all e‑commerce transactions in Canada in 2015, with Interac® online debit (3%) and e‑wallets (1%) making up the remainder.
Canadians’ affinity for credit cards—as both a source of credit and a payment method—may be rooted in the features they provide: rewards, loyalty points, cashback offers, insurance, fraud protection, interest‑free payment periods and more. With approximately 77% of Canadians over the age of 15 having a credit card, Canada has one of the highest credit card penetration rates in the world, well ahead of the UK (62%), the US (60%), Australia (59%), Germany (46%) and the Netherlands (34%).
Merchants typically accept multiple payment methods while consumers tend to favour one particular payment method, in many cases credit cards. This preference by consumers can contribute to higher costs for merchants (and ultimately to higher prices on goods and services as merchants recover these costs). For example, some rewards programs effectively pay consumers for using their credit card. These rewards programs, however, are funded from part of the merchant’s card‑acceptance cost.Footnote 19 As a result, credit card payments are the most expensive form of retail payment for merchants to accept.
To drive competition, consumers need to be incentivized to change their payment habits. The Code of Conduct for the Credit and Debit Card Industry in Canada enforced by the FCAC, states that merchants are able to provide discounts for using different methods of payment. But with very few merchants doing so, consumers do not see the benefit of using different payment methods when they are earning rewards at no apparent cost. There is, of course, a cost—and it is borne by all consumers in the form of higher prices.
While consumers enjoy their rewards programs, the issuers of their credit cards also benefit. Interchange revenue (minus the cost of funding rewards programs) makes up approximately one quarter of credit card revenues for Canada’s major banks. Many issuers also compete horizontally to issue lower cost Interac® debit cards but lack the incentive to promote this payment instrument, preferring the significant interchange revenues earned from credit card usage.
Ultimately, when consumers favour a single payment method (as has been the case with credit cards), competition is less effective and two‑sided market price effects may be more pronounced.
International policymakers have taken different approaches to reducing interchange fees. Australia introduced new interchange standards in 2016 of 0.5% for credit cards and AUD$0.08 (approximately CAD$0.08) for debit cards, with merchants permitted to surcharge transactions up to their "cost of acceptance for that card system." The European Union introduced similar regulation to cap interchange fees at 0.3% for credit cards and 0.2% for debit cards, while also banning surcharging. Both policies are aimed at improving competition and efficiency in retail payments.
An additional impediment to adopting or switching to a new payment service is the lack of interoperability between platforms and devices. In a two‑sided market such as payments, a large base of users on both sides of the transaction is necessary. Too many options may leave consumers unclear on what payment options are accepted where—and merchants with too many payments services to manage efficiently. Interoperability will be essential to ensuring consumers are able to pay with the instrument of their choice and merchants are able to accept a wide variety of payment options with minimal hardware or administrative investment. To this end, some degree of collaboration between market participants may be necessary to create an environment where competition between PSPs can flourish.
Access to banking services for new entrants
Many new firms employ business models that leverage the existing payments infrastructure, inserting themselves between the deposit‑taking institution and the payment‑making customer. While new closed-loop systems (e.g. e‑wallets) do not leverage existing payment networks directly, they still rely on them to transfer value in and out of the system or to hold funds within the system. At times, FinTech entrants are competing with the financial institutions from which they require these services.
During this study, several FinTech entrants expressed difficulty in obtaining the basic banking services required to operate. In particular, some PSPs or money‑transfer firms (e.g. peer‑to‑peer transfers, closed‑loop foreign exchange networks) operate as money service businesses (MSBs), a category of business defined by FINTRAC. With few institutions willing to provide services to MSBs, these entrants have faced delays in getting banking services set up as well as the termination of their services with little or no explanation.
Large institutions routinely engage in "de-risking" their portfolio of accounts; some simply refuse to provide services to MSBs. In some cases, the Bureau heard that these institutions’ policies stem from their approach to meeting their obligations under the Proceeds of Crime (Money Laundering) and Terrorist Financing Act or PC(ML)TFA, Canada’s anti-money laundering (AML) and counter-terrorist activity financing (CTF) law. As such, many choose not to deal with MSBs or aim to reduce their risk of non compliance with their PC(ML)TFA obligations by terminating service to businesses that operate as MSBs, despite MSBs being subject to the PC(ML)TFA themselves.
While banking services are critically important for any new business, entrants in the retail payments sector are in a unique position: they are direct competitors to some financial institutions’ products and services but still rely on those institutions’ services to meet the needs of their end users. As such, incumbents are in a position where they can effectively block the entry of any new competition.
The refusal of banking services can add to the sunk and ongoing costs of entry for new firms, resulting in ineffective or delayed entry.
These issues are not unique to Canada. Regulators in the US, the UK and Hong Kong have taken note of the increasing difficulty MSBs and FinTech companies face when opening and maintaining a bank account. The UK’s Financial Conduct Authority (FCA) commissioned a study into the recent wave of de‑risking by UK banks with FinTech companies in the UK raising competition concerns similar to those heard during the Bureau’s study.
In each case, regulators have issued statements or regulatory measures signalling their support for FinTech start-ups seeking to obtain basic banking services. The FCA suggests that "banks should not use AML as an excuse for closing accounts when they are closing them for other reasons." Policymakers at the EU level have gone a step further, with the revised Payment Services Directive stating that registered third‑party payment services must have access to banks’ payment accounts services in an "objective, non‑discriminatory and proportionate manner." In light of this requirement, many PSPs already have legal status in the EU, under the first Payment Services Directive; the revisions have clarified the liabilities faced by both PSPs and their financial institutions.
Barriers to entry attributable to regulation
Regulation in the retail payments sector covers the core infrastructure (such as the ACSS) and the schemes using that infrastructure. Consumer protection regulation also covers the credit and debit payment card networks. Given the risks associated with failure or misuse of the payments system, appropriate regulation is imperative. Unfortunately, regulation of market forces can unintentionally create barriers to innovation and competition.
A new oversight framework for retail payments
In 2015, the Department of Finance Canada released a consultation paper proposing a new oversight framework for national retail payments systems:
The current oversight of payment systems in Canada is focused on the core national payment clearing and settlement systems and, to a lesser extent, on retail payment systems supported by regulated financial service providers such as debit and credit card networks. This leaves other non‑bank retail payment services providers without specific regulation or oversight, resulting in an inconsistent approach for addressing similar risks posed by the activities of different payment service providers.
The Department of Finance Canada outlined its proposed framework in 2017—guided by the four principles of necessity, proportionality, consistency and effectiveness—and invited comments on its components, specifically asking whether the framework would sufficiently promote innovation and competition.
The Bureau believes it will do so and applauds the Department of Finance Canada’s initiative to develop a new regulatory oversight framework for retail payments.
Until this new oversight framework is finalized, however, new "non-bank" firms attempting to enter the market continue to face a degree of regulatory uncertainty and the gaps between oversight for existing PSPs and new entrants remain. As the Department of Finance Canada notes, non‑traditional PSPs are not subject to any specific regulatory requirements to address operational, financial and market conduct risks. Rather, the current oversight framework focuses on incumbent and traditional PSPs (e.g. national retail payment systems, deposit-taking institutions, payment card networks).
Regulatory uncertainty adds to the sunk costs as well as the risks involved with entering a market, particularly for smaller firms with limited resources. New entrants expressed their desire for appropriate regulatory oversight. Having "clearly defined parameters for market players" is an important step toward enabling effective competition. Reducing the costs, time and risks associated with market entry will encourage competition and spur innovation.
At the same time, incumbent industry participants noted that new entrants were not subject to the same regulatory oversight despite performing materially similar services. Some suggested this allows new entrants to innovate outside the regulatory purview, putting incumbents at a competitive disadvantage.
Regulation can also play an important role in facilitating the entry of non‑banks and other new firms into the retail payments market by promoting public confidence in alternative payment products and services. New entrants believe end users would be more likely to switch services if they knew alternative providers were subject to the same regulations as incumbents. Because many issues pertaining to retail payments remain unaddressed by regulation, the industry relies on contractual agreements between end users and PSPs in areas such as consumer protection.Footnote 20 Regulation, in this case, may help entrants overcome trust barriers by instilling confidence in different payment schemes. Clear disclosures and adequate dispute‑resolution mechanisms will help customers make informed decisions about the costs and benefits of switching, allowing new entrants to increase competitive pressure in the marketplace.
Regulation should, however, be minimally intrusive to market forces. Over the course of the Bureau’s study, industry participants suggested how policymakers could achieve an appropriate balance between regulation and competition. Many of these are included in the Bureau’s overarching recommendations from this study, including:
- technology‑neutral or device‑agnostic regulations that allow for new technologies
- regulation based on principles or expected outcomes rather than strict rules on how to achieve the desired outcome
- regulation based on the function an entity carries out
- regulation that is proportional to the risks it aims to mitigate
While regulation can reduce some barriers to entry by instilling confidence and bridging the trust gap, it can also erect other barriers to entry for new firms and inadvertently inhibit competition and innovation.
Many industry participants—new entrants and incumbents alike—said regulation should be based on the function a firm carries out rather than entities defined in regulation. Function‑based regulation can ensure fair competition by mitigating confusion in the applicability of regulation to new entrants and ensuring all firms are subject to similar regulatory oversight. The Bureau applauds the Department of Finance Canada’s work outlining the regulatory functions in its consultation paper.
The framework should also be proportionate in nature. While many firms perform similar functions, they may not pose the same level of systemic risk. Therefore, requirements that apply equally to all firms (e.g. prudential requirements) can actually create a barrier to entry for new and innovative firms, which have lower payment volumes, smaller customer bases and fewer capital resources. The Bureau welcomes a tiered approach to regulatory measures and views industry participants as well positioned to inform the setting of specific requirement tiers.
Access to core payments infrastructure
There has been relatively little entry by open‑ or closed‑loop system operators offering new POS, peer‑to‑peer or business payment options, especially compared to the number of players entering the downstream market and leveraging existing payment systems. Yet Payments Canada’s recent stakeholder consultations found Canadians are increasingly frustrated with their available options.Footnote 21 The lack of new payment choices is partly due to the significant "first-mover" advantages held by the existing systems (e.g. credit card networks, Interac® debit, Interac® e‑Transfer), which can leverage network effects and economies of scale to maintain market share. These advantages are amplified by the fact that new PSPs cannot access the core clearing and settlement systems underpinning these networks.
Gaining access to the ACSS, for example, requires membership in Payments Canada. The Canadian Payments Act outlines institutional restrictions on required and eligible membership.Footnote 22 Payments Canada members then face additional restrictions to access the exchange, clearing and settlement functionality of the ACSS as a "direct clearer."Footnote 23
Restrictions on participation and operational risk requirements exist to ensure that participants do not pose risk to other participants, the system or the Bank of Canada.Footnote 24 The restrictions for direct clearers in the ACSS, for example, exist because of its design as a deferred net settlement (DNS) arrangement for clearing and settlement. This DNS arrangement exposes direct clearers in the ACSS to credit default risk with every batch entry. Given the critical importance of direct settlement and the size of the average daily obligations cleared in the ACSS, direct clearers must be able to assume a significant degree of credit risk. The current direct clearers are large deposit-taking institutions that are all subject to substantially similar regulation. As a result, there is a high degree of mutual trust among the small number of participating institutions to extend credit to each other. In a less homogenous pool of direct clearers, individual participants may use significantly different mechanisms for managing risk, resulting in a more complex and inefficient payment system.
Specifically, potential direct clearers in the ACSS must maintain a settlement account and loan facility with the Bank of Canada. They must also have payment volumes of at least 0.5% of the total volume of payments cleared through the ACSS in the past fiscal year.Footnote 25 This threshold has effectively limited the number of direct clearers to just 12 institutions.
In contrast, an "indirect clearer" in the ACSS is a Payments Canada member that does not maintain a settlement account or loan facility at the Bank of Canada. Indirect clearers instead establish a settlement account and loan facility with a direct clearer, which acts as its "clearing agent." The clearing agent is also appointed to exchange and clear payment items for the indirect clearer.Footnote 26
These restrictions (and the limited direct participation resulting from them) can, however, have a negative impact on competition. FinTech entrants, indirect clearers and direct clearers all compete in end user markets and as a result, can face a significant degree of agency risk by not connecting directly to the system. Those directly accessing the system can act strategically to attain a competitive advantage for themselves—for example, by raising its downstream competitors’ costs. A direct clearer can also use non‑price discrimination to restrict competition in the downstream market by affecting the level of service its indirect clearer can provide to end users. While this may be inadvertent, clearing agents have a stronger incentive to impose costs strategically when they compete directly in end user markets with indirect clearers.Footnote 27
In the past, indirect clearers selected end user markets in which to offer services in a way that minimized or avoided direct competition with clearing agents.Footnote 28 A large number of the new entrants in the payments space, however, provide services in direct competition with incumbent direct clearers and clearing agents. In response, an increasing number of financial institutions may be unwilling to provide access to the ACSS to their competitors.Footnote 29 This directly affects the ability of FinTech entrants to compete with incumbents for end users. In the event FinTech entrants have been able to secure services from a financial institution, they face an increased level of agency risk that then influences their downstream service level and competitiveness.
