Small countries can make it big in FinTech

and what kind of opportunities a startup in different Member States has to access capital

The popularity of innovative financial technology services grows continuously, which is marked among others by the FinTech-themed programs of the ecosystem: numerous incubator programs, hackathons, courses and conferences are organised around this topic. Significant research is published, which shows remarkable results on the alternative (non-bank) finances; moreover, the Capital Market Union (CMU) initiative of the EU proposes the development of the sector, which is measured by the FinTech Indicator on a country level each year. The National Bank of Hungary published its FinTech strategy last year.

Our analysis is based on the AFME report and the FinTech strategy of the National Bank of Hungary from October 2019, the Global FinTech rankings of Findexable from December 2019 and the publication of the Financial Stability Institute from January 2020.

Since its emergence, FinTech has disrupted the financial industry. The innovative online as well as mobile payment, trading, investment and insurance services are not only faster, cost effective and more convenient than the traditional services, but also provide many users with access to earlier inaccessible services.

With beneficial regulatory environment, even the emerging regions can become FinTech giants

According to Findexable, almost half of the world’s top 100 leading FinTech hubs are in emerging countries, in cities such as Sao Paolo, Bangalore or Mumbai, ranking higher than some traditional financial centres such as Frankfurt, Zurich or Shanghai.

The key to success seems to be having a local regulator, who responds efficiently to innovative technologies and to the needs of startups, adjusts the regulation flexibly to the new services, actively communicates to bridge the gap caused by the lack of regulation and develop a beneficial environment for FinTech companies to grow and receive investment.

This sounds simple but in fact it is rather difficult to achieve. Financial supervisory authorities operate rather similarly to large corporations, whereas startups intend to disrupt their industry within a few months, therefore cannot wait for long for a regulatory response. The need for responsivity on the startups’ side poses a great challenge to regulators. In case the local regulatory environment is not supportive enough, the startupper seeks an environment, which better fits its needs. (This is called regulatory arbitrage.)

The scale of what can be achieved is best shown by Lithuania that despite having a population about a third the size of London, came in at fourth place on the global FinTech rankings, overtaken only by the US, the UK and Singapore. This success is to be explained by the forward-looking approach of the Lithuanian regulator. In 2016, the Lithuanian government has made it a strategic priority to develop the FinTech ecosystem, and since then has cultivated innovation by creating an advanced and attractive regulatory environment. The Lithuanian regulatory sandbox reduced the time needed for new technologies to acquire an operating licence to 3-6 months. The local Law on Crowdfunding has been in force for more than 3 years now, and recently the Bank of Lithuania uniquely issued guidelines for Security Token Offerings (STO). Due to these measures, more and more Fintechs (i.e.: Revolut, TransferGo, Shift4Payments) – headquartered in London, Stockholm, Amsterdam or other major European capitals – choose Lithuania to expand their business activity.

Another exemplary country is Estonia, launching the world’s first e-residency program that enables entrepreneurs to establish and operate a company from any point of the world. Companies can be established within one day, and thereafter all tax issues and banking can be arranged digitally, contracts can be signed electronically, which makes it possible to operate the company without having to employ a local director. Due to the e-residency program as well as the beneficial tax environment, thousands of entrepreneurs choose Estonia to set up a company.

One of the most successful crowdfunding platform, Funderbeam achieved global success and attracted capital into Estonian companies from more than 100 countries by establishing an investment model in co-operation with the local regulator and in compliance with the global regulations but without adopting a specific Estonian regulation on crowdfunding.

European crowdfunding soars, still bank lending is the leading external funding source

The Capital Markets Union (CMU) Action Plan of the European Union fosters the development of the European FinTech ecosystem, too. The initiative launched in 2015 with the mission to integrate the capital markets of the Member States, thus establishing better opportunities for investors and entrepreneurs, as well as making the financial system more resilient.

The completion of the objectives set out in the Action Plan was assessed comprehensively by the association of the leading European capital market players, AFME (Association for Financial Markets in Europe) and disclosed for the second time in October, 2019. The report assessed the progress both on a country level and on the EU-level against 8 key performance indicators.

The report examined how well non-listed startups as well as small and medium-sized companies of different Member States can access finance. Still, most business owners seek financing from banks, which is due to the low interest rates. In 2018, only 2.64% of SME finance was equity investment (including venture capital, angel investment and equity crowdfunding), which is quite low but shows considerable growth since 2013, when this proportion equalled 1.4%. The annual volume of equity investment was €25 billion in the EU, which is one eighth of the equity investment volume in the US.

In 2018, European SMEs experienced an increase in all forms of equity investment: 3% in business angel investment, 12% in investment from venture capital and 24% in equity crowdfunding. The EU leads in the availability of equity crowdfunding for SMEs, with a total of €440m raised in 2018 compared with €70m in the US.

