Law in Quebec

It began with little fanfare when Maureen Jensen, the first woman to be nominated as chair and chief executive officer of the Ontario Securities Commission, announced plans in late September to create the first innovation hub by a Canadian securities regulator to help financial technology companies navigate its regulatory framework. “We will work to tailor regulation and oversight to their unique business model, as long as investor protections are in place,” Jensen told the audience at the Toronto Region Board of Trade. The following day the OSC was at it again, and granted a Canadian fintech company regulatory approval to become the first online lender in the country to receive an exempt market dealer license for marketplace lending. On the same day there was more blunt confirmation that digital disruption was beginning to gain traction. The Laurentian Bank of Canada took the unusual step of closing its branches in and around Montreal for most of the day to allow staff attend a meeting to hear president and CEO François Desjardins deliver harsh news. The traditional banking model, he said, was becoming “obsolete.” The financial institution had little choice then but to shut down a third of its branches, and with it 300 positions, as growing droves of consumers were forsaking bank tellers in favour of smartphones.

It may be early days in Canada for fintechs, a catchphrase for new innovative financial technology start-ups and major technology companies that are challenging traditional financial institutions on their turf by offering cheaper and easier-to-use Internet or smartphone based services like payment apps or peer-to-peer lending or digital currencies, but Canada’s Big Six banks are paying heed even though they appear to be on solid ground. Canadian banks have strong brand recognition and higher levels of consumer satisfaction compared to other markets, in part because it was largely spared by the 2008 financial crisis. In other parts of the world, notably in the United States and the United Kingdom, the crisis gravely undermined public faith in financial institutions. Indeed some observers believe that the crisis – and the huge loss of talent pool in financial services that accompanied it – spawned in many ways the roots of the fintech movement. “As a result from pressures from the financial crisis, there was more of an impetus to innovate in some jurisdictions,” says Ana Badour, a Toronto financial services lawyer with McCarthy Tétrault LLP. “Our financial institutions fared well so there was less direct pressure to innovate outside of the institution.”

Canadian banks are still doing well, generating strong revenues and posting solid returns despite low economic growth, sagging commodity prices and a relentless slump in the energy sector. Consolidated revenues for the Big Six banks stood at $21.4 billion in 2015, up 4.3% from $20.5 billion in 2014. Average return on equity however dipped to 15.6% from 16.6% the year before. Spurred by the crawling economy, Canadian banks have restructured some operations to increase efficiencies, streamlined their cost base and “become fitter, faster organizations,” noted a report on fintechs by the advisory firm PwC Canada.

Yet there is an inescapable sense that a transformation in the way that consumers access financial products and services is underway. Canada’s fintech sector is relatively new and small, with some 100 companies, but holds promise. The ecosystem, the majority of which is clustered in Toronto-Waterloo, Vancouver and to a lesser extent in Montreal, is home to a thriving technology start-up culture that is buttressed by labs, incubators and accelerators. Public awareness in Canada over the existence of fintech offerings, while subdued, is expected to grow thanks in part to changing demographics. Millennials, now the largest generation in the Canadian workforce, are digital natives, and expect nothing less than seamless mobile solutions across all industry segments, including financial services.

“What we’re seeing is a demographic shift where younger consumers are not necessarily going into a branch to do their banking but are very comfortable trying financial services that are purely digital, off their desktop or on their mobile phone, so it’s really changing the customer engagement model,” says Salim Teja, executive vice-president of ventures for the Toronto-based innovation hub MaRS Discovery District. But it’s not just millennials who are open to financial service alternatives.

A survey by the advisory firm EY predicts that Canadian adoption rates of financial services developed by financial technology firms could triple from 8.2% to 24.1% in the space of a year, across all age groups and income levels. “Customers are more demanding than in the past,” Carolyn Wilkins, senior deputy governor of the Bank of Canada, said in a speech. “They are looking for more convenient and cheaper access to financial services that are well integrated with the rest of their online activities.”

