Well beyond the FinTech hype is the easily-overlooked domain of RegTech, technology that’s enhancing financial regulatory efforts and compliance. This domain touches on a wide range of topics critical to financial companies including privacy, security, and the movement towards digital identities.

At this month’s Fintech Conference in Vancouver put on by the Digital Finance Institute, a panel of experts convened to discuss the opportunities and challenges in RegTech and compliance in the era of automation.

To set the context, one panelist divided the history of FinTech into a number of eras:

• FinTech 1.0 was the telephone and telegraph.

• FinTech 2.0 covers the introduction of the ATM up to e-banking.

• FinTech 3.0 was the reaction to the risks revealed by the 2008 financial crisis; and now

• FinTech 4.0 is one that is not reactive to crises, but a proactive reform of financial markets.

Regulators have always tried to protect consumers, ensure financial stability, prevent bad behaviors, and maintain the reputation of the financial industry. While this used to be reactive, where financial companies would comply with regulations created after examining data from a crisis, now the aim is to perceive risks accurately in real time and be predictive.

The temptation for RegTech companies is to find and market an automated solution for this. But there are two problems with this idea.

The first is that FinTechs’ behavior is not precisely defined when it comes to certain regulatory standards. FinTechs have made regulators’ jobs tricky. Part of a regulator’s job, for instance, is regulating unauthorized deposit taking and insurance activities. “Fintechs sometimes blur the lines,” says Frank Chong, Deputy Superintendent of Regulation at the Financial Institutions Commission of British Columbia.

As an illustration, peer-to-peer lenders currently provide personal loans, but one can envision a time when these same FinTechs enter into mortgage lending, an area that is heavily regulated.

The second problem is that no off-the-shelf compliance solution or combination of tools is going to comprise an acceptable compliance program. As Badour said, automated compliance is a challenge today because “you have laws that were drafted at a certain time in a certain context, and it’s very hard to operationalize them and turn them into an algorithm.”

That’s not the only difficulty. Consumer confidence in the financial industry is a top priority for regulators, and achieving that still requires levels of human engagement.

This was explained by Ana Badour, Partner in the Financial Services Group of McCarthy Tétrault LLP in Toronto, who highlighted the concept of the three lines of defense as a fundamental compliance principle. The three lines of defense are:

1. Business operations: Software developers, marketers, and others should be actively considering compliance risk and control when discussing product development.

2. Oversight functions: Compliance officers are included in the discussion on product launches and are responsible for documentation.

3. Independent assurance: Early checks such as internal audits determine if policies and procedures have actually been followed.

RegTech is a complement to this, Badour said, but can’t replace a comprehensive compliance function. For FinTechs and companies thinking of adopting regulatory technology, a bargain must be struck between automation and the traditional regulatory and compliance set up.

Chong said, “We have specific controls when it comes to capital liquidity, licencing, and governance. The FinTech space is less clear with regulators and policy makers. The hard truth is that policy makers will always be playing catch up with regards to the FinTech space.” Tech companies move quickly into new markets, and when regulators catch up and determine there are non-compliance issues, it becomes very difficult for companies to unwind their positions.

There is a wealth of opportunity in the FinTech and RegTech spaces, but also a number of significant challenges that must be carefully navigated. The panel encouraged companies in these spaces to engage regulators, and open an ongoing conversation to discuss the services they look to provide.

According to PwC’s recently released “Canadian Banks 2016: Embracing the FinTech movement” report, Canadian banks are laser-focused on responding to the threats and opportunities posed to the banking industry, at the hands of a group of new companies building financial technology solutions.

FinTech offerings range from competing financial services such as alternative lending, to additive solutions atop existing banking services, to enabling technologies for the banks themselves.

According to the report, banks have a great deal to gain from FinTechs’ innovation which may become essential in propelling the sector forward by reimagining operating models, streamlining costs, increasing reach in underserved markets, innovating through new product development, and opening new revenue streams.

In some cases, FinTechs will be viewed as enablers to traditional innovation and continuous improvement. In others, it presents a series of disruptions and threats as they continue to make inroads into banks’ traditional territory by offering a competitive service or products.

“Canadian banks must stay the course with a long term view and continue, as they have, to respond to the needs of an evolving market to create a stronger ecosystem that will position them to be even more competitive on a global level.  This must encompass business model innovation, technology and architecture enablement, as well as cultural evolution to align with the new realities imposed by the tremendous uptick in the FinTech space,” says Diane Kazarian, National Financial Services Leader, PwC Canada. 

The report also indicates that Canadian banks continued to see strong performance in 2015, achieving positive revenue growth and posting solid returns. In addition, they improved their 2016 first quarter results over last year despite a slowing economy, slumping commodity prices and low economic growth.

Although there is great potential in the Ontario region, there is no true fintech ecosystem and various factors are inhibiting its development—and this comes at a cost to the region’s overall economic growth.

The Innovation Policy Lab at the University of Toronto’s Munk School of Global Affairs recently released a report on the region’s financial services technology sector and its impact on the region’s future economic success, which carries this sentiment.

The report, which was commissioned by the Toronto Financial Services Alliance, states that, despite having the necessary components, the lack of strong connections between Fintech firms and financial institutions is undermining our ability to create an effective ecosystem to drive economic growth.

Professors Dan Breznitz and David A. Wolfe, Co-Directors of the Innovation Policy Lab at the University of Toronto’s Munk School of Global Affairs, with support from Assistant Professor Shiri Breznitz, undertook a strategic mapping study of the key Fintech players, resources and innovation assets in the Toronto region.

“We have most of the right ingredients, but we are operating far below our real potential,” said Breznitz. “Our study revealed that on a global basis, Toronto’s Fintech growth is falling behind in comparison to other cities that have established hubs, such as New York and London.”

While progress is being made, the report says Canadian financial institutions do not act as true partners to Fintech startups to the same extent that other leading global centres do – where relationships do exist they tend to be located at the margins of the financial institutions’ main operations, in incubators or accelerators.

A critical element that is missing in Toronto is the presence of large, inexpensive incubator centres within the financial district, offering basic services with high connectivity at highly discounted rates, suggests the report. And although the federal and provincial governments have made efforts to increase the supply of seed and early venture capital to start-ups, there is still a shortage – a more direct approach through grants or conditionally repayable loans should be considered as policy reform by government.

“Both Fintech innovators and what we have defined as the ‘traditional’ financial companies are both essential to our growth and prosperity,” said Janet Ecker, President and CEO of the Toronto Financial Services Alliance. “The benefit of collaboration between these two groups is that financial companies have large existing customer bases that the Fintech community can leverage and cross-sell to, and the Fintech start-ups tend to have effective and significantly lower customer acquisition costs that can help financial companies.”