Legal threats for budding fintech companies

Financial technology or Fintech companies are taking the financial services sector by storm and are expect to revolutionize the traditional banking system. They have simplified the payment processes and promote financial planning. The growth of fintech companies in recent times has been really remarkable.

A recent report from KPMG showed that between 2013 and 2014, the number of companies reaching billion dollar valuations, termed as "unicorn companies", more than doubled.

"Through mid April, there were 14 new unicorns, putting 2015 on track to surpass 2014", the report said.

However, these start-ups are often confronted with legal hurdles. Larry Downes has discussed these threads in an article published on Washington Post.

1. Regulatory burdens becoming regulatory barriers ­

Traditional financial services companies I work with regularly complain about start-ups who don't have to play by the same rules. But as we've seen in industries as different as transportation (Uber) and hospitality (Airbnb), it's a short step from envying the start-ups to applying pressure on the regulators to throw the book at them - even when doing so kills innovation consumers want.  Banking incumbents have likewise become adept at turning regulations that slow their own innovation into effective barriers blocking fintech startups from launching new products and services. 

2. Lack of global standards

One of the great benefits of virtual financial services firms, is that they can efficiently tap a global market of like-minded individuals willing and able to provide financial support to companies and individuals who are otherwise shut out of the capital markets because of their small size or non-traditional risk profile. But up until now laws regulating lending practices have remained both fiercely local and bizarrely complex, reflecting historic and religious skepticism about the practice of moneylending. Until banking regulations are rationalized across borders, local lenders will maintain a distinct and unearned advantage.

3. Square regulation, round innovation

Banking regulators who haven't seen significant change in the industries they oversee since the Great Depression can also be blindsided by fintech innovation, pushing them to mechanically apply square regulations to round disruptors.  In 2008, for example, the SEC issued cease-and-desist letters to both Prosper and Lending Tree, claiming the peer-to-peer loans the companies were issuing were really unregistered securities, as the lenders expected to earn a profit "in the form of interest, which is at a rate generally higher than that available from depository accounts at financial institutions."  Both companies struggled to redesign their business to suit the regulators, nearly wiping out Prosper along the way. Partly in response, the SEC was tasked by Congress in 2012 with developing streamlined rules for investment-oriented crowdfunding-rules that were finally approved only a few months ago.

4. Government monopolies on currency

Much of the financial system has already migrated to all-electronic formats, but the production of cash stubbornly remains a government monopoly in much of the world. Now, Bitcoin and other digital currencies are testing the possibility of financial exchanges based on new forms of trust. Already, governments and industry trade associations have attacked crypto-currencies, sowing the seeds of doubt among users that could undermine their future growth and development.  If digital currencies fail, it won't be from a lack of innovation.

5. Technology challenging the need for traditional regulators at all

As we've seen since the early days of buyer-seller rating systems on eBay, Amazon, and other e-commerce platforms, one of the things that makes disruptive technologies so unsettling is that they not only break down conventional wisdom about how industries are organized but also how they are most effectively regulated. The banking system - incumbent and emerging - clearly needs strong oversight, but there's no reason to believe that regulation will always have to come from physical governments, which are slow to change, easily corrupted, and inefficient.

Self-regulation by fintech companies may prove the better approach, but even more promising is the emergence of rating systems built into new lending, banking, and investment platforms that empower consumers to do a lot of the policing themselves for each other's benefit.

Navigating these roiling legal waters is, in some sense, the true core competence of the incumbent financial services companies - at the very least the one that continues to buy them time to come up with their own innovations or swoop in and acquire the disruptors at pre-IPO prices. But while decidedly favoring the incumbents today, fintech innovators may find ways to reverse growing regulatory barriers and turn them to their own advantage.