Under strain

The technology revolution, driven by digitization, the ubiquitousness of mobile devices, cheap data processing, analytics and the cloud, is poised to do just that. What’s more it has created opportunities that threaten to erode a business model that served banks well over the years. The days when banks could service all of a client’s needs, be it financing, investing or transactions, is in peril. While few, if any, of the new players are interested in the business of taking deposits, some sectors of retail banking such as consumer finance, mortgages, lending to small and medium-size business, retail payments and wealth management, are ripe for the taking, and are precisely the segments that the majority of fintechs are targeting. By promising to lower costs, improve service and broadening access, the technology-led companies are counting on seducing growing numbers of consumers and chip away at the customer base incumbents worked hard to maintain.

A case in point is Mogo Finance Technology Inc., an online lender based in Vancouver. It has a new mobile app that allows one to sign up for an account in under three minutes, provides a free credit score, a free prepaid card and takes an “instant” decision on a personal loan using algorithms, IP addresses and links to social media. But it’s not only the upstarts that are trying to shake up the financial services industry. Technology giants such as Apple, Google, and Samsung too are new players in the market, and they boast innovation know-how as well as something that Canadian banks have – deep pockets, powerful brands and trust – that can be used to make inroads into banks’ traditional bastion.

“Fintechs are not changing the underlying products and services that consumers receive,” says John Jason, a financial services lawyer specializing in regulatory law at Cassels Brock & Blackwell LLP in Toronto. “But what we are seeing now is this cadre of individuals developing technology outside of the banks to the extent that you don’t need a financial institution to provide a product – that’s the big change.”

That big change could potentially undercut the bottom line of incumbents. According to a report by McKinsey & Co, globally banks could lose from 10% to 40% of revenues by 2025, and up to 60% of their profits in the consumer finance segment, as new competitors either poach market share or drive down prices. It’s no wonder then that these new companies have caught the attention of the investment community, even though they have yet to be tested by the rigours of a serious downturn in the economy. In 2014 investment from private capital in fintech companies amounted to US$12.21 billion, an increase of 201% compared to 2013, according to a joint report by the Digital Finance Institute and McCarthy Tétrault. In 2015, fintech investment surged by 75% to US22.3 billion, with 1,100 fintech deals announced. More of the same is expected this year.

Not that banks are technological luddites. Far from it. Banks are, and always have been, investing in innovation in financial technology. Canada’s banks introduced to Canadians the Interac system, Moneris payments processing, email money transfers as well as web and mobile banking. “They are very sophisticated technology customers, always on the cutting edge, and they certainly watch what’s happening in the marketplace in terms of innovations,” says Christine Ing, the co-practice group leader of information technology (IT) at Blake, Cassels & Graydon LLP in Toronto. They’re big spenders too. In 2015, banks in North America spent US$62.2 billion on external IT, a figure expected to increase to US$64.8 billion by year-end, said the Digital Finance Institute report.

But banks face obstacles that smaller and more deft upstarts do not. They are big, encumbered by large governance structures, costly infrastructure, competing interests, and a lower risk appetite. “Fintechs frankly want to be nimble and not have a governance structure that slows down the decision-making process,” notes Kashif Zaman, a Toronto financial services lawyer with Osler, Hoskin & Harcourt LLP. “That is something that sets them apart from big institutions who for good reason are a lot more prudent about engaging in certain types of activities.” Some banks risk losing even more ground because they are relatively inefficient and are weighed down by supporting systems that date back several decades, often not even interoperable within the confines of their institution, a situation that would make fintechs recoil in horror. “It’s about understanding what customers want and whether the banks have the skills and technology to get there,” highlights a recent PwC report. “If not, they should look to partner or collaborate with fintech disruptors.”

If you can’t beat them…

Canada’s Big Six banks have heeded the advice. The dynamics between banks and financial technology companies shifted particularly over the past year, and Canadian banks begun to employ parallel strategies, collaborating with and leveraging some fintechs while innovating to compete with others. The Canadian Imperial Bank of Commerce for instance entered a partnership to create a corporate innovate hub at MaRS, and then teamed up with online small business lender Thinking Capital in a referral partnership. Scotiabank also jumped into the fray with an investment in Kabbage, a U.S.-based online small business lender. “In the longer term there is definitely a view that there needs to be cooperation in working together in a space, and that fintechs have a lot to offer to banks, and that both will benefit from working together and playing off each other’s strengths,” explains Badour.