As they are currently ineligible for membership in Payments Canada, FinTech entrants said they cannot access the ACSS directly in any capacity (whether for exchange, clearing or settlement). In many cases, direct access to only the exchange function would be sufficient to alleviate this major barrier to entry. This kind of access would allow PSPs to deliver payment items directly to the system that would be cleared and settled between two financial institutions or, in the case of a closed‑loop system, transferred into the system. As a result, FinTech entrants would have greater room to innovate by reducing the agency risk faced by "non‑bank" PSPs, ultimately improving competition by providing more choice in payments services for consumers and businesses.
As the exchange, clearing and settlement are distinct functions defined in the ACSS by‑laws, the access criteria for these three functions do not necessarily need to be the same. Indeed, many payment systems around the world allow for non‑financial institutions to exchange payments directly. For example, the criteria for accessing the exchange function could be more lenient than access to clearing or settlement.
Payments Canada suggests they may explore allowing non-financial institutions to access exchange systems with sponsorship by an entity with a settlement account.Footnote 30 Allowing direct access to exchange systems for a broad range of entities such as FinTech companies, current indirect clearers and non-financial institutions, can increase competition in retail payments. A similar model in the UK resulted in a significant increase in the number of new entrants pursuing this method of direct access. The Bureau applauds Payments Canada’s work to pursue this objective.
Firms choosing to pursue sponsored access will still need to obtain settlement services from a direct clearer; and some participants may still choose to access the system indirectly owing to the potential back‑office cost savings.Footnote 31 While many of the ACSS direct clearers act as clearing agents, only two actively pursue the business of providing services to indirect clearers or those excluded from Payments Canada. Limited choice in clearing agents reduces the ability of indirect clearers to switch easily between clearing agents resulting in little competition between clearing agents. Some industry participants suggested that by easing the barriers to entry for direct clearers, competition between clearing agents would improve, either as the result of the entry of one or more firms focused on providing wholesale services or simply due to the legitimate threat of entry of a new player.Footnote 32
Payments Canada has also indicated they are exploring ways to make access more open by replacing the current volume requirement to become a direct clearer with an alternative risk-based measure. The Bureau applauds this decision and supports Payments Canada’s initiative. It is important to ensure the various forms of risk with the payment system are adequately mitigated and controlled. Canada may learn from the experience in other jurisdictions, where regulators have explored how to implement controls that achieve a better balance between competition and the safety and soundness of the system.
The Bank of Canada and the Department of Finance Canada, in a 1997 discussion paper presented to Payments Canada (then the Canadian Payments Association), highlighted similar competition issues caused by access restrictions and a potential lack of competition between clearing agents. As a result, Payments Canada membership criteria was amended in 2001 through the Canadian Payments Act to make three new classes of financial institutions eligible, including life insurance companies, securities dealers and money market mutual funds.Footnote 33 This change, however, resulted in little change to the membership of Payments Canada that remains today. The Bureau recognizes the inherent complexities in amending membership criteria but a different approach, such as institution-independent membership criteria, may encourage growth in membership in the future.
The 1997 paper highlighted that "many participants in the financial industry argue that the new competitive opportunities, and accompanying benefits for consumers, could be realized most fully only if they are able to have more direct involvement in the payments system."
The Bureau argues that Canada is now in a similar situation with the emergence of FinTech. Broader access to the ACSS, altering the Payments Canada membership criteria and creating a regulatory framework based on the functions carried out by a PSP can help mitigate the competitive impacts noted above, and increase the level of competition and innovation in payment services to the benefit of consumers and business.
Payments Canada modernization
Recognizing that many end user demands on its national payment systems have not been met, Payments Canada has announced plans to build a new real‑time retail payments system. This "real‑time rail" will be beneficial as many firms struggle with the high barriers to entry associated with establishing a competing retail payment system to meet demand. Like the existing payments system, it will be important to open access to a wide range of participants who wish to initiate or deliver payments into the system to drive intra‑network competition—not just in payment acquisition, but also from new players who wish to provide payment initiation, such as mobile and e‑wallets, bill payment providers and POS providers. The Bureau is encouraged that "more open, risk‑based access" is an expected outcome of Payments Canada’s modernization project.
Interoperability between platforms, if built into the real‑time rail, can also spur competition and innovation from competing payment systems or infrastructures, driving inter‑network competition. Once a network is in place, it is increasingly difficult for a firm to establish a competing network, as it would need to connect to enough financial institutions and end users on both sides of the market to establish a critical mass to support effective entry.
Interoperability can reduce the barriers to entry for new schemes, networks and infrastructure providers by helping them overcome challenges associated with network effects and economies of scale. It can also reduce barriers to switching between infrastructure providers or systems for financial institutions and PSPs providing services to end-users. The Single Euro Payment Area, for example, has created a marketplace where multiple infrastructure providers compete to process payments for PSPs throughout the Eurozone. This level of competition is achieved through interoperability, with all infrastructure providers having adopted a common messaging standard.
Payments Canada will adopt the ISO20022 payment messaging standard, which is already in use in many other jurisdictions around the world, as part of its modernization project. The adoption of ISO20022 will effectively lower the barrier to entry for infrastructure providers and payment schemes in jurisdictions utilizing that same standard, making it easier for them to enter the Canadian market and provide services to end users, financial institutions and PSPs.
A system with high interoperability, however, will require significant collaboration and coordination. Collaboration, in this context, can pose competition concerns. Competitors that collaborate upstream in designing the system may wish to reduce competition downstream for retail payment instruments and services by designing rules or technical specifications that prevent the entry of new or innovative firms.Footnote 34 Such rules may raise the cost of entry, for example, or assign a proportionately larger compliance cost to smaller firms. Given the collaboration necessary in any core system development, it is important that competition and innovation are encouraged in the downstream market and that system participants do not abuse their position in a way that would block the entry of a new player or harm their ability to provide a service.
A strong governance framework for the development of the real‑time rail will prevent incumbent members and early entrants from strategically developing rules that exclude future entry. In particular, governance should be independent of membership but take into consideration a wide range of stakeholders, including incumbent and new entrant PSPs, merchants and consumers.
Internationally, many jurisdictions have also separated the scheme level (e.g. financial institutions, PSPs) from the clearing and settlement infrastructure to drive competition between different infrastructure providers offering services to banks and card schemes. Part of this process in other countries’ payments modernization projects has also involved competitive tendering for the building of the initial infrastructure.
While restrictions on participation and operational risk controls are necessary in any core payment system, they may present a barrier to entry for new firms and increased competition. The design of the system, however, can have an impact on the necessary risk controls because different designs entail different risks. There is a trade‑off between credit and liquidity risk, for example. On the one hand, while a DNS system like the ACSS poses credit risk, the liquidity requirements on participants are lower. On the other hand, a real-time settlement arrangement reduces credit risk but is costlier in regards to liquidity. Risk controls such as collateralization in a real‑time settlement model can result in systems with higher levels of access, supporting competition and innovation. As Payments Canada continues its modernization journey, the Bureau agrees with the Bank of Canada that a real‑time settlement model may prove the best path to pursue. A real‑time settlement arrangement can and should support better access to the system, including clearing and settlement, provided an entity meets the relevant risk‑mitigation requirements.
Improving access to national payment systems is a key goal for policymakers internationally. Authorities in Australia and the UK have stressed the importance of competition in clearing and settlement services to ensuring an innovative payments ecosystem. In the UK, the Bank of England is extending access to its high‑value core payments system to a range of non‑bank PSPs to allow them to better compete with banks (access will not be open to all PSPs, however). Non‑bank PSPs have regulatory status under UK and EU law as either e‑money or payment institutions.
Policymakers abroad are trying to ensure regulation is designed in a way that promotes new entry. Core payments infrastructure is also becoming accessible to new entrants who may not be deposit‑taking institutions.
If the Canadian payments system is to remain competitive, policymakers in this country must keep pace with their international counterparts. Many FinTech firms with whom the Bureau spoke believe the regulatory environment in other jurisdictions, such as the EU, the UK and Australia, is more welcoming and conducive to innovation. While it remains to be seen what will come of the policy choices being made in these jurisdictions, Canadian policymakers may be well served to consider the direction of some of our peers.
Submissions were made by industry participants to Australia’s Financial System Inquiry noting that retail payment regulation was fragmented, complex, lacked clarity and was not always applied on a functional basis. The Financial System Inquiry suggests that clearly graduated, functional regulation would facilitate innovation and competition in the payments system. Functional frameworks provide competitive neutrality, while graduation can reduce barriers to innovation and ensure regulation is risk‑based.
A national real-time payments infrastructure is also being developed in Australia. The New Payments Platform (NPP) will open access to the system to a wide range of participants. "Connected institutions" will be able to connect to the NPP to send payment initiation messages (but not clear or settle) and are not required to be a deposit-taking or financial institution. "Overlay service providers" can also develop payment services, adding features or functionality to a standard payment message without having to be a financial institution. While overlay services are designed to introduce competition and innovation, they are subject to review and approval by the NPP’s Board of Directors. Industry participants in Australia expressed concern that the Board of Directors was composed primarily of incumbents who may benefit from restricting new entrants’ access to the NPP.
The Australian Competition and Consumer Commission (ACCC) responded to these complaints in a recent decision, suggesting the NPP’s governance was significantly transparent and contained adequate checks and balances to mitigate incentives for incumbents to act anti‑competitively. The operators of the NPP also told the ACCC that they expect a competitive market for wholesale services to develop, with many direct participants’ business models expected to focus on providing connection services to new entrants. Considering the potential anti‑competitive detriment to be limited, the ACCC authorized the regulations governing the operation of the NPP in April 2017.
Perhaps the most significant regulatory developments are occurring in the EU. The revised Payment Services Directive (PSD2) aims to reduce the barriers to entry faced by new entrants providing payment services.
PSD2 introduces a new licence for innovative PSPs that have emerged in several EU member states but were not recognized under the original Payment Services Directive, which went into force in 2007. This gap in regulation created legal uncertainty and regulatory challenges, the removal of which is expected to encourage entry and stimulate competition in electronic payments.
Restrictions on access to crucial parts of the existing payments infrastructure applied by incumbent PSPs based on their market position present another major barrier to entry for new firms.
In many cases, banks in the EU have blocked third parties from accessing consumer payment accounts. The German Banking Industry Committee, for example, drafted terms and conditions for online banking that prevented customers from using their banking credentials in non‑bank payment systems. In May 2016, the Bundeskartellamt (Germany’s competition authority) declared this rule to be in violation of German and EU competition law, stating it "significantly impeded and continues to hinder the use of non‑bank and innovative payment solutions… which provides [sic] a lower‑priced alternative to the payment solutions already established in the market."
Providing objective, proportionate and non‑discriminatory access to payments infrastructure will level the playing field for all PSPs. PSD2 sets out a clear legal framework for the conditions under which third party PSPs can access consumer payment accounts, without being required to use a specific business model by the account‑holding financial institution. It will also establish the obligations and liabilities of both parties. Provisions for the non‑discriminatory treatment of a PSP using the technical infrastructure of any payment system are also included.
In the UK, the Payment Systems Regulator (PSR) views access to payment systems as a key enabler of competition and innovation in payments, noting that PSPs should be able to access systems on a fair, open and transparent basis, and do so in the way that they choose. The PSR has undertaken extensive work to ensure effective competition in the payments market by lowering barriers to entry and increasing the options available for payment systems access.
In the UK, a near real-time retail payments infrastructure exists in the Faster Payments Service (FPS). More than 1,000 non-bank PSPs rely on the functionality of the FPS, with many of them accessing the system indirectly. The PSR published a market review into the supply of indirect access to payment systems in July 2016, highlighting specific concerns with the quality and limited choice of indirect access to payment systems as well as barriers to switching between indirect access providers. The Bank of England also expressed concerns that the reliance on access provided by banks, which are often the direct competitors of new PSPs, limit these firms’ growth, potential to innovate and competitive impact.
