US fintech regulation: a divided picture at the federal level
Hogan Lovells’ partner Aaron Cutler and associate Loyal Horsley address the views of the Department of Treasury, the CFPB, and the SEC on the regulation of the fintech industry in the US.
This is the second in a series of three articles discussing the regulation of the fintech industry in the US. Click here to read the first article, which provides an overview of the current fintech regulation by the prudential regulators: the OCC, the FDIC, and the Federal Reserve.
While the prudential regulators are testing the waters in fintech regulation, other federal agencies have also focused on fintech’s potential, both as a disruptor and as a potential market infrastructure tool. Marketplace lending has been a topic of regulatory and industry conversation for the last several years.
Currently, marketplace lending is attempting to fill gaps still left in credit availability after the financial crisis, especially in small dollar small business loans. In this case, small dollar means $250,000 or less. Community banks have generally provided the lion’s share of small business and agriculture loans in the US, but the financial crisis and the response to it both eliminated many community banks and created a credit crunch. Marketplace lenders have stepped up to fill in the resulting gaps for both small business and personal loans. While the first generation of marketplace lenders tended to be distinct, separate entities, many are now partnering with banks. Marketplace lenders are not the only ones: money transmitters are exploring bank partnerships in order to avoid costly and time consuming fifty state licensing solutions.
The Department of Treasury oversees the entire US financial system and economy and is a guiding force when it comes to regulatory scrutiny.
The Securities and Exchange Commission (SEC) regulates the primary and secondary markets of the US and safeguards consumers in that space. A recent expansion of the rules on raising capital online, as well as the entry of new players, such as online marketplace lenders, in the mortgage securitisation space has implicated the SEC’s involvement in fintech, which will likely only grow as fintech expands its footprint.
The Consumer Financial Protection Bureau (CFPB) regulates consumer financial products and services, which covers most of fintech’s new and exciting tools. The CFPB has direct supervision over financial institutions with $10 billion or more in total assets. Each agency has taken an interest in the growing role fintech is playing in the U.S. and international financial systems.
Treasury takes notice
In May 2016, Treasury released a white paper entitled “Opportunities and Challenges in Online Marketplace Lending” and has sent representatives to speak at several conferences on the topic of marketplace lending. The white paper was drafted as a follow-up to Treasury’s request for information (RFI), “Public Input on Expanding Access to Credit through Online Marketplace Lending”, which was issued in July 2015.
Treasury received about 100 responses to its RFI and the white paper is generally positive about the potential for online marketplace lending to expand access to credit. Treasury offers its view of the RFI responses and provides some advice and recommendations for moving forward in this space. It found that online marketplace lending has expanded access to credit, especially small businesses, though the majority of the loans originated were for consolidating debt. The expansion of data used for underwriting was one of the more exciting innovations by online lenders and is being adopted by a larger segment of the financial services industry. However, these “data-driven algorithms” do not provide the borrower the opportunity to correct information and they may result in fair lending violations and disparate impacts. It’s really too early to determine the impact, but the expansion of data and modeling are an area on which Treasury will continue to focus. In addition, online marketplace lending has emerged in the low cost of credit environment during the Obama years; these lenders have not been properly tested during a higher cost of capital environment.
Small business’ access to credit has been a big focus in the last few years. Many RFI responders drew attention to the relative lack of financial protection for small businesses. The Obama years have seen an immense focus (at both legislative and regulatory levels) on consumer protection, exemplified by the creation and expansive authority of the CFPB (which will likely be narrowed by Congress and the Trump Administration).
However, small businesses do not enjoy the same level of oversight and protection. Clearly, small businesses do not uniformly want increased regulatory oversight, but offering enhanced protections for small businesses in terms of consumer-like disclosure and reporting obligations were generally favored by the commenters. Some consumer advocates argued that small businesses should be treated as consumers for lending purposes. Considering people often have different definitions for what constitutes a small business, this treatment seems rife with potential misuse and unlikely to survive legislative or regulatory muster.
Finally, the white paper reviews the secondary market for loans originated by online marketplace lenders. Securitization of these loans is not well developed at the moment and will require further regulatory guidance. The SEC is reviewing the implications of online marketplace lenders selling loans into the secondary market.
Fintech in the markets
The SEC is also getting into the game on fintech. It has established a Distributed Ledger Technology (DLT) Working Group to investigate the new technology and its potential uses and abuses. Further, the SEC is looking at the growing field of crowdfunding, both its Regulation Crowdfunding equity crowdfunding model and others, including debt crowdfunding. In addition, the marketplace lending market, especially securitisation of loans, is of particular interest to the SEC.
Acting Chairman Piwowar is especially interested in promoting fintech and the SEC’s role as regulator and ally to the growing industry; he championed the SEC’s Fintech Forum, which was held in November 2016. The Fintech Forum reviewed robo-advisors, DLT, new paths for capital formation, and investor protection. Robo (or digital) advisors are increasingly common and are often used by individuals with smaller investments who either cannot afford an investment advisor or would like to supplement that advice. Digital advisors’ assets under management are projected to reach $2.2 trillion by 2020.
The panel participants stated their view of the future is that this becomes just “investment advice” rather than “digital investment advice” as humans would lean on algorithms and computing power to give investment advice anyway. The future of investment advice does not appear to be solely computer-based, but will certainly be an intricate blend of algorithmic and experienced-based advice, which would likely trigger the Investment Advisers Act of 1940’s provisions requiring registration (Section 203) and compliance with a fiduciary standard (Section 206, as understood by the Supreme Court in SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963)).