When banks do collaborate with fintechs it usually starts off with a development and proof of concept, a stage when intellectual property licensing issues almost always surfaces, says Ing. If negotiations are fruitful, a commercialization agreement is drafted where the parties identify who’s doing what and what role and responsibilities the actors have, adds Ing. “Commercial agreements are very interesting because the business models are shifting as well so we have to pay attention to find out what the new normal is,” says Ing. Protecting then intellectual property rights and filing patents has never been more important for Canadian financial institutions who historically have taken a rather lackadaisical view towards protecting their innovations. Interestingly, the legal landscape for fintech patents is currently more favourable in Canada than in the U.S. in the wake of the Alice and Mayo decisions by the U.S. Supreme Court. In its 2012 decision in Mayo Collaborative Services v. Prometheus Laboratories, Inc., the U.S. Supreme Court unanimously held that a particular medical diagnostic process claimed was ineligible for patent protection. More recently still in 2014, in a closely watched case that clarified standards for awarding patents, the U.S. Supreme Court established in Alice Corp. v. CLS Bank International a two-step approach in order to test whether an invention is eligible for patent protection.

But even then, Canadian patent offices and the courts have struggled to establish clear lines on what is and what is not patentable, says Giuseppina D’Agostino, law professor and founder and director of IP Osgoode. While the Federal Court of Appeal held that the Amazon.com “one-click” buy interface feature was a patentable subject matter, the Patent Appeal Board of Canada found several investor tools to be patent ineligible. Guidance provided by the Canadian patent office has not helped matters either. “The law and the guidance are not clear so it’s a challenge,” says D’Agostino.

Regulatory uncertainty

Also opaque is the regulatory landscape for fintechs. Fintech, more so than many industries, is greatly influenced by the legal regime and therefore the laws and regulations will have a “significant impact” on the development of Canadian fintech, says Genevieve Pinto, a Vancouver business lawyer with McCarthy Tétrault LLP. At present technology upstarts do not deal with the same regulatory constraints as banks, a sore spot for some like Toronto-Dominion Bank chief executive Bharat Masrani who called on policymakers to level the playing field and regulate fintechs. Banks must play by the rules laid out by the Bank Act, which regulates prudential matters, including activities of financial institutions, corporate governance and ownership. Banks also have to answer to the Office of the Superintendent of Financial Institutions (OSFI), a widely-respected banking watchdog that issues guidelines and supervises and regulates federal financial institutions with a firm hand. The regulatory framework that governs banks yields certainty but can also make it challenging for banks to be agile and innovative, note financial services experts.

It would however be a misnomer to believe that fintechs operate in the Wild West, free of any regulatory checks. While it’s true that the business models and financing methods of some fintechs like Mogo, Vancouver-based Grow and Toronto-based Borrowell are not examined by OSFI even though they lend money to Canadians, they nevertheless have a panoply of regulations they must adhere to. Canada’s overlapping levels of regulation between the federal government and provincial governments, with different regulatory bodies responsible for different elements of the financial system, be it financial, securities, consumer protection and privacy, is bewilderingly complicated to navigate.

“One of the challenges any business has, and more so with fintechs who have a smaller budget to allocate to compliance, is the nature of provincial regulations across Canada,” says Zaman. Fintechs in short are regulated depending on their line of business, says Badour. Fintechs in the payment space would have to comply with federal anti-money laundering legislation as well as provincial consumer protection and privacy legislation while securities legislation would cover business models such as online advising, peer-to-peer lending, crowdfunding platforms and angel investor organizations. Figuring out what laws apply to what products is almost always a time-consuming headache, says Lisa Skakun, chief legal and administrator at Mogo. “It’s a lot of regulators,” adds Skakun. “It’s a lot of legislation. Each province can have nuanced legislation, with different requirements. It hampers the speed of growth because it takes to time to understand each province’s legislation. For companies without legal departments it is a challenge to fully research, maintain and be compliant. It’s definitely a barrier to entry.”