The PSR, however, was encouraged by significant improvement in the choices available to non-bank PSPs, as noted in its 2017 access and governance report on payment systems. Eleven new direct participants are expected to join the FPS in 2017, with at least four intending to become indirect access providers representing a significant increase in choice for non-bank PSPs. The FPS has also introduced licensed aggregators, who are typically FinTech vendors that provide a direct connection to the payments infrastructure for many smaller non-bank PSPs, enabling access for firms with insufficient payment volume for direct access. The PSR, the FCA and the Bank of England are also working together to extend direct access to central bank settlement accounts to non-banks, which will provide an alternative to relying on a sponsor bank for settlement.
Conclusions and recommendations
The keys to encouraging competition and continued innovation in the payments services sector are access, awareness and ability to induce switching. Specifically, broader access to core infrastructure such as the ACSS and the forthcoming real‑time rail must be provided, along with access to banking services for PSPs; greater awareness of product and service options must be fostered among consumers and merchants; and merchants need the ability to apply discounts or surcharges to encourage consumers to choose less costly methods for paying.
The Bureau has prepared several recommendations that policymakers, regulators and Payments Canada should consider to continue to ensure the payments system stays safe, secure and efficient. However, the responsibility to achieve these goals must be shared among policymakers, regulators, Payments Canada, industry participants, consumers and merchants.
Regulators should allow PSPs and financial institutions to participate in pro‑competitive collaborations while recognizing the potential risks of such collaboration. Agreements or arrangements that have the potential to prevent or lessen competition should be approved only in exceptional circumstances and where necessary to meet policy objectives.
Merchants should continue to be permitted to use discounts or other incentives to entice consumers to adopt alternative or lower‑cost payment methods. Regulators should also examine the benefits of introducing measures aimed at interchange fees, such as surcharging or regulation, similar to other jurisdictions.
A clear delineation of the regulatory and legal responsibilities between a PSP and the financial institution supplying its accounts is necessary. To allow new entrants to introduce services without creating incentives for financial institutions to thwart these efforts, it is important that PSPs and financial institutions understand their responsibilities and liabilities, and that those responsibilities and liabilities are appropriately allocated. Adhering to regulatory requirements, such as AML/CTF and the new retail payments oversight framework, should afford FinTech entrants the opportunity to maintain bank accounts and access established payments infrastructure.
When terminating or refusing to provide account services to a business, such as an MSB, financial institutions should be required to provide their reasoning along with supporting evidence. Applicants who are refused or clients who have their accounts terminated should have a suitable course of redress if they have been unduly terminated or refused, such as the Ombudsman for Banking Services and Investments.
Policymakers should consider replacing the current volume requirement for direct clearers in the ACSS in favour of a more objective, risk‑based measure. They should also continue to explore alternative measures that promote competition. Such a change would result in an increase in the number of financial institutions participating as direct clearers and clearing agents, and likely improve competition for clearing and settlement services for smaller clearers and participants.
Payments Canada should consider allowing non-financial institutions to access the exchange function of payment systems such as the ACSS and in the future, the real-time rail. Some industry participants suggested the ability to access exchange systems to deliver and process their own payments would be sufficient to increase competition. This recommendation is broadly in line with developments in Canada’s peer jurisdictions and will support the global competitiveness of Canada’s payments system.
Payments Canada should explore the possibility of providing an application programming interface (API) or a direct technical interface or access point for eligible participants, particularly for the real-time rail. A direct technical access point can lower the cost of entry for new PSPs while encouraging competition between payment systems by reducing switching costs for financial institutions and PSPs.
Regulators should assess the possibility of moving toward a real‑time settlement model for its core clearing and settlement system in an effort to provide broader direct access to the payment systems operated by Payments Canada for PSPs and financial institutions.
Lending and equity crowdfunding
Small and medium‑sized enterprises are key drivers of economic growth—and their success is crucial to Canada's long‑term prosperity.
The availability and provision of financial credit is a key driver of economic activity in Canada. SMEs use financial credit to bridge cash flow gaps (e.g. between the purchase of inventory and its sale) and make investments (e.g. in equipment or real estate). Consumers use financial credit to help bridge gaps in cash flow and obtain things like an education, home or vehicle.
Canadian consumers have generally been well served by financial institutions in terms of credit availability, enjoying easy access to mortgages, home equity lines of credit, personal lines of credit and loans, car loans, student loans, credit cards and payday loans. As such, this study focuses on the SME financing sector.
Since the 2008 financial crisis, increasing risk aversion has led to a tightening of credit markets, especially for SMEs. In response, FinTech lenders have entered the market to provide new forms of SME financing with two main business models emerging:
- peer‑to‑peer (P2P) lending (also called debt‑crowdfunding, loan-based crowdfunding or marketplace lending), which brings together lenders (institutional and retail) and borrowers (consumer and SME) in an online platform to fund loans
- equity crowdfunding, which allows SMEs to raise capital from a large pool of investors through an online platform
These new forms of SME financing have the potential to help relieve some of the frictions faced by SMEs in obtaining financing, while at the same time allowing lenders and investors to access new products that have typically been out of reach in traditional markets.
While these new products have the potential to stimulate economic activity, providers of these services have faced significant barriers that may be inhibiting their entry and growth.
SME financing ecosystem
Like retail payments, the SME lending marketplace is a two‑sided market. In its simplest form, a loan requires one or more lenders and one or more borrowers. Inefficiency arises when lenders cannot find borrowers and vice versa. Just because someone needs a loan does not mean they will find someone to lend funds to them. Similarly, just because someone has the funds to lend does not mean they will find a creditworthy individual to borrow from them.
Generally speaking, SMEs rely on several sources of financing, which can be broadly divided into formal and informal sources. Informal financing sources include owners' savings, personal loans taken out by owners and loans from friends and family. Formal financing comes from debt financing (including business loans and lines of credit),Footnote 35 lease financing (including business term loans),Footnote 36 equity financing,Footnote 37 and trade credit and government grants.
In 2014, 72% of SMEs that received debt financing obtained it from chartered banks, while 25% received debt financing from credit unions. While these deposit‑taking institutions make up the majority of SME lending, they are not the only source of capital for SMEs. Alternative lenders who do not rely on deposits also provide credit to SMEs, as do an entrepreneur’s friends and family from whom they may borrow.
SMEs can also raise capital by selling equity in their business to investors. However, without a network of investors to whom they can pitch their business, raising equity outside of friends and family is currently out of reach for many SMEs. For this reason, FinTech firms have emerged to provide SMEs with new tools for reaching ready investors on a large scale.
Approval rates of SME lending in Canada
Market participants told us that traditional lending channels (mainly retail banks) often do not fill the financing needs of many Canadian SMEs. Smaller and newer businesses have more difficulty accessing financing than larger or more established SMEs because they often lack the credit history and collateral needed to secure a loan from formal sources. According to a survey by the Department of Industry Canada (now Innovation Science and Economic Development), 12.8% of SMEs who requested debt financing in 2014 were rejected. The loan rejection rate for businesses with five or fewer employees was 22.3% in 2015, according to the Canadian Federation of Independent Businesses. For SMEs with between five and 49 employees, the loan rejection rate was 12.6%.
Many small businesses are rejected by traditional financial institutions because they do not meet the tight lending requirements. The top reasons given by credit providers who declined debt‑financing requests were insufficient sales or cash flow (35.1%), insufficient collateral (30.3%) or the project was considered too risky (26.9%). In some cases (8.9%), no reason was provided by the credit provider.
Banks require and analyze the same information (e.g. business plans, forecasts and projections, financial statements, creditworthiness), whether they are considering a $100,000 loan or a $1 million loan. The process is manual and costly, making small loans (under $250,000) less attractive for banks.Footnote 38
As a result, 49% of SMEs in Canada rely on informal financing sources such as personal financing, personal loans from family and friends, retained earnings and personal savings.Footnote 39 Of greater concern is the 30% of SME owners who have turned to credit cards as a means of financing as well as those who have turned to alternative or private lenders who can charge interest rates in excess of 20%.
Competition in lending and equity crowdfunding
Lenders earn profit on the differential between the interest rate they are repaid by a borrower and the interest rate paid to the source of funds (or their cost of capital). Banks and other deposit-taking institutions have a competitive advantage in the lending market because their cost of capital has been quite low in recent years.
Banks and other deposit-taking institutions use the money that consumers and SMEs hold in their savings and chequing accounts to fund loans to borrowers. The bank plays "matchmaker" between a large number of deposit holders and borrowers, filling a role that any one deposit holder is unlikely to be able to achieve on their own. As interest rates paid on deposits drop, banks are able to offer more attractive loan interest rates to potential borrowers. Although some depositors may seek to earn higher returns and pursue investments other than deposits, many Canadians still require a funded chequing or savings account to pay their bills, receive their wages and access cash when needed. As a result, banks are able to secure funds to issue loans at relatively low cost. At the same time, deposits at FRFIs are insured (up to $100,000), as are most other regulated deposit‑taking institutions (through equivalent provincial insurance plans). The risk of losses due to non‑payment by a borrower is very low for depositors, making a bank an attractive place for Canadians to hold their money.
Banks and other deposit‑taking institutions typically face the same cost of capital and therefore have very similar loan interest rates to one another. They instead compete on other, non-price dimensions, such as product bundling (e.g. combining payment services and account services for a discount) or different repayment terms.
Lenders not relying on deposits depend on other sources of capital to fund their loans. Typically, they cannot offer the same liquidity as a bank, nor can they offer the same security by way of deposit insurance. Generally speaking, alternative lenders will issue debt notes to investors who provide the capital to fund the loans. The risk of losses due to borrower default is borne almost entirely by the investors. Alternative lenders must attract capital away from the relative safety and security of a bank with higher rates of return. As such, they often have higher loan interest rates.Footnote 40
For SMEs looking for financing, banks and other deposit-taking institutions are often the first choice as the interest rates at a bank are likely to be more favourable than an alternative lender (due to the banks’ lower cost of capital). This same low cost of capital, however, has pushed some depositors to seek other places to earn return on their money.
For equity investments, the options for SMEs are few and far between. Typically, SMEs will rely on a network of contacts to generate equity investment; however, it is often not worth the effort to seek and secure investments without such a network. Most SMEs therefore rely on debt financing, at least at the outset. FinTech solutions in crowdfunding may help ease the process of obtaining equity investment.
FinTech enters lending and crowdfunding
New online alternative platforms have emerged in recent years, leveraging technology and online networks to match SMEs looking for capital with others who have money and are looking for alternative investments. Others have entered the marketplace using more traditional models but with improved application and approval processes that make it easier for SMEs to apply for and obtain credit.
P2P lending platforms operate in much the same way as traditional lenders in that they play "matchmaker" between borrower and lender. The difference is that they leverage technology to allow borrowers to appeal directly to lenders or investors. By using technology to evaluate borrowers’ credit risk, many P2P platforms can quickly evaluate risk and assign a rating to a potential loan. When a loan is posted to the platform, individual investors can pledge funds to the loan, making their decision based on information provided by the borrower about why they are seeking the loan as well as the risk rating or interest rate set by the platform. The P2P lending platform typically earns an origination fee on the loan rather than an interest rate differential (although some platforms will also take an interest rate differential). Some online lenders use their own capital to fund loans—capital that is often provided by large institutional investors or financial institutions rather than by retail investors.
P2P lenders are appealing to borrowers who have been denied by traditional lending institutions or who do not have the resources to submit to a bank’s rigorous approval process. They are also a good match for lenders looking to participate directly in the credit market rather than through a bank or investment fund. However, the borrowers who may be attracted to P2P lending platforms may be riskier borrowers, reducing lender confidence in these platforms.
Despite presenting interesting opportunities for investors and borrowers, the market for P2P lending is still quite small in Canada, making up less than $25 million (2016) of the more than $53 billion in SME credit issued (2014). While growth is expected, the trust that depositors have in Canadian deposit-taking institutions, low cost of capital those institutions enjoy and perceived risks associated with P2P lending, it is unlikely that P2P lending in Canada will grow to be a significant threat to traditional lenders in the near term. This is not the case elsewhere, however. In the UK, P2P lending accounted for more than £3 billion (approximately CAD$5 billion) in credit issued in 2015. Globally, the emergence of technology-led online lending platforms was spurred by the 2008 financial crisis. During that time, some banks in the UK and elsewhere failed and the credit market tightened leading many borrowers to seek alternative credit sources and investment vehicles. Because the financial crisis did not impact Canada on the same scale, demand for alternative credit has been lower.
Similar to P2P lending platforms, equity crowdfunding platforms operate by playing matchmaker between potential investors and SMEs looking to raise capital. The difference is that SMEs are issuing equity in their company to investors through the equity crowdfunding platform (i.e. they are giving up a stake in their business in return for capital). Investors in equity crowdfunding are purchasing shares in a company, which brings different risks than a loan. In particular, because the equity acquired may not be liquid or transferrable (depending on the type of equity), an equity crowdfunding investor may be holding that equity for a very long time.
