The European Securities and Markets Authority (ESMA) has published a speech given by Patrick Armstrong, Senior Risk Analysis Officer in ESMA’s Innovation and Products team, on the opportunities and challenges arising from financial technology.

Among other things, Mr Armstrong explains that 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 both in terms of the range of innovation ESMA tracks as well as the tools it employs.

Mr Armstrong explains that designing a framework to analyse financial innovation across the EU is not without challenges. Such challenges include:

  • the heterogeneity of the financial markets across the 28 Member States differ markedly in breadth, depth, volume and sophistication of market participants;
  • the concept of ‘innovation spiral’. What may have been designed and targeted to a given segment of sophisticated market participants may over time migrate to a market segment home to less informed investors for whom the product introduces unexpected risks;
  • ESMA’s task is complicated by the fact that when an innovation is newly introduced its user base is typically narrow and in turn its scope for creating systemic harm is limited;
  • the perceived utilities of innovations are often situation or time dependent;
  • monitoring innovative products using classical risk management tools is limited. One of the primary obstacles to understanding the risk profile of newly introduced products is the lack of time series information with which to measure volatility and tail risk; and
  • ‘regulatory dialectic’ in the sense that the private sector has incentives and resources to respond rapidly to regulatory measures with innovative tools, techniques and products that seek to circumvent the intended regulation.

Mr Armstrong also gives an update on the regulatory work that ESMA is carrying out. This includes  work on:

  • robo-advice. The Joint Committee of the three European Supervisory Authorities (ESAs) published a discussion paper on automation in financial advice in December 2015. The results of the discussion paper highlighted certain risks: first, the risk that consumers could misunderstand advice provided to them without the benefit of a professional advisor to support them through the advice process; second, the potential for limitations or errors in automated tools; and third, risks associated with the widespread use of automated advice tools. Having analysed the responses received to the paper, the ESAs are currently deciding whether further cross-sectoral action is warranted or needed at this stage;
  • big data / artificial intelligence. The three ESAs are working to better understand the phenomenon relative to the relevant regulatory frameworks and understand possible benefits and risks of the use of Big Data by financial institutions. Potential benefits could derive from an improved quality of services or products, more efficient processes or better management of risks or fraud situations. Potential risks may relate to the impact on access to products or services for certain consumers, lack of transparency around the processing of data and the firms’ decision-making using Big Data technologies, the potential limitations or errors in the data and analytic tools, or to security and privacy concerns. The ESAs will analyse the issue in order to decide which, if any, regulatory and/or supervisory actions may be required to mitigate the risks while at the same time harnessing the potential benefits;
  • ESMA has adopted a step-by-step approach to enable crowdfunding to reach its potential as a source of alternative finance while ensuring the risks to users of crowdfunding platforms are identified and addressed in a proportionate and convergent manner across the EU; and
  • distributed ledger technology (DLT). ESMA is analysing the technology and its potential application across the securities markets investment life-cycle. In particular it is analysing the responses to its June 2016 consultation paper on the potential uses, benefits and risks of DLT as applied to securities markets.

Mr Armstrong concludes his speech by stating:

“We have said that our framework for monitoring financial innovation is a principles-based approach. In using this approach, we recognise that the topic of innovation differs in magnitude from the vast majority of work ESMA does in the policy space. There is no Level 1 legal provision to follow within the sphere of financial innovation. The types of innovation and need for innovation differ greatly across Member States. In turn, our framework needs to remain flexible and adaptive to market events. It also need to subtlety to know when to respond in a supportive as opposed to a protective manner, a tipping point of sorts. We intend to revisit the framework on a regular basis to ensure it remains effective and relevant.”

View ESMA speech on financial technology: the regulatory tipping points, 30 September 2016

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