Among the European Member States, Ireland and Estonia leads in terms of the amount of available risk capital for SMEs (in proportion to total SME financing, which also includes bank lending). Hungary is among the five Member States at the bottom of this indicator. This means that Hungarian entrepreneurs rely on bank financing to a greater extent than the EU average. But what happens if bank lending dries up due to a crisis?

The most important aspect for a successful FinTech ecosystem is a supportive regulatory environment

Moreover, the AFME report assessed to what extent the Member States are able to host and support a vibrant FinTech ecosystem, based on the following four aspects:

Talent pool: the main strength of the Member States lies in their talent pool. The Member States provide quality education and quite a high proportion of the population has at least a tertiary degree. The proportion of European university graduates with a Science, Technology, Engineering or Mathematics (STEM) degree is almost 10% higher than in the US.
Degree of Innovation: in spite of the talented and educated minds, the degree of innovation in Europe is behind that of the US or Asia. Both in the US and in China almost three times as much FinTech patents have been registered than in the EU.
Availability of finance by companies: the European investment culture is underdeveloped compared to that of the US, which is also shown by the investment volume: EU FinTech companies have benefited from only $27.5bn in investments 2010-2019, compared with $120bn in the US. In Europe, the UK stands out as the country with the most developed investment culture: 78% of European investments are made in the UK.
Regulatory landscape: the report highlighted that one of the most important aspects for a successful FinTech ecosystem is the quality of the local regulatory environment. The best practices of FinTech regulation are discussed in the next sections.

Considering the above four aspects, the United Kingdom leads the European FinTech rankings, scoring almost the same as the US. The Scandinavian and Benelux Member States also score well on a European level but they lag behind the UK. The Central, Eastern and South European Member States are at the bottom of the rankings. Lithuania is among those Member States that have developed the most during the past few years by establishing a robust regulatory environment following the governmental strategic decision in 2016.

Hungary ranks 20th in the FinTech-rankings, and is among the 7 least developed Member States based on the further KPIs. Regulators need to take action in order to develop the local FinTech ecosystem and improve the country’s rankings.

The development of the FinTech industry requires international co-operation and global regulatory convergence

An efficient regulatory environment is characterized by its responsiveness and forward-looking approach, facilitating the development of innovative companies, the protection of consumers and investors, as well as the resilience of the financial system.

Most Member States set up an Innovation Hub in order to provide support and guidance on regulatory requirements applying to innovations, as well as to serve as a communication channel with the FinTech sector.

Innovation hubs may be established as part of supranational collaboration initiatives, with the aim to enhance the efficiency of the industry by sharing knowledge and best practices. The Bank for International Settlements (BIS) established an Innovation Hub scheme, involving 60 central banks with the aim to identify the critical trends in financial technology in order to enhance the functioning of the global financial system. The Hub’s agenda includes central bank digital currencies, global stablecoins, payment innovations, the impact of big tech on financial intermediation, regtech and suptech, fast-paced electronic markets, and digitalisation of trade finance. Similarly, the European Forum of Innovation Facilitators encourages coordination between Member States’ Innovation Hubs.

Five Member States have established a regulatory sandbox, too. Startups participating in such a controlled testing environment usually benefit from regulatory forbearance and alleviation, thus reducing the time and cost of introducing innovative services. Some jurisdictions with a regulatory sandbox have implemented a “fast track” approach for the adoption of specific FinTech innovations in their markets. For example, Singapore has created a Sandbox Express but the FinTech Strategy of the National Bank of Hungary includes the concept of implementing a fast track, too. Regulatory sandboxes are beneficial for the regulators, too: it facilitates the analysis of associated risks as well as the assessment whether the regulatory approach is balanced for mitigating those risks while enabling innovation in their markets.

Regulatory sandboxes may be established at an international level by financial authorities from multiple jurisdictions. For example, the Global Financial Innovation Network (GFIN) is an international alliance of government regulators led by UK’s FCA seeking, among other objectives, to provide firms with an environment to trial cross-border solutions. To date, this global sandbox scheme is composed of 50 financial authorities, central banks (including the National bank of Hungary) and international organisations.

Besides the aforementioned international co-operations, global regulatory convergence is a cornerstone of the Capital Markets Union Action Plan, too. Part of this initiative is the European Crowdfunding Service Providers Regulation (ECSP), which has been finalized in December 2019 and is expected to enter into force early summer. The regulation on platform-based investments addresses several key elements of the Action Plan: facilitating cross-border investment and fostering better conditions to access to finance for innovative SMEs. This means that companies can launch crowdfunding campaigns with a funding target up to 5 million euros without the obligation to publish a prospectus and that if the platform intends to attract global investors and companies, then the licensing process is governed by this regulation.