By presenting a new business model for retail investors, equity crowdfunding opens a marketplace that was typically restricted to those with greater knowledge of new offerings or an entrepreneur’s contact network. It also opens new opportunities for SMEs, which no longer need to have their own network of contacts to find investors.
Other FinTech firms in the lending space have entered the market using a more collaborative approach with existing financial institutions. These entrants are leveraging technology, computer algorithms and big data to improve efficiency in credit adjudication—simplifying and speeding up the application and approval process for lenders. These improvements have caught the eye of traditional lenders, who are beginning to enter into partnerships with FinTech firms to better serve their customers. Throughout this study, the Bureau heard that while incumbent financial institutions have the customers, FinTech entrants bring the technology; by working together, they can better serve SMEs seeking financing.
Although P2P lending and equity crowdfunding platforms have the potential to provide financing to SMEs at a lower resource cost and to open new and interesting investment opportunities barriers to achieving this potential remain.
Barriers to entry not directly attributable to regulation
Compared to some of its peers, Canada fared well during the global financial crisis. The large financial institutions in this country did not fail, largely due to Canada’s strong regulatory regime and the sound business practices of those institutions. Because our financial institutions did not fail, demand for P2P lending and equity crowdfunding is significantly lower in Canada than in jurisdictions where the financial crisis had a greater impact or where regulatory regimes were insufficient to prevent widespread bank failure. In those jurisdictions, regulators responded by strengthening restraints on financial institutions, effectively causing a contraction in available SME credit. As a result, demand for P2P lending and equity crowdfunding increased significantly faster than in Canada.
Canadians justifiably have confidence in the strength and resilience of our regulated banking system, and may therefore lack the desire or will to venture outside that system.
Additionally, banks and other deposit-taking institutions have a significant competitive advantage with respect to the source of capital, relying on deposits (or their own internal capital) to fund lending activities rather than investments from risk-averse investors. To attract lenders, P2P lending platforms must offer a more competitive, risk-adjusted return than other investment avenues. For example, if a P2P platform offers a lower return than a savings bond, guaranteed investment certificate or very safe mutual fund, it is unlikely that an investor would choose to fund a P2P loan. At the same time, P2P lending platforms must compete against other lenders for borrowers, meaning they need to keep rates as low as possible to attract borrowers. This is not in itself a barrier to entry or growth; it is simply the reality facing the P2P lending model.
Consumer confidence in these FinTech platforms, however, does present a barrier that is not caused by regulation but may potentially be overcome through regulation. One of the issues raised throughout this study was that FinTech lenders suffer from a lack of clear regulation to govern their business. For example, it is not clear what happens to investors and borrowers in the event the P2P lending platform fails, with investors lacking guidance on how to collect on debts without the platform intermediating. Another issue that can lead to a lack of confidence is the principal-agent problem inherent in a platform that shifts risk to individual investors—that is, the platform may underprice risk or approve or facilitate loans to overly risky borrowers, collecting the origination fee while shifting the default risk entirely onto investors.Footnote 41 Finally, equity crowdfunding and P2P lending platforms are attractive not only for legitimate borrowers but also potentially fraudulent ones. The relative anonymity offered, combined with the self-reporting nature of much of the information required about a borrower, can increase the risk of making investments based on false information.Footnote 42 Investors may see these risks as too great to leave the relative safety of their existing portfolio.
Barriers to entry attributable to regulation
The FinTech marketplace lending space currently suffers from both too much and not enough regulation. At the time of writing, Canada does not have any laws, federal or provincial, that specifically govern both sides of P2P lending platforms (i.e. the lender and the borrower). Instead, the activity of lending is subject to a number of separate federal and provincial statutes depending on the type of activity conducted or, in some cases, the entity that conducts it. By and large, most applicable regulation on the provincial side is enshrined in securities law and designed to protect investors in marketplace lending platforms. Although regulators have recently made efforts to apply more flexible approaches to regulatory compliance—in areas such as electronic client on-boarding—emerging business models in the FinTech lending space are for the most part subject to the same regulation that applies to their bricks‑and‑mortar counterparts.
One key element of the Canadian landscape that has challenged FinTech lenders is the confederated nature of Canadian laws, concurrent laws in different jurisdictions creating subtle variations from one province to the next. There is a high degree of complexity when navigating the various federal and provincial laws that could possibly apply to a FinTech lender’s specific model depending on the provinces in which it operates, the nature of the entity providing the services, the business activities in which it engages and the investors and borrowers to whom it provides services.
Technology‑neutral and device‑agnostic cost‑of‑credit disclosure
Several jurisdictions have regulations that set out a lender’s obligation to disclose the cost of a credit facility clearly and plainly to borrowers. At the federal level, the FCAC enforces these regulations, which apply only to FRFIs. These regulations are sometimes written in a way that contemplates credit agreements delivered on paper rather than electronically or through a computer application.
For example, many federally‑regulated banks are required to ensure certain disclosure information is presented in an "information box" that must be surrounded by "sufficient margins above, below and to either side of the text such that sufficient white space is provided around the text." While such a requirement is reasonable, it may be difficult to ensure sufficient white space is available on the screen of a mobile phone or tablet computer in the same way as a legal‑sized sheet of paper. While the regulation as written may be technology‑neutral, compliance across different delivery media may be prohibitively difficult.
Money services businesses
As with payment service providers, if a P2P lender operates a platform in which funds are transferred through an electronic funds transfer network, it may be characterized as an MSB. While P2P lending involves a loan being funded by an individual investor (or group of investors), the mechanism by which funds are transferred varies in practice. As a result, the determination of whether a P2P lender or equity crowdfunding platform is an MSB—and therefore subject to an MSB’s client identification and reporting requirements—will depend on the specific business model involved, leaving some P2P lending and equity crowdfunding platforms in a position of regulatory or legal uncertainty.
FINTRAC has provided guidance on the interpretation of MSBs as they relate to crowdfunding,Footnote 43 but this uncertainty may increase, at minimum, the perception of the risk to a platform, causing entrepreneurs to decide the risk is not worth their effort and deploy their capital elsewhere. As a result, Canadians could miss out on this innovative opportunity.
Securities regulation and the prospectus requirement
Securities regulators in Canada have indicated that P2P lending and equity crowdfunding platforms are in the business of dealing in securities. For equity crowdfunding, several provinces have introduced a regulatory framework for dealing with retail investors, which allows entry by these platforms and sets out their responsibilities to investors. These guidelines provide clarity to both the platform and potential investors.
For P2P lending, unless otherwise exempt by securities regulators (as has happened in one instance), platforms are subject to stringent know‑your‑client (KYC) and know‑your‑product (KYP) rules. In dealing in securities, they are also required to conduct suitability assessments for every investor and every loan on the platform.
In addition, securities regulators have indicated that a P2P lending platform, unless relying on an exemption in the law or a condition of registration, may need to prepare and file a prospectusFootnote 44 for each loan on which they intend to sell securities to investors.
The potential need to file a prospectus for each loan could make market entry cost-prohibitive for an upstart firm as borrowers may avoid P2P lending in the face of the costs of preparing a prospectus. For example, if an SME was looking to take out a $50,000 loan, the resources required to prepare the prospectus could outpace the value of the loan itself.
As a result, FinTech lenders almost always seek exemptions from the prospectus disclosure and registration requirements. All P2P lending platforms operating in Canada at the time of writing rely upon existing exemptions (for instance, the accredited investor or offering memorandum exemption) or have specific exemptions as conditions of their registration.
Many of the exemptions vary from one province or territory to the next. This fragmentation can slow innovation and impede the ability of a firm to expand nationally in a reasonable timeframe. Since 2015, securities regulators have introduced three different regimes to fill regulatory gaps regarding equity crowdfunding. These crowdfunding exemptions establish a clear regulatory framework for those looking to establish crowdfunding platforms, helping alleviate regulatory uncertainty.
As these exemptions are generally targeted toward certain types of investors, relying solely upon narrow exemptions or discretionary exemptive relief may create additional hurdles for FinTech lenders who later wish to gain broader access to markets and attract different types of investors outside their existing exemption category.
Barriers to collaboration
Some FinTech firms in the lending industry have designed tools and services to improve efficiency and cut costs in the loan application and approval process. Many of these firms have partnered with existing financial institutions to provide loans to SMEs and consumers. These arrangements, however, are subject to regulations governing partnerships and outsourcing by FRFIs.
During this study, some FRFIs expressed concerns about compliance with federal third-party oversight rules. Some FRFIs are concerned they could be held responsible for the activities of their vendors and partners. This fear may prevent them from collaborating with FinTech firms on a more productive level.
One challenge with such partnerships is the significant difference in regulatory environments for established financial institutions and FinTech companies. Regulated financial institutions typically have processes, policies and standards that create challenges for FinTech companies, whether as partners or service providers.
An arrangement between a FinTech company and an FRFI may be characterized as a "material outsourcing arrangement" that requires compliance with OSFI’s Guideline B-10, Outsourcing of Business Activities, Functions and Processes. This guideline sets out OSFI’s expectations for an FRFI with respect to outsourcing arrangements that can hinder their ability to collaborate with FinTech firms to provide services to their clients. These rules are important to mitigate the potential for regulatory arbitrage and ensure that the risks from third‑party service providers do not spread through the entire system and that FRFIs are accountable for their outsourced operations. They may, however, have a deterrent effect on innovation. FRFI regulators should consider the impact of rules surrounding outsourcing and partnership agreements on competition, innovation and collaboration to ensure that the rules do not unnecessarily hinder FRFIs from tapping into FinTech ingenuity.
Although the barriers to entry for P2P lending and equity crowdfunding platforms may be significant, financial sector regulators are working toward solutions that embrace FinTech and what it has to offer. In particular, securities regulators have launched programs to help FinTech firms better understand the law and regulators’ expectations. These initiatives are a positive step forward in embracing competition and innovation.
A Canadian FinTech Sandbox
In 2017, the Canadian Securities Administrators (CSA) launched its Regulatory Sandbox initiative, which focuses on innovative technology-focused or digital business models whose activities trigger the application of securities laws. These models range from online platforms (such as crowdfunding portals, marketplace lenders and angel investor networks) to those using artificial intelligence for trades or recommendations, ventures based on cryptocurrency or distributed-ledger technology and technology service providers to the securities industry. The aim of this initiative is to facilitate the ability of these businesses to offer innovative products and services across Canada, while ensuring appropriate investor protection.
Through its sandbox, the CSA is considering applications, including for time-limited registrations and exemptive relief, on a co-ordinated and flexible basis to provide a harmonized approach across Canada for admissible start-ups or incumbents, while providing flexibility and rapidity in the treatment of registration and other applications. The sandbox also functions as an information- and expertise-sharing forum for regulators. The CSA sandbox is a fully dedicated team with expertise in regulatory matters. The team monitors developments closely and regulatory change is informed by its frontline experience with live models and applications.
Demand for P2P lending and equity crowdfunding in Canada is low compared to its peer jurisdictions, largely due to Canada’s relatively better performance during the financial crisis. In addition, fewer Canadians are unserved or underserved by existing financial institutions than in our peer jurisdictions. As a result, Canadian regulators are in the enviable position of being able to observe and learn from the outcomes of P2P lending regulation in other jurisdictions.
Perhaps the most developed market for P2P lending is the UK, where P2P lending has become an increasingly important channel of finance for SMEs. In 2015, revenues in the FinTech sector reached £6.6 billion (approximately CAD$11 billion) and investment in FinTech companies reached £524 million (approximately CAD$875.5 million).
One explanation behind the growth of P2P lending is significant government backing. In October 2014, the UK’s FCA launched the Innovation Hub as part of its Project Innovate program, with the objectives of adding greater flexibility to its regulatory framework and removing barriers to entry for innovative businesses. Among other initiatives, the UK government legislated in 2015 that eligible SMEs that had unsuccessfully applied to a designated bank for a loan, overdraft, invoice finance, asset finance (excluding operating leases) or credit cards, be referred to a designated "finance platform."
The UK also announced a specialized regulatory framework for "loan-based crowdfunding platforms" (which includes P2P lending platforms) and "investment-based crowdfunding platforms" (which includes equity crowdfunding platforms). It follows on the heels of the government amending the Financial Services and Markets Act Order 2013 to include "operating an electronic system in relation to lending." The specialized framework:
- establishes minimum capital standards for companies looking to enter the P2P lending market
- forces platforms to design a business model that protects clients’ money from the platform’s creditors
- establishes rules for firms to disclose "relevant and accurate information" to customers, having regard to relevant information considerations (although specific terms or disclosure practices are not mandated)
- forces platforms to create a resolution plan to maintain loan repayments in the event the platform fails
The FCA also introduced rules applying to all firms that are designed to be proportionate and technology‑neutral and to reduce the need for the FCA to apply individual restrictions to investment-based crowdfunding platforms’ operating licences. The new rules include restrictions on marketing, allowing platforms to communicate direct offers only to consumers who take regulated financial advice, are high net worth or "sophisticated" investors, or confirm they will invest no more than 10% of their net assets in non-readily realizable securities. The rules also require clients not seeking regulated advice to pass an "appropriateness test" in line with the provisions of the EU’s Markets in Financial Instruments Directive.
