Federal policy-makers studying the barriers to competition that financial technology (fintech) firms face have found the same long-standing obstacles that impair competition among traditional financial services firms.
In early November, the federal Competition Bureau released a draft report on its fintech market study, launched in May 2016, for a brief, two-week comment period that ended Nov. 20. The Competition Bureau anticipates it will issue its final report and recommendations by yearend. Specifically, the final report will provide input to regulators on how to encourage innovation and competition in the financial services sector without sacrificing consumer protection.
The draft report focuses on three main areas - investment advice; equity crowdfunding and peer-to-peer lending; and retail payments. The study found that barriers to entry for fintech firms include securities regulations, anti-money laundering rules, payment regulations and other laws, such as privacy rules.
In the investment advice business, the major impediments to competition for fintech firms include long-standing problems that hinder competition in the advice business overall, including poor price transparency, the high cost to investors when switching firms and an underlying lack of financial literacy among investors.
These issues impact fintech firms and traditional financial advisory firms in similar ways. For example, the draft report points to the lack of transparency caused by the prevalence of embedded commissions for mutual funds as a key concern.
"Retail investors often find themselves without the ability to compare the cost of advice accurately, as embedded commissions are not readily determined from mutual fund marketing materials," the report states. "The lack of transparency into mutual fund commissions makes it difficult to comparison-shop for financial advice, reducing the effectiveness of competing [financial] advisors."
The use of embedded commissions also poses other problems for investors, the report notes, pointing out that advisors may have incentives to recommend proprietary mutual funds or mutual funds offering higher commissions: "The investor ends up paying more (and saving less) than in a competitive market with price transparency and faces a product selection that is limited to a subset of what is actually available."
The draft report also states that low levels of financial literacy impair competition because investors may not be equipped to understand the impact of fees on their portfolios or to compare service offerings among competing firms.
The draft report lauds regulators' efforts to enhance disclosure, particularly through the second phase of the client relationship model (CRM2) reforms. However, it also warns that disclosure may not be enough to foster competition, which is due to many investors' weak understanding of financial matters: "If Canadians lack the financial literacy to understand the impact of lower fees on their overall savings and investment growth, increased disclosure alone may not be sufficient to encourage them to shop around for advice."
In addition, the draft report points out: "Surveys have shown that Canadians have low levels of financial literacy when it comes to investments and how they work."
Another key barrier to competition is the cost and inconvenience for investors when switching firms, the draft report states. In a related matter, the report notes that some robo-advisors have stated that they find that completing account transfers can take a month and that traditional firms charge fees for the process, which can act as a deterrent to investors who contemplate switching firms.
In addition, the report states, some traditional firms require hard-copy signatures on their paperwork although regulators have approved electronic delivery and signatures. Although the benefits of potentially saving thousands of dollars in excess fees would outweigh the cost and hassle of switching firms, the report notes that low levels of financial literacy could undermine these calculations by investors.
The draft report also identifies barriers to competition that can be attributed to regulation. But these apply equally to all firms, either as a result of the prevailing regulatory structure or because the regulators have established rules designed to provide investor protection at the expense of industry efficiency.
For example, the draft report points out that Canada's fragmented regulatory system is an impediment to competition for fintech firms. In addition, requirements such as suitability, "know your client" (KYC) and "know your product" rules also may prevent fintech firms from operating as efficiently as they'd like. (These issues aren't specific to fintech firms. Many traditional firms also would like to see a more uniform regulatory structure and less onerous suitability requirements).
The draft report makes several recommendations to address these barriers to competition. Specifically, it recommends that regulators give firms more freedom to automate the KYC and suitability analysis processes. As well, regulators should encourage the use of technology to facilitate switching firms by investors.
Still, some of the draft report's recommendations are more universal, such as requiring better upfront fee disclosure and encouraging more comparison shopping by investors.
A submission from the Canadian Foundation for Advancement of Investor Rights (a.k.a. FAIR Canada) in response to the draft report calls on the Competition Bureau to work with regulators to ensure "investors are served by an investment industry that has effective competition."
In particular, FAIR Canada endorses the Competition Bureau's proposals to facilitate more comparison shopping by investors and make switching firms easier. However, FAIR Canada's submission also calls for higher conduct standards for all firms and suggests that regulators could be using tech better to improve investor protection.
FAIR Canada's submission cautions against assuming that tech-driven innovation is necessarily good for consumers and for competition: "The benefits of fintech should never be assumed and should always be encouraged with an eye to ensuring fair and efficient markets and adequate investor protection."
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