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Innovation – what is the supervisor’s mandate?

24. May 2019

3rd Baltic Financial & Regulatory Summit – FinReg 2019, May 24, 2019
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Kilvar Kessler, Chairman of the Management Board of the Estonian Financial Supervision Authority

As an introductory remark, I really should note that the topic of innovation in financial markets is a broad one. Approaches across jurisdictions may differ to a great extent, and this means that my view is only one among a million others. I will start off with a couple of assumptions, then I will discuss the work of Finantsinspektsioon with fintechs, and I will conclude with some lessons learned from our fintech experience.

First, I believe in private enterprise and private initiative, and that each citizen is responsible for their own success to a great extent. The state or the sovereign should not be nanny for all aspects of human life, but rather it should play a role in limited areas. However, the institutions that regulate these areas should be strong enough that they can make sure that commonly shared values are followed by all parties.

Second, the financial sector and the real economy have different characteristics. The first of these – the financial sector – may take on our risks, our trust and our excesses, and redistribute them across society on a contractual basis. It has been like that and so it will stay. An unexpected incident or the insolvency of a financial sector entity will erode public confidence or, in the worst case, even hit the stability of financial markets in a negative way, so that public money from guarantee schemes should sometimes rush in to save stability.

Third, the mandate issued to the supervisory authorities comes from the whole nation. This mandate is in the form of statutes and legislation. This mandate is a distillate, the result of total risk-reward evaluation. And an evaluation that is carried out not only by one or a couple of stakeholders, but by the nation as a whole. 

Moreover, the public sector should not dive into adventures and risk public money outside of its mandate. It is for these adventures that we have the private sector. There - in private sector, risk taking, and the ups and downs connected to it, are clearly and causally linked. 

So, what has Finantsinspektsioon been doing when it comes to innovation? Let’s scroll back to the beginning of the 2000s when words like “fintech” or “insurtech” were not yet known, and nobody had a clue about sandboxes. What we had then, and what we still have, is the readiness to engage in dialogue and to be a business-minded supervisory authority.

In 2003 or so, Estonia decided to open up the insurance brokerage market, so that we could create more competition and facilitate the freedom to choose. It took until 2005 or so before a group of tech savvy people got together and established an insurance brokerage firm to offer services in new ways. As a result, the firm came up with a web-based brokerage platform with links to the ID-card, several databases and internet banking. The platform was easy to use and very convenient for the consumer. Nobody had done anything like that before. However, we had quite rigid consumer protection rules in insurance back then and sometimes in these situations, you hear it constantly echoed that “the law does not foresee such platforms”.

These people, now known as Iizi, hired a team of lawyers to work out a contractual framework that would fit into the statutory norms, but at the same time would not impede the operation of their innovative platform and the way it communicated with customers. The lawyers used in-depth analysis and transparent argumentation to make sure that the supervisor felt comfortable that this innovation was within the statutory framework, and within the mandate given.

The result was that three motivated counterparties made a miracle together:

  • Business – made money by offering better customer experience through an innovative product;
  • Lawyers/attorneys – offered working legal solutions by rendering practical legal advice in a good and reasoned dialogue with the client and the supervisor;
  • Supervisors – made sure the insured are protected, risks managed, and laws followed.

Nowadays, Iizi is a clear market leader in the insurance brokerage market. It capitalized on financial innovation, and on the lack of agility of the insurance companies in investing in their sales channels. They also capitalized on professional legal advice and on a good dialogue with the supervisory authority. Thus the recipe for this was no sandbox or other similar magic spell, but open and frank communication, and a professional attitude from Iizi towards the supervisory authority.

Well, as you know, around 2015 the FCA in the UK came up with its sandbox. The policy behind this was to pay more attention to start-ups so as to create new opportunities and better competition, and because there are too many supervised entities for the FCA to handle, the processes are streamlined or even automated for regular supervised entities. The idea of the sandbox sounded reasonable in the UK, where the FCA has more than 3000 employees. As I understand, there was no policy of cutting any slack for a particular segment of the market, but rather one of paying more attention to them and taking a more personalized approach.

As early as January 2016 we at Finantsinspektsioon drafted a provision for the Finantsinspektsioon Act that would give a concrete legal framework for our proposed initiative for financial innovation. One idea behind this was to capitalize on the buzzword ‘sandbox’. The merits of the idea, however, were that it would facilitate unique technical innovation in the field of finance and give Finantsinspektsioon the legal grounds to exercise non-action under certain limited circumstances. This draft is still circling somewhere, but we at Finantsinspektsioon have dropped the idea as we see the tide of sandboxes has gone, and this is not a good sales pitch any more. Three years is a century in financial markets, but I agree that sometimes it is wise to take the time to kill certain initiatives.

Second, in February 2016, we established a fintech working group together with a hub for it at Finantsinspektsioon. The tasks of the group were:

  • To establish close contact and exchange information;
  • To gather and analyse information on the development of innovative financial technology and the legal barriers to it.

In summer 2016, we proposed a draft law on the minimum regulation for crowd-funding platforms. We saw that the law on contracts is limited to dealing only with certain types of risk, like the division of assets following insolvency, or conflicts of interests on a broader scale. This means there is room for public law involvement. Moreover, we saw that this market should be opened for our platforms at the EU level.

In summer 2017, we issued guidance on ICOs and crypto-assets. Our main point here was that offering tokens is not that different from offering any other instruments. We should look at the legal terms and conditions and financial characteristics of tokens, and not concentrate on technical parameters and promotional mumbo-jumbo. Securities regulation is already in place, it should be followed.

In 2018, our fintech team answered around 150 questions and held around 40 face to face meetings. The main topics covered were GDPR, PSD2, and public offerings. We have had a number of expressions of interest about several types of licences that can be used to operate in or from Estonia. However, we have not used any sweeteners, as we are not sure that this is the right way to start a business that relies to a great extent on public confidence. As a parallel, would you really want to go to a dentist who is excellent at building and repairing tools, but who is not at all skilled at good old cavity-fixing work?

Some of our recent developments, I will leave to be discussed at panel later today.

All in all, what are the lessons we have learned from our fintech experience? There are three lessons that I could highlight as concluding remarks:

  1. it is clear that fintech may have game-changing potential under certain circumstances. The case of Iizi provides clear evidence of that. Equally though, we have also seen less successful examples;
  2. the supervisor’s mandate is in the law, and this reflects the overall risk appetite and demand. The supervisor is a servant of the whole of society and its main task concerns financial stability and transparency. Supervisor should not be innovation lab, as this may conflict with the goal of stability. [I have serious doubts as to whether the private sector should be keen on the public sector being deeply involved in their innovation, for reasons ranging from the capacity to innovate to worries about confidentiality];
  3. an open and business-minded supervisor, which does not mean one who is biased, is the best for any real business case, including the cases of fintechs. Mere institutionalization of “better communication”, such as sandboxes, is nothing but a marketing tool. As relevant as last winter’s snow. As a separate note, excessive sweeteners may create the wrong incentives or distort the risk environment.

That is it from my side. As I was referring, looking forward to the panel discussion, as well.

Kilvar Kessler