Regulatory uncertainty also does not help, and can actually impede innovation in the early stages due to higher risks and increased costs. Marketplace lenders for instance might be covered by provincial securities laws though no one is certain. That’s the conundrum that nanoPay, an early-stage fintech company that provides loyalty and payment solutions for retail and ecommerce merchants, too faces. The Toronto-based upstart, which last December acquired MintChip, a digital currency product developed by the Royal Canadian Mint, lies in between the cracks of the regulatory system, says Tracy Molino, nanoPay’s general counsel and chief compliance officer. It’s a confounding  situation because the Parliament of Canada approved the world’s first national law on digital currencies more than two years ago but it has yet to be enacted. When the rules come into force entities involved with digital currencies will have to register with Canada’s financial intelligence unit, the Financial Transactions and Reports Analysis Centre of Canada (Fintrac).

Until then, Fintrac has curiously taken a hands-off approach even though the director of Canada’s anti-money-laundering watchdog said last summer that the agency is studying the vulnerability of certain emerging technologies, like those being pioneered by fintechs, to “criminal exploitation.” “There needs to be a rational basis to determine which entities are subject to regulation or not because right now the answers are all over the map,” says Matthew McGuire, an anti-money laundering and counter-terrorist financing expert. The lack of clarity around applicable federal regulations can be damaging especially since Canadian business, particularly financial institutions, are fairly cautious, says Molino. “Regulatory uncertainty can be really frightening to a lot of financial institutions and a lot of other businesses,” says Molino. “We have come to the conclusion that it would be preferable to have a well-articulated legal framework that applied to fintechs generally. I think it would make it easier to do business in the country.”

Wait and see

That is unlikely to happen any time soon as regulators are clearly waiting to see the effect fintech has before introducing new rules or revising old ones just as the U.S. Department of the Treasury did last year when it submitted a public request for information to understand the impact of online marketplace lending on small business, consumers and the broader economy. Quebec’s security regulator has two committees now examining the sector while the federal Competition Bureau launched a study earlier this year to assess the impact fintechs have on the competitive landscape, examine barriers to entry and gauge the state of current regulatory frameworks.

“What regulators are struggling with is whether there is anything new or different that makes it such that our regulatory model is no longer perfectly aligned,” says Jason. “They are not certain. No one has really come down on whether or not our regulatory model is up to task or not. Maybe it has perfectly kept pace.” Other regulators and policymakers are regularly having informal discussions with startups to try to understand the kind of innovations now taking place in the startup community, to find out what they can do to create a better environment for innovation, and to ensure that the upstarts have in place proper checks and balances to protect consumers and business, says Teja. “Our regulators and policymakers are trying to understand the risk points that may exist in new and emerging models,” adds Teja. “It’s a function of technology evolving so quickly and business models emerging that are changing the way people are consuming financial products.”

Some legal observers suggest that Canadian regulatory authorities would do well to follow in the footsteps of the U.K., Singapore and Australia and create a so-called regulatory sandbox, or legal bubble, that would effectively temporarily suspend, relax or relax certain financial transactions or business lines in order to bolster innovation – a tack that the OSC after all decided to emulate. The OSC Launchpad will be staffed by a dedicated team who will work directly with fintech companies to help them navigate Ontario’s securities laws. “There are a lot fintech companies in a variety of spaces and this is a complex regulatory regime so enabling startups to play in that sandbox to test things and see if they will be successful without having to invest in large compliance regimes would be very helpful,” said Skakun. But Badour, like others, doubts that a pan-Canadian regulatory sandbox is feasible. The jurisdictional split in powers between the federal government and provincial governments is at the heart of the quandary.

The danger though rests with the status quo because while fintech innovations promise to solve current problems, they could also create new ones, says the senior deputy governor of the Bank of Canada. “Because it is early days, no one knows for sure what fintech developments will ultimately mean for business models or for the financial system more generally,” says Wilkins. “But we are all trying to figure it out.”