The FCA has also moved to grant full authorization for banking licences to certain P2P lenders, which essentially permits customers to hold loans and investments in P2P lending platforms within an "innovative finance individual savings account." This move recognizes the importance of P2P lending as an investment and offers consumers access to returns that will be tax-free.
P2P lending is largely fragmented at the EU level and the regulatory framework varies according to local member state rules. However, the Consumer Credit Directive (CCD) is one piece of legislation that provides limited harmonization in this area. The CCD sets out some basic transparency and consumer protection rules, including the right to withdraw from a credit agreement within 14 days and the right to repay the credit early at any time.
While there is no broad EU framework that covers P2P lending, certain countries have specific, local P2P lending regulatory regimes, including France, the Netherlands and Spain.
In 2016, the US Office of the Comptroller of the Currency (OCC) announced its plans to issue special-purpose national bank charters for FinTech companies. This will allow FinTech companies that collect deposits, issue cheques or make loans (among other traditional banking activities) to operate under a single national standard to enable them to act throughout the US in exchange for rigorous oversight by the OCC. In conjunction with this announcement, the OCC also released a publication, Exploring Special Purpose National Bank Charters for FinTech Companies. However, many state regulators are opposed to the OCC’s special-purpose FinTech charters and several have commenced litigation.
More recently, the US Congress passed the Financial Choice Act, which seeks to amend a number of the elements of the Dodd-Frank Act (enacted in response to the 2008 financial crisis). As proposed, the Financial Choice Act would: eliminate limits on how much a company can raise using crowdfunding; requirements for financial statements or other types of disclosure by the issuer; requirements for the issuer to file annual reports after completing a raise; and the risk of inadvertently becoming a reporting issuer, as purchasers of these securities are not counted toward the non-accredited shareholder limit. While it is unclear if the US Senate will approve the Financial Choice Act in its current form, Canadian securities regulators should, at the very least, consider whether some of the proposed reforms could be helpful in this country.
Under Australian law, providers of marketplace lending products generally need to hold both an Australian Financial Services (AFS) licence (as is the case with all businesses providing financial services in Australia) and a credit licence (as is the case with all businesses engaged in credit activities). Both of these licences are granted by the Australian Securities and Investments Commission (ASIC). Some providers may seek to rely on exemptions by either acting as a representative or relying on an intermediary authorization. ASIC has the power to give relief in circumstances where it can be demonstrated it would be unreasonably burdensome to comply with the applicable requirements.
In December 2016, ASIC launched its version of a regulatory sandbox. Under Regulatory Guide 257, Testing fintech products and services without holding an AFS or credit licence, ASIC opened an avenue for firms seeking to test products before obtaining an AFS licence. Among other measures, it introduced a "fintech licensing exemption" that allows eligible businesses (after notifying ASIC) to test certain products and services for 12 months without the need to apply for a licence. After the end of testing, businesses provide ASIC with a short report that includes information about clients and complaints as well as regulatory requirements identified as barriers to viability.
Changes in securities legislation have also been introduced in Australia to allow more companies to crowdsource equity funds though a new category of licensed intermediaries. The new framework allows unlisted public companies with less than AUD$25 million (approximately CAD$24.4 million) in assets and annual revenue to raise capital via equity crowdfunding platforms up to AUD$5 million per year (approximately CAD$4.9 million), while retail investors can invest up to AUD$10,000 (approximately CAD$9,758) per company per year. It also includes a cooling off period for investors of five business days.
Conclusions and recommendations
P2P lending platforms and equity crowdfunding platforms have significant barriers they will need to overcome to be successful. P2P lenders and equity crowdfunding platforms need a compelling business model to attract investors away from traditional investment options, trusted relationships with their institutions and to overcome the challenges associated with the low cost of capital FRFIs enjoy. They also need to address the lack of consumer trust or confidence in their platforms resulting from an uncertain regulatory framework and unclear consumer protection regime.
Regulators have an opportunity to build a framework that ensures this sector can continue to innovate and be successful in the future, while continuing the fundamental role they play in consumer and investor protection.
Securities regulators should continue to provide clarity and guidance regarding the regulatory framework for P2P lending, including the requirements and process to obtain exemptive relief from KYC, KYP, suitability and prospectus requirements, as appropriate.
Consumer protection regulators should ensure their guidance and regulations are technology‑neutral and device‑agnostic. Regulations should be written to achieve principles rather than to prescribe how those principles are met.
Securities regulators should continue to harmonize their approach to prospectus exemptions for innovative business models, including P2P lending and equity crowdfunding, to ensure differences in their laws do not unduly inhibit competition and innovation.
Regulators contemplating "sandboxes" should look to other jurisdictions, such as the UK and Australia, for best practices and lessons learned with respect to FinTech lenders.
FRFI regulators should consider the impact that rules related to outsourcing and partnership agreements may have on competition, innovation and collaboration to ensure these rules do not unnecessarily hinder an FRFI from tapping into FinTech ingenuity, while ensuring that appropriate risk-management frameworks are in place.
Investment dealing and advice
Affordable, automated investment advice can help Canadians grow their savings and encourage diverse participation in financial markets.
In 2015, Canadians’ holdings of investment fund securitiesFootnote 45 approached $1.5 trillion, nearly three times their holdings of equities and bonds combined. Given the critical importance of saving for the future, a massive industry of financial professionals exists to help Canadians achieve their savings goals by giving advice, planning and allowing Canadians to access financial markets.
Financial advice is a broad term that includes a number of services provided to consumers, businesses and other entities. It encompasses the sale of securities or other investment products, insurance advice, debt counselling, wealth and estate planning and other services across the entire financial scope of a client’s life.
This study looks specifically at the advice industry, which has been affected by technology, particularly the advent of online advisory services and online investment platforms for retail customers (i.e. individuals rather than businesses or large programs like pensions or group insurance).
Retail investors currently have many options when it comes to purchasing investments, with varying levels of research, advice and investor control and differences in how advisors are compensated.
Traditionally, advice was supplied in person and decisions were made by investment professionals. Shifting customer demand, combined with the advent of new technologies and the mobile Internet, has led to a new wave of tools for retail investors. In just the past few years, FinTech entrepreneurs have entered the market with products and services designed to take advantage of this shift, targeting customers who may not want or have time to meet and discuss financial plans with an advisor during the day.
A handful of these so-called "robo‑advisors"—more accurately "online advisers" (as opposed to bricks-and-mortar advice delivery)Footnote 46—have been successful; however, there remain impediments to their growth and their ability to put downward pressure on advice pricing. Some of these barriers, as with the payments and lending sectors, can be attributed directly to regulation, while others cannot.
Investment advice ecosystem
The industry today has many options for retail investors in terms of the products available, the way in which they buy and sell these products and the number of firms offering investment services. Despite the plethora of options, in 2015, 78% of investment products were issued by deposit-taking institutions (such as banks) and insurers.Footnote 47 Branch delivery (through a deposit-taking institution or insurer) was the most popular form of distribution accounting for approximately 32% of distribution, with other financial advisors and planners making up 31% of distribution. Surprisingly, only approximately 4% of funds were distributed through online or discount brokerages.
Product and service offering
Retail investors can access funds and advice in a variety of ways, from do-it-yourself (DIY) investing to full-service portfolio management. Each channel offers a different set of characteristics. The products available to investors also differ, ranging from directly holding equity to mutual funds to lower cost exchange‑traded funds.
This study focuses on mutual and exchange-traded funds, given their popularity in Canada.
Mutual funds are products that contain equities, bonds, money, treasury bills, other mutual funds or a combination thereof. Investors can purchase partial units and benefit from liquidity in that they can sell the mutual fund back to the issuers at any time. Mutual funds typically have an embedded fee, called the management expense ratio (MER), expressed as a percentage of the net asset value of the fund. The MER covers the costs of managing the fund, trading securities within the fund and, depending on how the fund was purchased, compensation for the investment dealer selling the product.
Exchange-traded funds (ETFs) are similar to mutual funds in that they can contain similar types of securities. Unlike mutual funds, they are traded on an open exchange, meaning only full units can be bought and sold. Additionally, ETFs may not provide the same liquidity; to sell an ETF, a buyer must be foundFootnote 48 and, even when one is found, they may not want to buy the entire volume the seller wishes to sell. ETFs also carry MERs; however, they are usually drastically lower than those of mutual funds—meaning they are less expensive—in part because they are not typically actively managed and also because they are delivered via an exchange, so there is no embedded compensation for dealers.
Discount brokers (or the DIY channel) offer investors access to products with no personalized advice. Investors conduct their own research and make their own trading decisions. These trades are executed by the registered brokerage, which is a member of IIROC. Typically, the DIY channel offers investors access to most securities available to be purchased (unless the security has specific limits on distribution). Investors will generally pay a commission on each trade, which may differ based on the type of investment fund purchased. These fees vary from one brokerage to another. Fees for the products themselves depend on the type of investment; however, in the case of mutual funds, DIY investors have access to the lower-fee D-series funds, which typically carry MERs exclusive of embedded commissions.
Full-service firms vary in the actual services offered. Some provide advice and recommendations to investors based on conversations and their own expertise, but the investment decisions are made by the investor. Portfolio managers are full-service advisors, some of whom make investment decisions on behalf of investors based on their expertise and client knowledge; others simply provide advice and the investor is left to decide. Robo-advisors in Canada fall into the portfolio manager category. These types of advisors can be independent or affiliated with an institution (such as a bank, insurer or investment group). Full service advisors are typically compensated in one (or a combination) of four ways:
- salary paid by the advisor’s firmFootnote 49
- sales fees or commissions (in the case of mutual funds, these are embedded in the MER); the vast majority of funds are sold on a commission basis
- fee-only, where the investor pays the advisor directly (in the case of mutual funds, fee-only advisors do not receive commissions from the fund issuer, resulting in a lower MER)
- fee-based, which combines a fee paid by the investor and a commission paid by the advisor’s firm or MER
The robo‑advisors in today’s marketplace typically operate on a fee-only basis.
Competition in investment dealing and advice
Investment dealers and advisors compete on both price and non-price elements. These include the fees charged, customer service (e.g. availability of the advisor to answer questions, opening hours of their offices), the way advice is delivered and the success of the investment portfolio or the investment’s performance based on the advice proffered.
Price transparency and the principal-agent issue
Retail investors often find themselves without the ability to accurately compare the cost of advice, as embedded commissions are not readily determined from mutual fund marketing materials. As a result, advisors who are paid through embedded commissions or fees are often able to offer advice for "free" to the investor. Of course, this is not always the case—and investors dealing with such advisors may be paying much more than they would with a fee-only advisor or by purchasing funds directly. At the same time, by embedding commissions, advisors are able to offer financial advice and investment dealing services at no upfront cost to investors, potentially increasing access to advice for Canadians, particularly those with little financial literacy or who lack the time to conduct their own research and trading. Nonetheless, the lack of transparency into mutual fund commissions makes it difficult to comparison-shop for financial advice, reducing the effectiveness of competing advisors.
The opacity of embedded commissions has also exacerbated the principal-agent problem that can exist in industries where customers rely on a supplier’s expertise to make decisions. When two substantially similar funds are available and suitable for a client, for instance, the advisor may be incentivized to recommend the fund with the higher commission, acting on the lack of transparency. Similarly, advisors representing large fund issuers (e.g. large banks and insurers) may have increased incentives to recommend the funds issued by their firm, rather than those that may cost less. Ultimately, the investor ends up paying more (and saving less) than in a competitive market with price transparency and faces a product selection that is limited to a subset of what is actually available.
To address this issue, securities regulators in each province and territory collaborated to require increased disclosure of fees and commissions paid to advisors. The details of these requirements are contained in the Client Relationship Model 2 (CRM2), which came into effect in 2016. With CRM2, investors now receive periodic statements showing the amount they paid for advice, whether or not they actually received advice. This is an important first step to facilitating competitive switching. However, despite regulation requiring such disclosure at account opening, a recent mystery shopping exercise found that fees were discussed only about half the time and advisor compensation discussed only about a quarter of the time. Given the asymmetry of information inherent in these relationships, to truly provide transparency, such costs should be available in all fund marketing materials in a clear and understandable way, taking into account that many retail investors lack strong financial literacy.
