European Union : Speech by Patrick Armstrong - FinTech, Oslo Børs ASA Conference, 18 January 2017

Date: 23 January 2017 ESMA71-844457584-330

Financial Technology: Applications within the Securities Sector Oslo Børs ASA: Stock exchange and Securities Conference 18 January 2017

Patrick Armstrong

Senior Risk Analysis Officer, Innovation and Products Team

Ladies and gentlemen,

It is both an honour and a great pleasure to be here today to speak at the Oslo Børs ASA: Stock exchange and Securities Conference.

Let me start by thanking the Oslo Børs for hosting us today and for having invited me to participate. The issue of FinTech and the regulatory response is a critical topic for both regulators and market participants. The challenge is what I call a regulatory 'tipping point' when does the regulator step in --- the point between 'too small to care' and 'too large to ignore'.

In my remarks today, I will present to you a regulatory perspective on the opportunities and the challenges arising from financial technology and the securities sector. Allow me to add that the topics of technology and regulations are especially relevant, as most academic literature on the topic of financial innovation places them as the primary drivers of innovation.

ESMA Mission

As you know, ESMA's focus is on European securities markets and it has as its primary objective to promote investor protection, orderly markets and financial stability. It achieves this by assessing risks to investors, markets and financial stability, completing a single rulebook for EU financial markets, promoting supervisory convergence and directly supervising credit rating agencies and trade repositories. And specifically in terms of innovation, ESMA is in charge of ensuring a coordinated approach to the regulatory and supervisory treatment of new or innovative financial activities in the securities markets.

What do we mean when we say financial innovation? ('...the act of creating and distributing new financial instruments, processes, business models and markets, including the new application of existing ideas in a different market context.'). We view Financial Technology or 'FinTech' as a subset of financial innovation, and define it as a type of financial innovation that

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relies on Information Technology to function, e.g. internet, cloud etc. and that can result in new business models, applications, processes, products, or services with an associated effect on financial markets and institutions and the provisions of financial services. Let us next discuss ESMA's approach to monitoring Financial Innovation.

Approach to Monitoring Financial Innovation

ESMA has put in place a framework within which the analysis of financial innovation can best take place. The framework provides a principles-based approach to the work both in terms of the range of innovation we track as well as the tools we employ. In designing the framework, we have been guided by the three core objectives of ESMA --- investor protection, financial stability and orderly markets. The ESMA objectives serve to ground the analysis of financial innovation. We bring to the subject a balanced approach, both protective and supportive.

Let us now turn our attention to FinTech.

Drivers of FinTech Innovation

We have observed that while we are now witnessing a virtual torrent of technological innovations coming to market, why has the FinTech phenomena occurred only now when compared to non-financial sectors some of which were borne over 20 years ago? If we look to commerce, we know the way in which goods and services are traded has been permanently transformed by the like of Amazon (founded in 1994); peer to peer merchandise trading such as EBay (founded in 1995); and more recently Airbnb (founded in 2008) and Uber (founded in 2009),

So what are some of the factors driving today's post-financial crisis FinTech revolution. Let us break them down by supply factors and demand factors. Supply factors are those that lead innovators to offer a new product or service, and demand factors are those that lead customers to use the innovation.

On the supply side. First, there has been a sharp increase in power of technological capabilities and an attendant decrease in costs. We see this in the increased ability to process large volumes of data combined with a sharp fall in hardware, software and storage costs.

Second, is a phenomenon that we refer to as the 'innovation spiral', where multiple new products or services may spring from a single innovation, which itself may or may not have been successful. For example, we see this in the way smart phones are transforming the way in which certain financial services are transacted --- payments, budgeting and investments. As we said, often times the original innovations are failures, but some derivative of the original spawns' successful innovations. The potential for the distributed ledger technology to change the way in which we transact, borne out of the largely discredited bit coins, is one such example.

Third, the withdrawal of traditional financial firms from some markets has opened the door to new entrants. Often these entrants arrive with novel ways of providing a service that legacy

providers may have overlooked. Those entrants employ new technology to scale up quickly. They often come unburdened by regulatory incumbency, compliance costs, capital requirements and legacy systems. Some point to the retreat of many traditional banks from certain riskier lending activities owing to capital requirements as the window that has allowed online market place lenders to occupy that space.

On the demand side. First, trust, post-financial crisis there has been a notable decline in trust in traditional institutions, i.e., banks. Previously this 'trust' factor had been a barrier to entry for new entrants to financial services. As a result, consumers may now be more willing to use the services of new market entrants, and crucially they may now be willing to use 'a la carte' specialist providers of some services, such as payment services and savings products, that formerly were offered by a single bank.

Second, heightened expectations, the spread of internet access and the real-time transacting capability of users of internet-connected devices provide an enhanced customer experience. This experience has given rise to higher customer expectations with regard to convenience, speed, cost and user-friendliness of financial services, which has in turn become one of the most important factors in consumer purchasing decisions. Furthermore, as consumers become increasingly accustomed to using internet-connected devices to undertake financial transactions, they may become more willing to use newer Fintech financial services providers.

Third, a related factor, are demographic factors driving demand. Today, the IPhone 6 has infinitely greater speed, processing power and memory than did the Apollo Guidance Computer that powered the first astronauts to the moon. As a result, generation Z are what we call 'digital natives' and have a very different relationship with, and expectation of, technology from the generations before it.

Regulatory Challenges

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.

The first, banning, is a power that ESMA and the MSs will have once MiFID II/MiFIR becomes effective on 1 January 2018. Until then, if we believe a harmful 'tipping point' has been reached, we can take measures such as issuing warnings as we have done against 'contracts for differences' in 2013, and reinforced this past year, or the Statement we issued in 2014 on the risks to investing in Contingent Convertibles, in which we outlined that these instruments should only be purchased by sophisticated investors and are not appropriate for retail.

The second, the 'wait and see' approach as I will make clear later, is largely the approach that ESMA, like most regulators, have 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. We also recognized that there existed both EU-wide regulation and local regulation that were potentially serving to inhibit the growth of crowdfunding. Our action was to draft an Opinion to the 28 National Competent Authorities on how they should consider supervising crowd funding; and Advice to the European Institutions (Parliament, Council and the Commission) on how they should consider regulating crowd funding.

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 regulator. However, if the technology fails to develop as anticipated, the approach could lead market participants to suggest that the Regulator acted impetuously.

In turn, I would like to discuss three topics each of which relates to the securities industry: --- Robo Advice, Artificial Intelligence/Big Data; and the Distributed Ledger Technology.

RoboAdvice

'Robo advice' also known as automated advice is of interest to us as regulators across the financial sectors. In December 2015, the Joint Committee of the three European Supervisory Authorities launched a Discussion Paper on the topic of automation in financial advice, which explained the concept of automated advice and highlighted the potential benefits and risks to consumers and to financial institutions. The aim of the document was to assess what, if any,