Capital formation for small(er) businesses was an ongoing preoccupation for the Obama administration and the Republican Congress, which signed the bipartisan JOBS Act in 2012. One of the most exciting provisions of the JOBS Act was the advent of SEC-regulated equity crowdfunding, which allows businesses to offer securities over the internet. Its main utility is for small businesses, since it limits offerors to raising $1 million per year. This is an example of simple fintech: a tool providing a new route to capital for small businesses that would not be able to conduct an IPO or have access to venture capital. Regulation Crowdfunding, 17 C.F.R. § 227.100 et seq., became effective 16 May 2016 and has so far been a great success, according to the SEC.
Blockchain/DLT is one of the only truly new innovations and its use for traditional financial services, as well as other industries, is still being discussed. However, some organisations are forging ahead with its use. For instance, Sydney Stock Exchange has revamped its settlement system, and so has its larger competitor Australian Securities Exchange (ASX), which is expected to start using blockchain later this year. Both stock exchanges believe the new technology will drive down costs, increase efficiency and transparency, and decrease risk.
One of Switzerland’s largest market infrastructure providers, SIX Securities Services is currently working on a proof-of-concept (PoC) to integrate blockchain into the Swiss financial system.
In the US, Cook County, Illinois, is currently running a pilot program to use blockchain to transfer and track property titles and other public records. The Cook County Recorder’s Office is the second largest in the US, so the adoption and success of a DLT system there would likely encourage other states and counties to use the technology.
On top of DLT, the advent of “smart contracts” has the ability to change payments drastically. A smart contract is an autonomous program that directs money without human interference according to an algorithm. An example: if an investor is willing to provide funding to a start-up, but only if they reach a certain capital threshold; they can execute a smart contract that will automatically go into effect upon the start-up reaching that threshold. The parties will not need to discuss it further or provide any instructions after the original agreement.
This sort of tool could simplify complex payment agreements in many spheres. For example, in a farmer’s drought insurance agreement, the parties could agree that after 15 days of zero rain, as recorded by the National Weather Service in the farmer’s zip code, the insurance company would make a certain payout without the farmer having to make a claim.
DLT and smart contracts are also being discussed in the healthcare industry, as a way to keep up with patient records. In both the health care and financial services sector, the biggest potential issues are privacy and security, which must be adequately addressed before DLT can be used for mass market record-keeping.
The CFPB, fintech and the future
The CFPB has been among the most active agencies in engaging the fintech industry. Because so much of financial innovation does not fit within the bailiwick of “banking” or even the broader “business of banking”, but is certainly a consumer financial product or service, the CFPB is the relevant federal agency. In this role, it has undertaken “Project Catalyst,” which encourages “consumer-friendly innovation in markets for consumer financial products and services”.
One of its major “outreach” efforts is the new no-action letter policy, which encourages fintech companies to reach out to the CFPB by providing information regarding their product or service and their understanding of the compliance requirements. By providing a no-action letter, the CFPB is indicating it believes the company is in compliance with the relevant laws and regulations and the CFPB is not going to file an enforcement action so long as the company does not make material changes.
While the CFPB’s policy is quite friendly, its no-action letters are not binding on other agencies, so that leaves a fintech company vulnerable to the determination, by another regulator, that it is not in compliance with all relevant laws and regulations. This is obviously true of any agency’s no-action letter, but considering most of the federal financial regulators are having trouble deciding what to do with fintech, many companies may decide not to take the chance of relying on the CFPB’s say-so. Again though, regulating by No-Action Letter is much less desirable than actually going through the Administrative Procedure Act-mandated rulemaking process.
The CFPB did recently release its long awaited Prepaid Card Rule, which provides a very broad definition of “prepaid card” that encompasses mobile wallets, like Google Wallet and Paypal, where you can not only send money, but also store it. Money transmission is moving money from one place/person to another, and while Paypal and Venmo provide that service, they also allow users to keep money in the app rather than transfer it to their bank account. This service places them within the scope of the CFPB’s new rule.
Mobile wallets are one of the more exciting and popular recent innovations, splitting the bill at dinner or having multiple friends purchase a present has never been easier now that everyone can transfer funds quickly and for free. Considering their popularity, the CFPB likely felt compelled to provide consumer protections where there may be a need, but this sort of rule could cut down on start-ups entering this space as they would have to hire experts and attorneys to ensure compliance and avoid potential enforcement actions.
The CFPB is likely the most vulnerable agency in a Trump government. Its broad mandate and limited congressional oversight has made it a target of Trump and Congressional Republicans. While it is incredibly unlikely the CFPB would actually be dismantled, its structure and leadership will almost certainly change, likely relatively early in President Trump’s term. The Court of Appeals for the D.C. Circuit’s recent decision in PHH Corporation, et al. v. Consumer Financial Protection Bureau found the current structure of the CFPB is unconstitutional.
However, the court provided a simple fix: the president can now remove the Director of the CFPB at will, rather than only for cause. The D.C. Circuit granted an en banc rehearing on 26 February 2017 and oral arguments began in March. Due to the rehearing, the previous order is on hold pending the rehearing. A rollback of current regulations and policies will be difficult to enforce, but the uncertainty may further discourage fintech innovators from working with the CFPB.
States are also involved in regulating fintech and their role may grow if President Trump follows through on his early moves to cut down on federal regulation. Several states, including New York, which is very influential in financial services regulation, have stated their goal of stepping into any federal void created by regulatory rollback. In addition, Congress is focused on both financial regulatory reform, in general, and fintech-specific legislation. The new Congress and President Trump’s terms have barely begun, so their effect on the fintech industry remains to be seen.
Click here to read the third article in the series, which looks at state-level fintech regulation, proposed legislative solutions, and provide a brief overview of international regulation.