— A Summary of How to Address Investors’ Concerns on Fintech Regulatory Risks
When Covid took most of the headlines in 2020, the past year also marked a year of regulatory hustle for fintech companies. Ant Finance, the Chinese icon fintech company, delayed its IPO due to concerns around monopoly and unfair competition. For the same reason, Visa had to call off the acquisition of Plaid. Robinhood went through multiple SEC investigations regarding its IPO and settled with a $65 million fine. Revolut suspended customers’ accounts for compliance reasons and received an increasing number of complaints.For fintech companies, the regulatory risks have significant impacts on growth and brand reputation.
Early-stage fintech disruptors may fly under the regulatory radar, but will eventually attract attention once they reach a meaningful size. Most fintech builders understand this and are keen to build robust in-house capabilities for regulatory risk management as soon as possible. However, at the formation stage, lack of resources and funding will always limit the options. This means that, when pitching to potential investors, regulatory compliance strategy becomes an important story to tell. Showing an in-depth understanding of the risks/impacts can set the investors’ worries at ease.
I.Understand your battlefield
The impacts of regulatory risks vary by product and business model. Generally speaking, regulators’ tolerance is low for breaches of anti-money-laundering, credit-related disparate impact, and know-your-customer rules. If your fintech venture is or will be highly involved in those activities, planning ahead will make you better positioned for scaling. For example, lending/borrowing/crowdfunding in all formats of currencies, including crypto, have little room to play with the regulatory requirements during all stages of the business cycle. Integrating regulatory factors late in the business planning will increase the risks of regulatory requirements’ disruption. On the other side, B2B, SaaS companies, such as chatbots, document processing, etc., may shift the risks to end customers by integrating compliance considerations into the product features.
Regulations regarding different fintech products/business models evolve differently. Understanding which bucket you are in will help to manage the risk of uncertainty. Most regulatory requirements for fintech remain unchanged from the traditional regulatory framework for established financial institutions. It is either because the nature of Fintech does not change fundamentally, such as for Robo-advisor, or the regulation evolvement needs time to reflect the complexity of disruption. The formation of fintech oriented regulations put both opportunities and risks to entrepreneurs. Late-stage ventures can have the advantages of lobbying to educate and influence regulators. The early-stage players will be better off to keep alert and agile on regulatory changes and adapt quickly. Fortunately enough, the general direction of the changes is not a total blackbox but a matter of timing and level of strictness. This gives enough evidence to plan ahead.
Regulatory impacts also vary between and within countries. For example, in the US, besides federal law, the states govern the licensing and regulations individually. Expanding to the whole US market requires a relatively longer preparation and heavier licensing investment. Another example, the UK has launched the “Sandbox” program in 2016 for those fundamentally disruptive business models that do not fall into any regulatory framework. The “Sandbox” allows the startups to scale faster without waiting for the regulations to reform, to gain strong credibilities, and to get feedback from a regulatory perspective. Also, rules on peer-to-peer finance, including lending, crowdfunding, or money transfer, is more strict in some Asian markets. Given the geographic regulatory dispersion, the expansion plan will be a mix of considerations of your team’s expertise and geographic regulatory constraints.
II. Choose your strategy
- Outsource
It is always a dilemma as an early-stage startup, when lack of branding and capital prevent you from hiring top talents, while it is a time when talents are needed the most. Leveraging third parties to get through this phase is always an option. There are law firms and boutique consulting firms that provide services to fintech startups to act as the external compliance function. The quality services are costly, but it is a shortcut to ensure everything is in place and in good shape. Another benefit is to leverage their expertise to train the internal team to get in line with the market standards. When considering your options, don’t forget to consult your network and advisor board for feedback and advice. Those are usually cost-efficient and genuine opinions.
2. Partnership / Vendor
During the early days of the business journey, fintech disruptors could enjoy some advantage of not owning a license by partnering with or becoming a tech vendor of traditional players. It seems a smart way to scale faster without investing too much money and time in the paperwork. However, it may limit the possibility to scale. First, missing the licenses could backfire on the growth plan, and partnership means giving up a portion of the revenue. When partnering/being a vendor means to change the potential consumer-facing business to a 2B model, the addressable market is much smaller than expected. Second, proper licenses are inevitable. For example, no matter how hard Ant Finance is arguing its “technology company” propositioning, it eventually became a financial service provider in the regulators’ eyes. Third, if your innovation has considerable exposure to the risks that regulators are closely watching, obligations are not much smaller if your partners violate the rules. So, it is ok to partner, but don’t undermine the importance of building and enhancing the in-house capabilities and qualifications.
3. Build in-house capabilities as early as possible
There is no need to speak too much about this. The most powerful strategy is to build legal compliance into the processes as early as possible. Ignorance of regulatory factors in business planning significantly increases the regulatory risks. On the contrary, sometimes, regulation constraints can enhance product development. For example, under data privacy regulations, federated learning, a state of art Machine Learning model, enables data science to work over data that is stored locally on users’ devices. Its pioneering use cases include privacy-preserving medical research and interest-based targeting.
4. Diversify products and market
Designing your product and business model to be agile for diversified businesses or markets is a strategy that enables fast expansion and a way to make your venture more adaptive to regulatory changes. For example, most currency exchange startups target as many currency pairs as possible at the very beginning. It is not only because it is a way to enlarge the addressable market, but also a way to minimize the capital control risks by diversifying the markets that they serve.
III. Tell your story
- Regulatory compliance to Fintech is a strategic component of growth
The regulatory risks management strategy should be a structured strategic plan that is aligned with your roadmap. Starting from the core business, map out the major direct and indirect regulations around it, then peel down layer by layer and give supporting evidence of what you are doing to mitigate the risks and how it worked. Don’t forget to mention the future, such as how your compliance procedure will evolve according to product and geographic expansion or how your capabilities will shift from outsourcing to in-house.
2. Provide supporting details of your qualifications
Don’t be afraid of the potential investors ask detailed questions around regulatory risks and compliance procedures. An experienced investor who can help spot regulatory issues early will be a significant value add on top of the funding she/he can provide. When answering the questions, make sure you showcase your in-depth understanding of the topic’s significance, what you need to do, what you have been doing, what you will do, and how much investments are required. Be prepared to answer with details, such as the current procedure, your compliance team’s qualifications, and product compliance features.
3. Have an attractive business model with a sustainable competitive advantage
For any strategy ever made for a startup, the ultimate goal is to create a business model that can sustain through macrocycles with an enduring brand. That is also the ultimate value the VCs are looking for in startups. It will not be a bad investment if the regulatory risks come with a business model that will change competition or engage customers differently.
References:
Policy responses to fintech: a cross-country overview — Bank for International Settlements
The new picture in finance — Mckinsey & Company
Regulation Hacking — Evan Burfield
The Future of Fintechs: Risk and Regulatory Compliance — Deloitte