Robo‑advisors enter the market
Responding to shifting demand, robo‑advisors have targeted consumers seeking basic advice, "set-and-forget" portfolio management and a better online experience. Using lower cost ETFs and operating predominantly on fee-only or fee-based models, robo‑advisors have established themselves as low cost alternatives to incumbent advisors. Leveraging technology to collect information and using investment strategies based on model portfolios, these new FinTech competitors have been able to cater to those seeking advice and portfolio management but who may not want or have the resources to meet with a financial advisor in person.
The difference between mutual funds with embedded commissions and those purchased directly can be significant. In 2015, data aggregator Morningstar found the typical advice portion of MERs on Canadian mutual funds to be around 100 basis points (1%). That is the difference between $60 and $50 on a $1,000 investment over just one year, or $300 over a 30-year period—or 30% of the original $1,000 investment (excluding reinvestment of the savings).
Using the average fee for common ETFs in robo-advisor portfolios and an approximate fee as charged by these robo‑advisors (together, approximately 0.75%) and the approximate MER of a mutual fund (2%), the following graph illustrates the difference in fees over time charged by a robo-advisor and a compensation‑based advisor. Footnote 50
An initial investment of $20,000, with $1,000 monthly contributions over 30 years
|Returns ‑ traditional adviser||Returns ‑ robo‑adviser||Difference|
|*Assuming: 4.5% average market growth,|
0.75% fees and MER at robo-advisor (incl. ETF fees),
2% MER and fees at traditional adviser (incl. trailing commission or other fees)
Difference shown for intervals of 5 years
These lower fees associated with robo‑advisors can potentially reduce the barriers faced by investors with lower net wealth. These robo‑advisors could reach consumers not yet receiving advice and areas where there is currently limited competition.
Using technology to keep fees low
Robo-advisors have the potential to take advantage of substantially lower costs and fees. By leveraging technology and employing process automation, robo‑advisors can decrease the marginal cost of managing an additional portfolio. Using model portfolios based on model investor profiles, they can greatly reduce the time and cost of meeting with clients. Without the need to support a branch network of advisors and multiple offices, robo-advice platforms may be able to operate at a substantially lower cost than traditional operators in this industry, putting pressure on other firms to lower their fees to remain competitive. And while the development of algorithms and user interfaces may impose larger sunk costs than start-ups employing a traditional advisory model, subsequent marginal cost per client may be substantially lower.Footnote 51
Scale plays a large part in the cost efficiencies to be gained; the ability of robo‑advisors to continue reducing prices relies on sustaining and increasing the customer base while maintaining the productivity efficiencies of automation. As robo‑advisors employing these new business models face high sunk costs relating to regulatory approval and software development, they must be able to gain the scale necessary to recoup these costs if they are to remain effective competitors.
Product differentiation and non-price competition
The benefit of competition from FinTech models in this industry extends beyond offering the same service at a lower price. Robo-advice platforms offer a number of services that are different from those of traditional advisors and may therefore appeal to investors with entirely different preferences for advice services. For example, the onboarding process might be entirely automated and done electronically (depending on the quality of the questionnaire and robustness of the process) attracting more technologically‑engaged investors and those less inclined to meet with an advisor in person.
This potential shift in consumer preference—toward fast and simple online services—has been recognized by traditional advice providers. Large financial institutions have developed automated advice platforms offering electronic onboarding and DIY options to their customers. Others are now partnering with new robo‑advisors to reach the segment of the market to which this service model appeals.
Although a handful of robo‑advisors have entered the marketplace, certain impediments persist that reduce the potential competitive impact FinTech can have in this industry.
Barriers to entry not directly attributable to regulation
A vital element of a competitive market is the ability for consumers to easily switch between suppliers of a good or service. If it is easy for consumers to switch, they are more likely to do so if a more competitive offer exists. In response to this ever-present threat, firms must ensure their prices and services deliver value to their customers; if they do not, they risk losing those customers to a competitor. In a competitive market, firms continuously innovate to stay ahead of competitors and attract a larger share of consumers.
Transparency in pricing
To determine whether or not a competitive switch will bring lower costs, consumers must be able to easily determine the price of a good or service.
For many goods and services, prices are clearly advertised and consumers understand what they will receive for what they pay. In the investment dealing and advice industry, however, these fees are often not discussed between investment dealers and consumersFootnote 52 or are embedded in the MER, effectively skewing the consumer’s perception of the price of advice. It is no surprise that one FinTech bank found that almost half (47%) of investors are unaware that their advisor is compensated for their advice.
Without the ability to easily compare the prices paid for advice, investors are unable to determine if they are receiving the most competitive offer.
The amendments to client disclosure in CRM2 are an important step toward fee transparency and greater clarity in interactions between advisors and clients. Incumbents and new entrants with whom the Bureau spoke were generally in favour of the initiative. Although it may be too early to tell, increased disclosure of the costs of advice can be expected to drive at least some competitive switching.
In its submission to the Bureau, a consumer advocacy group said that it believes "the online‑based financial advisory services sector is poised to take advantage of the frustration experienced by some Canadian investors when they discover the cost of their financial service advice." In fact, they speculate that competition will increase, as industry stakeholders identify a potential loss of business and react aggressively, as was seen in the US.Footnote 53
Increased fee transparency may also help overcome the principal-agent problem that exists in the industry.
Financial literacy and trust
If Canadians lack the financial literacy to understand the impact of lower fees on their overall savings and investment growth, increased disclosure alone may not be sufficient to encourage them to shop around for advice. Surveys have shown that Canadians have low levels of financial literacy when it comes to investments and how they work. As a result, they put a lot of trust in their financial institutions and advisors.
This issue has been noted by the CSA, which stated the following in a consultation paper on embedded commissions: "To the extent that clients do not rely on disclosure for their investment decisions, the resulting benefits of the disclosure may be limited as they may not be fully informed with respect to all account fees and performance and may not fully or effectively question or assess the services provided."
Further, disclosure goes beyond price. For consumers to be able to compare service levels, it is important that they understand what services are and are not available from a particular advisor. Some advisors are limited in the products they offer, whether in the types of funds they sell or the issuers they represent. Consumers must be able to easily compare the levels of service between advisors as well as price.
Cost of switching
In addition to the effort involved in switching financial advisors—finding and comparing prices, determining services offered and quality—there are sometimes more tangible costs to consumers. These include the time needed to set up new accounts, the costs and time associated with transferring assets or accounts (and potentially costs or penalties involved in selling investments early or cashing out if necessary) and, in some cases, account closure fees.
The Bureau heard from some robo‑advisors that transferring funds from an account to their firm can take a long time, with manual transfers taking up to a month to complete. The Bureau was also informed that there are rules governing account transfers and switching with the Account Transfer Online Notification system (ATON),Footnote 54 with the maximum time experienced usually 10 business days. Although the process is completed through computer networks, many institutions still require a paper form to be filled out and returned to effect the transfer. Some assets may not even be able to switch, either because the product itself is proprietary and not offered by competing advisors (such as some guaranteed interest certificates) or because the accepting advisor does not sell those types or lines of investments. Some investors will therefore resort to a manual transfer (cashing out investments at one institution, then depositing and re-purchasing investments at another), though limits and hold periods can also slow the process.Footnote 55
While 10 days may not sound long, particularly in the context of saving thousands over the lifetime of an investment, in a digital age when consumers have grown accustomed to instantaneous solutions at the click of a button, many may be deterred by this wait or the need to fill out paper forms. This is especially true when they are registering for an online-only service and have typically done all their transactions online.
The Bureau also heard that some financial institutions charge fees to consumers to transfer or close accounts. These fees can present themselves as a flat fee as well as a fee per trade and per share. In cases where multiple products are transferred, this can add up to thousands of dollars.Footnote 56 As an example, a simple transfer or closure of a tax-free savings account (TFSA) at a bank can cost a client $50. When a client owns an investment account, a TFSA investment account and a registered retirement savings plan with similar fees, switching for non-complex products can add up to $150. It is possible that the fees for switching may appear to outweigh the benefits of switching, deterring a consumer from doing so; however, this may be a misguided assumption, emphasizing the importance of increased financial literacy.
Technological impediments to switching
When switching to a robo-advisor, part of the rationale may be the expectation of an online, fully electronic experience. However, barriers may present themselves. In particular, electronic forms or signatures are not yet accepted throughout the industry. While regulators and self-regulating organizations have generally authorized the use of electronic delivery for documents and e-signatures, a number of industry participants told the Bureau that some traditional advisors continue to require forms to be submitted in-person or via means other than electronic delivery, with a "wet" signature needed to transfer certain accounts.
Laws of general application to e-commerce recognize e-signatures. Federal legislation defines an e-signature as "a signature that consists of one or more letters, characters, numbers or other symbols in digital form incorporated in, attached to or associated with an electronic document." Provincial e-commerce laws do not necessarily prescribe a form for an e-signature and consider it as equivalent to a wet signature. For instance, British Columbia defines an e-signature as "information in electronic form that a person has created or adopted in order to sign a record and that is in, attached to or associated with the record."
There are exceptions where an e-signature is not considered equivalent—for example, for documents related to wills, trusts, powers of attorney (over a person’s financial affairs or personal care) or transfers of lands. These continue to require "wet" signatures—and in the advice context, so does designating a beneficiary for a registered account.
Certain market participants may be hesitant to accept electronic forms and signatures because of potential uncertainty that existsFootnote 57 or because of variances in provincial e-commerce regulations. Combined with the remaining exceptions to the use of wet signatures, this may discourage certain industry participants (whose operations may overlap with a number of the aforementioned exceptions and who may be risk-averse) from accepting electronic documents and signatures, imposing a barrier on electronically based service providers. At the same time, this low adoption rate may also be simply a matter of traditional advisors not yet having made the investment in the technology needed to accept and process electronic forms and signatures.
Barriers to entry attributable to regulation
The activities of participants in the securities industry are regulated at the provincial and territorial level by the relevant securities regulators. Two of the cornerstones of securities regulation are investor protection and capital market efficiency. Securities regulators oversee securities trading, dealer registration and disclosure compliance; engage in investor education initiatives; and enforce securities legislation and regulation. Additionally, securities dealers are governed by a self‑regulatory organization depending on the type of dealer—for example, IIROC governs the conduct of investment dealers and the MFDA governs the conduct of mutual fund dealers. Registration requirements are set out in a harmonized instrument (National Instrument 31‑103). While registration itself does not present a significant barrier to entry for FinTech robo‑advisors, some of the regulatory requirements imposed on registered investment dealers may create unintentional barriers for robo‑advisors, inhibiting their ability to grow and compete with traditional advisors and institutions.
Under securities law, investment dealers owe a duty of care to ensure any investments offered are suitable for a particular client. Suitability is typically determined by an advisor through conversations with clients to understand their risk tolerance, investment objectives and investment time horizon. To meet the suitability requirement, an advisor must gather sufficient information on a client to meet the KYC standard and also understand the products they are selling sufficiently to meet the KYP standard.
The suitability requirement provides some level of investor protection by ensuring investors are not recommended or sold products that do not match with their investment objectives. For example, a leveraged portfolio of volatile equities would likely be deemed unsuitable for a risk‑ and debt‑averse investor with a short time horizon who wishes to preserve capital. The KYC and KYP requirements ensure the advisor has the information needed to protect the investor from this type of scenario.
Suitability, however, does not mean an advisor must offer the lowest‑cost investment that is suitable. Consider two identical funds both suitable for an investor: the first has a low MER and low embedded commission and the second has a higher MER with a high embedded commission. The advisor is not obligated to recommend the less expensive option to the investor; in fact, they likely have the incentive to recommend the higher commission fund, assuming this hypothetical client, like many Canadian retail investors does not understand the fees or the fact that they are paying for this "advice."
Although the suitability, KYC and KYP obligations are important consumer protection measures; they may be creating a barrier to competition from robo‑advisors. Traditionally, advisors meet the KYC requirement and perform suitability assessments through conversations, meetings and phone calls with clients. Robo-advisors, on the other hand, use online questionnaires and text-based chats to collect KYC information. Securities regulators have generally embraced this way of doing business, issuing guidance in 2015 to online portfolio managers setting out expectations for the collection of KYC information online. Securities regulators should be applauded for these efforts.
Issues arise, however, on two fronts. First, robo‑advisors who have received approval to do business in Canada must have registered advising representatives (AR) that are actively involved in portfolio decision-making. That is, an AR is involved in matching clients to portfolios, rebalancing portfolios, making buy and sell decisions and any process that requires a suitability assessment. This may impede the development of more automated portfolio matching based on model portfolios and model investor profiles derived from KYC information. It may also lead to higher costs for robo‑advisors as they grow. Instead of reducing their marginal costs by leveraging technology, robo‑advisors could end up with increased marginal (and fixed) costs as they hire ARs to meet this obligation—effectively dissipating the competitive advantage of automation.Footnote 58
Second, the guidance from securities regulators requires that robo‑advisors’ KYC questionnaires amount to a "meaningful discussion" by using behavioural questions to establish risk and KYC information, prevent clients from advancing before answering questions, test for inconsistencies and offer investor education about terms and concepts used. In addition, these questionnaires must involve more than just "ticking the box."
