Excerpts from speech by Patrick Armstrong, senior risk analysis officer, Innovation and Products Team, Financial Technology: ESMA’s Approach at Luxembourg Fintech Conference, 10 October 2018
The issue of fintech and the regulatory response is a critical topic for both regulators and market participants. The challenge is to identify when the regulator should step in. This is the regulatory ‘tipping point’ — the point between ‘too small to care’ and ‘too large to ignore’. I want to share how ESMA approaches the challenge.
When confronted with a financial innovation, a regulator can roughly take one of three approaches, each of which is in its own way ‘pro-active’ rather than ‘reactive’:
1) Ban or restrict products or processes, in the light of the potential risks (restrictive approach).
2) Take a “wait and see” approach (watchful approach).
3) Actively facilitate and regulate the product or process because of its potential economic and social benefits (facilitative or catalyst approach) and/or because of known threats to our objectives.
On the first approach, this year, we believe a harmful ‘tipping point’ has been reached, with the distribution of ‘contracts for differences’ and binary options. In turn, we acted to restrict leverage on the issuance of contracts for differences and banned the distribution of binary options across the EU.
The second, the ‘wait and see’ approach, is largely the approach that ESMA, like most regulators, has taken towards the DLT. There is a collective need to better understand DLT and its possible applications in the financial market. Now, do not interpret this as a passive approach, but rather one in which we actively try to learn more about the innovation, but do so while it remains sufficiently immature that we are not placing our objectives, stability, protection and integrity, at risk by not taking action.
At the same time, by waiting to see how the innovation develops we do not risk stifling a potentially socially or economically useful product or process. The innovation has not reached a ‘tipping point’ where active regulatory participation is needed.
The third of the three approaches, actively facilitate and regulate the product or process, is an approach we will take when we believe an innovation has matured or become too large to ignore; that is, a tipping point has been reached. An example of this is the work we did in investment-based crowdfunding, where after extensive research we saw the potential for investor protection harm to arise, if the crowdfunding platform operated outside of MiFID rules.
Why have we taken the second of the three approaches to the DLT? We can rule out the first restrictive approach as we do not see the DLT presently posing risk to our three objectives: stability, protection and integrity. While the third, ‘facilitative’ approach has merits, it may reduce regulatory uncertainty around DLT and it may potentially lead to more rapid development in ways that are irresponsible, perhaps in accordance with guidelines established by the regulator. However, if the technology fails to develop as anticipated, the approach could lead market participants to suggest that the regulator acted impetuously.
ESMA will continue to closely monitor market developments around DLT to assess whether a regulatory response may be needed. Meanwhile, regulators must actively engage with market players to ensure both that the technology does not create unintended risks and that its benefits are not hindered by undue obstacles. For their part, we believe that the industry should work towards common solutions to the issues posed by the technology.
As for crypto assets, in November 2017, our Board of Supervisors requested that we analyze how these instruments fit within existing European regulation to determine which are clearly financial instruments and need the attendant regulatory and supervisory oversight. As well, during March 2018, as part of the EC FinTech Action Plan, the EC requested that ESMA analyze the characteristics of crypto assets relative to existing European regulation, whether they were financial instruments, and for those deemed not, whether a separate regulatory regime was needed.
In summation, while we would look forward to ways in which fintech can improve the ways in which the financial system operates, we at the same time are aware that such promises are not without risks. It is the reason that we as regulators must think carefully on how to respond.