While robo‑advisors can use technology and algorithms to meet these requirements, they are subject to the same rigorous oversight as traditional advisors. Regulators tasked with ensuring these crucial investor protection measures are followed properly may benefit from the use of technology as well. Online questionnaires that create an exact record of an exchange between the robo-advisor and the client can make it easier to verify the robustness of the KYC information gathering process to ensure it was done appropriately and accurately; in comparison, the task of verifying exactly what was asked and said during an in‑person conversation may be more difficult.
Securities regulators have identified a number of FinTech‑related risks in this area, including cyber security risks, improper questionnaires and flawed algorithms (for KYC and also for matching portfolios and investors). Most importantly, however, appears to be the need for investor recourse and enforcement. These issues relate to responsibility for the advice given or actions taken by the robo‑advisor. Although securities regulators have not yet been approached with a proposition for fully‑automated advice, given these risks, the prospect of fully‑automated advice is not something Canadians should expect in the near term. As robo‑advisors grow, so, too, will their costs—and they may be left with an inability to further exploit the technology they are attempting to leverage to outprice the competition.
Like MSBs and lenders, securities dealers (including robo‑advisors) are subject to AML and CTF laws and regulations. With respect to robo‑advisors, the identity‑verification requirements of the PC(ML)TFA may present unique challenges vis‑à‑vis traditional advisors or institutions with a branch network. While the Bureau has heard that the PC(ML)TFA requirements are onerous and favour brick‑and‑mortar establishments (where verifying identity can be as simple as showing a driver’s licence), recent developments have greatly improved the ability of advisors to meet identity‑verification requirements entirely electronically.
In 2016, following amendments to the PC(ML)TFA, FINTRAC updated its guidance regarding the verification of identity. In particular, it added the possibility of relying on a credit file that has been in existence for at least three years as well as a dual process where identity could be verified from two reliable and independent sources. The dual‑process method could be done in an entirely electronic method, by using, for example, a micro‑deposit and a credit file that has existed for at least six months.
Fragmentation between jurisdictions
Several robo‑advisors indicated that Canada is a relatively small country in terms of potential customers. From a service provider’s perspective, fragmented regulation will harm innovation.Footnote 59 With fragmentation, a small market is essentially subdivided into smaller markets. The incremental burden of each additional layer of regulation impedes the entry of smaller players when compared to established players who have been present for a longer period of time and have established compliance frameworks.
In a national landscape with a number of internal jurisdictions, even if the majority of jurisdictions seeks to promote innovation, a firm operating across all jurisdictions will likely follow the most restrictive rules and regulations to simplify compliance. In this scenario, the spread of FinTech innovations across jurisdictions can be slowed significantly. This stresses the importance of harmonization in promoting innovation and competition in this sector, for example, through initiatives such as the regulatory sandbox recently introduced by the CSA. An incumbent may wish to implement a new business model or use new technology; however, the compliance costs associated with even subtle jurisdictional differences may impede it from doing so.Footnote 60 The institution must evaluate the cost of applying one set of restrictive compliance standards nation‑wide versus the cost of applying up to 13 different compliance standards across national operations to deal with potentially different enforcement approaches to the same or similar regulation.
There are economies of scale in compliance. Smaller entrants and market participants indicated to the Bureau that they do not have the established compliance teams of larger incumbents.Footnote 61 While regulatory authorities have launched initiatives such as the OSC’s LaunchPad, the FinTech Support Team at l’Autorité des marchés financiers (AMF), British Columbia Securities Commission’s Tech Team and the CSA Sandbox, in addition to the number of hubs that have emerged to pool resources, the burden will always be heavier on smaller participants. However, the Bureau was also advised that larger market participants face diseconomies of scope, given that they often offer more products and more diverse services to their clients—and therefore face additional burden due to the number of regulatory regimes to which they are subject for each product or service offered.Footnote 62
Due to the provincial nature of regulation in this industry, participants must register in each province in which they wish to sell their services. In terms of securities regulation, this process is simplified by the "passport" system in place between most securities regulators. However, to meet their requirements under corporate registration law, participants, including robo‑advisors, must at the very least, have an agent‑for‑service in each province where they provide services to clients and must pay registration fees in each province. The purpose of the agent‑for‑service is to have a person present to accept service of process should the corporation be sued in a particular province.
Although they gain no competitive advantage from having a physical presence in each province in which they operate (such as facilitating identity verification for AML purposes or offering a physical point of sale), online‑based service providers are expected to invest in an agent‑for‑service and registed in each jurisdiction in which they wish to operate.Footnote 63
A robo-advisor looking to keep costs low by leveraging technology to operate from a single location (or even in the cloud) across Canada may find even small hurdles such as the agent‑for‑service requirement can contribute to cost inflation.
Canada’s federalist system presents unique challenges for regulators and FinTech robo‑advisors looking to enter the market. Yet, the issues regarding KYC, suitability, automation and identity verification are not unique to Canada. Regulatory authorities around the world have tackled similar issues in the securities context and may provide some useful guidance.
Regarding the automation of KYC and suitability requirements, Canada lags behind its peers. Of the 17 jurisdictions that contributed to the International Organization of Securities Commissions (IOSCO) survey on automated advice, 11 reported that there are automated advice firms operating within their borders. Of those, only three—Canada, Indonesia and South Korea—have only hybrid model firms as opposed to a mix of hybrid and purely automated models. In Indonesia, this is the result of business decisions by market participants. In South Korea, at the time of the report’s publication, the regulatory restrictions on fully automated advice were in the process of changing.
In the UK, the FCA has issued guidance to address not-in-person KYC information collection, placing a clear onus on questionnaires and their design to ensure they collect sufficient information to understand the client.
In Australia, ASIC released Regulatory Guide 255 Providing digital financial product advice to retail clients in 2016. It provides guidance on collecting KYC information through online questionnaires and outlines expectations for how firms should monitor their systems to ensure they meet ASIC’s suitability requirements. In particular, Regulatory Guide 255 states that a licenced advice provider must ensure there are people within their firm who understand the technology used to provide advice and are able to review the advice generated by the algorithms. While an individual is not required to review each transaction or planning decision, there must be someone available to ensure the consumer protection standards of suitability, KYC and KYP are met and implemented. The guide further adds that regular verifications should be conducted on the algorithms and the recommendations issued by the firm’s software. It also sets out clear expectations for the information that should be provided to customers regarding the limitations of the advice provided and also for filtering out clients to whom such advice is not appropriate.
Conclusions and recommendations
Canadian securities regulators are to be commended for their efforts to embrace FinTech. Since launching this study, significant progress has been made by securities regulators with regard to FinTech innovation not only within Canada, but through partnerships with foreign jurisdictions.
Initiatives such as the OSC LaunchPad, CSA Regulatory Sandbox, the British Columbia Securities Commission’s Tech Team and the AMF’s FinTech Support Team are examples of progress. The Bureau applauds these efforts and encourages securities regulators to continue to incorporate a desire to improve competition and encourage innovation in their work.
Regulators should continue their efforts to increase price transparency and plain-language disclosure. Prices for advice should be clear and easily understood by Canadians. Fees should be presented up front (i.e. in advance of purchase) and consumers’ attention should be drawn to these fees.
Regulators should continue their financial literacy and consumer education efforts. In addition, consumers should be encouraged to ask about the fees they pay and to shop around. Price transparency in the MER and other fees should be made clear prior to purchasing a product.
Regulators should encourage the use of technology to facilitate account switching. The use of APIs may facilitate the creation of rich databases of price and fee information to facilitate shopping around. Similarly, the use of APIs to access consumers’ portfolio information can help make switching easier. Regulators should reduce barriers to switching by allowing and encouraging firms to leverage technology such as e-signatures and digital identity verification to facilitate client onboarding.
Regulators should continue to collaborate with robo‑advisors on the design of regulation to facilitate entry of these low-cost alternatives to traditional advice—for example, by providing clarity and certainty in interpretation and expectations. Regulators should review their regulations periodically to ensure they do not place unnecessary burden on market participants.
Regulators should consider providing firms with more freedom to automate additional processes, including analysis of KYC information and portfolio matching for suitability and portfolio rebalancing. The risks related to recourse, redress and enforceability can continue to be managed by designating responsible individuals within a firm.
Regulators should continue to promote the existing passport system to facilitate Canada-wide market entry by FinTech companies, and continue efforts to ensure such systems adapt and remain relevant in an increasingly digital world.
Global reactions to FinTech innovation
The Canadian federalist system presents unique challenges for regulation in the financial services sector—challenges highlighted by FinTech’s position in the "borderless" Internet.
Many FinTech entrants indicated that other jurisdictions have more welcoming and innovation‑conducive regulatory environments than Canada. In a study on international FinTech ecosystems, Ernst and Young LLP identified the UK, the US, Singapore, Germany, Australia and Hong Kong as the world’s leading FinTech hubs—based on talent, funding availability, government policy and demand for FinTech from consumers, businesses and financial institutions. With the exception of the US, these countries have a similar competitive dynamic in the financial sector: the market is highly concentrated, dominated by a small number of large financial institutions with a competitive fringe of smaller players making up the rest of the market.
Various international jurisdictions including those listed above, are examining competition in the financial sector. The emergence of FinTech in these countries has prompted policymakers to reassess their current financial sector frameworks.
Some of the primary driving forces behind the growth of FinTech in these countries are common to Canada. The sheer pace of technological innovation, for example, is allowing new entrants to innovate and compete with a relatively homogenous incumbent financial sector and the growing use of mobile and online banking is increasing consumers’ comfort, albeit slowly, in interacting with digital‑only providers. Several factors, however, that are driving FinTech growth and adoption in other countries are lacking in the Canadian context.
The global financial crisis had a considerable impact on relationships between end users (consumers and businesses) and their financial institutions in the US and the UK. Many countries’ post‑crisis policies were designed to prevent a future crisis by promoting financial stability and prudential regulation that, in some jurisdictions, may have come at the expense of competition in the sector. The Netherlands, the UK and the US nationalized some of their banks; Germany, the UK and the US also moved to purchase or ring‑fence toxic assets following the crisis. Many governments intervened on the basis that the financial sector as a whole was "too important to be weakened," not allowing their intervention to be disciplined by competition policy considerations.
In contrast, FinTech development in Asia and Africa has been prompted primarily by the pursuit of broader economic development. FinTech is leveraging the growing ubiquity of technology and consumer trust to deliver financial services through new channels and providers to underserved citizens.
Renewed focus on competition
The pendulum has begun to swing back toward an approach to financial policy‑making that considers competition as important as other policy objectives like safety and stability. A number of reports by the Organisation for Economic Cooperation and Development (OECD), for example, contributed to a growing concern for competition in the financial sector. These reports highlight the importance of competition to enhance the effectiveness of the financial system, which, in turn, allows for long‑term economic growth. The World Bank also suggests that the importance of competition "should not be sacrificed for the sake of stability."
The European Commission and the Dutch Authority for Consumers and Markets are in the process of soliciting public comments on competitive forces in the financial sector, while the financial sectors in Australia and the UK have been through numerous reviews leading to broad reforms and policies designed to improve competition. The Bundesfinanzministerium in Germany also commissioned a comprehensive report on that country’s FinTech market, concluding that the future development of FinTech will depend on market forces.
In the UK, this renewed focus on competition has led to the establishment of the "twin peaks" of regulatory structure: the Prudential Regulation Authority (PRA) and the FCA. The FCA has a primary objective to "promote effective competition in the interests of consumers,"Footnote 64 including ensuring regulations "allow competition in financial markets to thrive."
A pair of Australian studies—the Review of the Four Major Banks and the Financial System Inquiry—concluded that competition in the financial and banking sectors had decreased since the financial crisis, highlighting a lack of consideration of competition by regulators. This led to recommendations to bolster both financial regulators’ consideration of competition and the ACCC’s understanding of financial services.
Approach to FinTech development
Jurisdictions around the world are beginning to develop their approach toward FinTech innovation. Unlike Canada, these countries do not have the added challenge of a federalist system. As such, many have been able to take a national, unified approach to encourage FinTech development. Typically, their response has been to encourage experimentation in a controlled environment and to create regulatory frameworks that are flexible and proportional to the risks presented by FinTech innovation.
The common element across these jurisdictions is the clear identification of a policy lead on FinTech, which is something Canadian policymakers should consider going forward.
Collaboration and experimentation
Other countries are increasingly establishing fora for regulatory experimentation and engagement between the private sector and regulators. The UK’s Project Innovate, for example, combines its innovation hub with a specialized staff unit to provide feedback to firms developing automated advice models. Singapore’s Smart Financial Centre, meanwhile, is dedicated to facilitating collaboration among a diverse range of stakeholders: new entrants, financial institutions, academia and think tanks, legal professionals and government agencies. Both countries have also adopted regulatory sandboxes for experimentation.
International organizations such as the Financial Stability Board (FSB), Basel Committee on Banking Supervision (BCBS) and IOSCO play key roles in the development of regulatory frameworks for the financial services sector.
Earlier this year, the IOSCO Committee on Emerging Risks collaborated with other IOSCO committees on a study of the evolution of FinTech, including its intersection with securities markets regulation. In June 2017, the FSB released the results of its analysis of the financial stability implications from FinTech, outlining a number of supervisory and regulatory issues, including the importance of international cooperation among regulators to examine whether the current oversight framework is sufficient to manage the operational risk of third-party service providers (e.g. cloud computing and data services).
In August 2017, the BCBS released its consultation document, Sound practices: Implications of fintech developments for banks and bank supervisors, which explores 10 recommendations on supervisory issues for consideration by banks and their supervisors, including ensuring "frameworks are sufficiently proportionate and adaptive to appropriately balance ensuring safety and soundness and consumer protection expectations with mitigating the risks of inadvertently raising barriers to entry for new firms or business models." Based on its survey of banking supervision approaches—noting that many have been put in place only within the last two years—the BCBS encourages learning from practices such as innovation hubs, accelerators, regulatory sandboxes and other forms of interaction to facilitate innovation. Below reproduces the BCBS’ presentation of jurisdictions’ initiatives.
|Innovation Hub||Regulatory Sandbox||Accelerator|
|Australia||Australian Securities and Investments Commission|
|Belgium||National Bank of Belgium |
Financial Services and Markets Authority
|European Commission||Single Supervisory MechanismFootnote 65|
|France||Autorité de contrôle prudentiel et de résolution||Banque de France|
|Germany||Bundesanstalt für Finanzdienstleistungsaufsicht|
|Italy||Bank of Italy|
|Hong Kong||Hong Kong Monetary Authority|
|Japan||Bank of Japan |
Financial Services Agency
|South Korea||Financial Services Commission|
|Luxembourg||Commission de Surveillance du Secteur Financier|
|Netherlands||De Nederlandesche Bank/Autoriteit Fianciële Markten|
|Singapore||Monetary Authority of Singapore|
|Switzerland||Swiss Financial Market Supervisory Authority|
|United Kingdom||Bank of England |
Financial Conduct Authority
|Financial Conduct Authority||Bank of England|
Innovation hubs provide guidance to businesses on how to navigate the regulatory framework, ranging from hosting and attending industry events to informal assistance when applying for authorization. They may take the form of a single point of contact, dedicated newly created units and identified networks of experts.
Accelerators are fixed‑term education or mentorship programs, typically founded by the private sector. These programs may culminate in a public pitch event or demo day for selected firms to present use cases or solutions to a problem, sometimes with the involvement of funding support or authorities’ endorsement.
A regulatory sandbox refers to the live testing of new products or services in a controlled environment. More than just dialogue or informal exchange, they involve the supervisor’s active cooperation during the test period and have the added implication of legally provided discretion for authorities. Their use depends on the jurisdiction and typically entails an application and selection process by the regulator according to specific criteria (e.g. innovations with a consumer benefit that do not easily fit into the existing legal framework and are ready for the market). Sandboxes can also grant temporary relief from certain regulatory obligations (e.g. in the form of restricted licences). It is important to note that "sandbox participants must typically inform consumers and all relevant stakeholders that the company is providing the service under a sandbox regime" and they must work to ensure the confidentiality of customer data during testing.
These approaches lower barriers to entry, encourage innovation and improve competition by:
- reducing regulatory uncertainty and lowering the immediate sunk cost of navigating the regulatory framework and obtaining the right approval
- allowing some firms that would otherwise have abandoned entry in the early stages to test their services and ability to meet regulatory standards
- improving regulators’ understanding of the market resulting in policy‑ and decision‑ making that better facilitates new business models or technologies
It is clear that collaboration between regulators and industry, in some form, is part of the solution to finding balance, a theme that also resonated during the Bureau’s February 2017 FinTech workshop.
Flexible and proportional regulatory frameworks
Numerous jurisdictions have developed specialized regulatory frameworks or licensing regimes to respond to regulatory uncertainty and clarify the application of rules in the digital world. For example, the US OCC intends to issue special‑purpose national bank charters to FinTech companies that would allow them to undertake some traditional banking activities—collecting deposits, issuing cheques, making loans—provided they meet the national standard for operations in the US, including rigorous oversight and minimum capital requirements. For equity crowdfunding and P2P lending, a number of jurisdictions have introduced tailored regulatory regimes rather than placing these business models under existing regulation, with the UK’s specialized regulatory framework for "loan‑based crowdfunding platforms" serving as one example.
The aforementioned 2017 BCBS survey of bank supervisors found that licensing regimes typically have a range of options that vary by entity or type of activity. However, in most jurisdictions, traditional financial services are covered by one type of licence—reflective of activities typically conducted by banks (e.g. lending, deposit‑taking)—while other types of licences cover financial services involving non‑banks (e.g. payment services, investment services). New products or services are more likely to be subject to limited licensing, supervisory precedents or no licensing at all. The EU’s licensing regime, for example, takes a graduated approach, expanding its scope based on the scope of services provided.
Limited and restricted licensing adjusts the regulatory parameter according to the activity in question, potentially offering new entrants, over time, a gateway to broaden their service offerings toward attaining full bank licences and benefit from the economies of scope already available to more traditional services providers.
Open banking, open access and standard‑setting
The concept of "open banking" has been echoed in the financial services sector over the past year without a consistent understanding of its meaning. Some believe it means opening the banking sector completely and dismantling existing financial institutions; others think it means absolute portability of all products everywhere. Open banking, as the Bureau understands it, is the concept of providing limited open access to consumer data through an API, with consent of the consumer, to offer better, more competitive alternatives.
The UK CMA published a detailed study on competition in the retail banking market in 2016. Among its conclusions, the CMA found that banking customers face substantial barriers to searching for information on different banking products as well as barriers to switching between providers, resulting in low levels of customer engagement and poor competition.
Regulators in the EU have also been examining access to data and banking infrastructure in the development of FinTech. PSD2 represents a fundamental shift in approach, allowing third parties, including FinTech firms, to access customer bank account data to develop services. Certain third parties will also be able to transfer value from a customer’s bank account.
Regulators in other countries, such as Singapore and Australia, have expressed interest in developing frameworks that put consumers in control of their data.
The UK and the EU have moved toward open banking standards (through open APIs) to encourage both product comparison by consumers and the development of third‑party applications or overlay services. The CMA’s 2016 report, Making banks work harder for you, concluded that older and larger banks do not have to compete hard enough for customers’ business, while smaller, newer banks find it difficult to grow, meaning many people pay more than they should and do not benefit from new services or from switching providers.
In response, the CMA is implementing a series of wide reaching reforms, including a requirement for banks to implement an open banking standard by early 2018. This standard could not only reduce or remove frictions but also "change the nature of the customer journey," for example, by:
- unbundling products typically sold together
- removing incumbency advantages based on access to consumer transaction history for SME loans
- overcoming customer inertia (or "stickiness") by automatically transferring cash from accounts paying low interest to ones that earn higher interest
- enabling consumers to manage and move funds between different accounts with different banks through a single provider
The regulation also aims to help third parties earn consumers’ trust. Similarly, Singapore aims to open its banking platforms via APIs to enable faster innovation and integration of IT systems within their financial sector.
The Bureau has long recognized the value that the development of standards (through formal standards development organizations) can provide to competition, such as increasing efficiency and consumer choice, reducing barriers to entry and fostering interoperability and innovation. Developing standards, however, can raise competition concerns; they could create regulatory "moats" that reduce price and non‑price competition, foreclose innovative technologies and restrict firms’ ability to compete by denying or providing access on discriminatory terms. Ensuring broad and diverse representation and engagement in the development of standards is critical.
Open banking in the UK and PSD2 in the EU do not come into effect until 2018. It is too early to tell what may come from such proposals, but the potential impact on competition and innovation is promising. While Canada’s complex federalist system make it more difficult to follow the lead of other jurisdictions, the Bureau encourages policymakers to continue to examine the experience of peer jurisdictions and adopt best practices as they balance the potential risks with the competitive benefits.
"[FinTech] will disintermediate functions, not firms. It will intermediate some of the financially excluded. It will increase competition. It will test regulators."
FinTech has the potential to significantly change the way Canadians access financial services. It promises to increase choice and convenience, while also lowering prices and frictions existing in the marketplace today. Regulators must ensure, however, that they keep pace and embrace innovation.
As was noted by the Senior Deputy Governor of the Bank of Canada, Carolyn Wilkins, at the Bureau’s FinTech workshop:
"Innovation in financial services is a huge opportunity to improve the financial system by leveraging the technology and new business models to increase access to financial services, increase the efficiency of the services that are being provided by replacing legacy systems, and perhaps creating a little bit more competition and more contestability of markets in the services, so that businesses and households can benefit from that. (…) With great opportunity comes the responsibility to manage the risks that are associated with new technologies and new services that are being provided so that they indeed do reap the benefits for households and for businesses."
Striking this balance is not an easy task. Regulators and policymakers carry a heavy burden in protecting Canadians while, at the same time, embracing Canadian entrepreneurial spirit and adapting to continuous change and uncertainty. The World Economic Forum recently concluded a four‑year project into disruptive innovation in financial services, finding that "although fintechs have failed to disrupt the competitive landscape, they have laid the foundation for future disruption." The Bureau encourages regulators to view the impact of current and future regulation through a competition and innovation lens to help Canadians realize the promise of that foundation.
The Bureau is encouraged by significant steps taken by regulators at both the federal and provincial levels to welcome FinTech to the sector, such as the Department of Finance Canada’s inclusion of FinTech, open banking and competition matters in its ongoing regulatory framework reviews; the various sandbox and concierge services being introduced by securities regulators; and working groups that have been established to study FinTech at all levels of government.
The Bureau is hopeful that regulators and policymakers will accept its continued invitation to help ensure legislation and regulations do not unnecessarily impede competition and innovation in this important economic sector.
- Australian Competition and Consumer Commission
- Automated Clearing Settlement System (operated by Payments Canada)
- Australian Financial Services (Australia)
- Autorité des marchés financiers (Québec)
- Anti-money laundering
- Advising representative
- Australian Securities and Investments Commission (Australia)
- Account Transfer Online Notification system
- Basel Committee on Banking Supervision
- Competition Bureau of Canada
- Consumer Credit Directive (EU)
- Canadian Deposit Insurance Corporation
- Competition and Markets Authority (UK)
- Client Relationship Model 2
- Canadian Securities Administrators
- Counter‑terrorist activity financing
- Deferred net settlement
- Exchange‑traded fund
- European Union
- Financial Conduct Authority (UK)
- Financial Consumer Agency of Canada
- Financial technology (used throughout this report to refer to the innovative technologies being introduced by a financial services firm—not a firm itself)
- Financial Transactions and Reports Analysis Centre of Canada
- Faster Payments Service (UK)
- Federally‑regulated financial institution
- The Financial Stability Board
- Investment Industry Regulatory Organization of Canada
- The International Organization of Securities Commissions
- Know your client
- Know your product
- Large Value Transfer System (operated by Payments Canada)
- Management expense ratio
- Mutual Fund Dealers Association of Canada
- Money services business
- Officer of the Comptroller of the Currency (US)
- Organisation for Economic Co‑operation and Development
- Office of the Superintendent of Financial Institutions
- Proceeds of Crime (Money Laundering) and Terrorist Financing Act
- Point of sale
- Prudential Regulation Authority (UK)
- Revised Payment Services Directive (EU)
- Payment service provider
- Payment Systems Regulator (UK)
- An investment advisor with whom retail investors interact remotely via the Internet
- Small- and medium‑sized enterprise
- Tax‑free savings account
- United Kingdom of Great Britain and Northern Ireland
- United States of America
How to contact the Competition Bureau
Anyone wishing to obtain additional information about the Competition Act, the Consumer Packaging and Labelling Act (except as it relates to food), the Textile Labelling Act, the Precious Metals Marking Act or the program of written opinions, or to file a complaint under any of these acts should contact the Competition Bureau's Information Centre.Address
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