As the world of embedded finance continues to grow, regulation is becoming increasingly important. Being a new offering, customers around the world are still getting accustomed to the convenience it brings to the table, making this a suitable time for regulators to take notice.
The reason behind this is simple, embedded finance has opened up many new opportunities for businesses and customers globally, and thus naturally, it also carries some risks, which, if not regulated, can result in devastating consequences. Right from fraud and money laundering to data theft, the opportunity for misusing this revolutionary technology are abundant.
Thus in today’s blog post, we will take a closer look at why regulation should sit at the heart of embedded finance’s global growth and how regulators can step in and take charge.
The Importance of Regulation in Global Finance
Although regulators around the world have made significant progress in the last couple of decades, events from recent history aptly highlight how regulation has always been a second thought.
Take, for example, the 2008 financial crisis. At the start, the idea of selling subprime mortgages appeared to be an incredible opportunity for all stakeholders, but as its popularity rose among banks across the USA, abiding by standardized rules and regulations took a back seat. The result, the lack of regulation in the subprime mortgage market, led to a widespread collapse in the global economy, which resulted in the loss of millions of jobs and homes.
Another prime example of how the lack of regulation can lead to disastrous consequences is the Wirecard fraud of 2020.
Wirecard was a German payment processor that was considered a leading fintech company before it filed for insolvency in 2020. The company had been at the centre of a massive financial scandal, with senior executives being accused of fraud, money laundering, and other financial crimes.
Its activities first came under scrutiny in early 2019 after a series of articles by the Financial Times raised questions about the company’s accounting practices. The articles alleged that the company had inflated its revenue and profits and that it had engaged in fraudulent activities in order to do so. Wirecard denied the allegations and launched legal action against the Financial Times, claiming that it had manipulated the stock market.
However, as investigations continued, it became apparent that Wirecard’s problems went far deeper than anyone had suspected. In June 2020, the company revealed that it had been unable to locate €1.9 billion in cash, which was supposed to be sitting in a trust account in the Philippines. The revelation caused Wirecard’s share price to plummet, wiping out billions of euros in market value.
Further investigations by the German financial regulator, BaFin, revealed that Wirecard had been engaging in a complex web of fraud and deception, including falsifying financial statements, inflating revenue, and setting up shell companies to hide losses. BaFin came under criticism for its role in the scandal, with some accusing it of being too slow to act.
The Wirecard scandal highlights the importance of regulation in the fintech industry, the lack of which allowed it to carry out its fraudulent activities for years, causing significant damage to investors, employees, and the wider economy.
The Need for Regulating Embedded Finance
Regulating embedded finance is a critical component of the industry’s growth, as it will enhance consumer protection, reduce fraud and money laundering, and promote financial stability. As the demand for embedded finance grows, regulators worldwide must take quick and proactive measures to ensure this technology adheres to rigorous standards.
Here are a few practical steps regulators can take today to ensure safety and compliance:
Set Clear Guidelines and Standards
Regulators can set clear guidelines and standards for embedded finance, providing a framework for companies to comply with. Such guidelines should cover data protection, anti-money laundering (AML), know-your-customer (KYC) requirements, and how to identify and manage the risks involved.
Establish Licensing Framework
Additionally, regulators can establish a licensing framework for companies engaging in embedded finance to ensure they meet specific requirements to provide the service safely and legally. An effective licensing framework will ensure that only trustworthy and reliable companies are allowed to participate in the industry.
Encourage Innovation
Regulators must strive to strike a balance between fostering innovation and protecting the interests of consumers. Encouraging companies to participate in embedded finance sandbox sessions can help regulators thoroughly test the safety and effectiveness of innovative product’s and monitor them closely, before being launched for the general public.
Educate Consumers
To make informed decisions, consumers need to be educated about the risks and benefits of embedded finance. Regulators can partner with financial institutions to provide consumer education programs highlighting the risks, benefits, and procedures of embedded finance, simply because a well-informed customer is less likely to fall into the trap of fraudulent activities.
Designing a Playbook
As the global embedded finance industry is still at its nascent stages, regulators can look at nations that have successfully incorporated regulations in other areas of fintech advancement.
For example, the United Kingdom’s Financial Conduct Authority (FCA) is globally recognized for its excellent standards of fintech regulation. Since its inception in 2013, the FCA has been consistently proactive in supervising and controlling the fintech industry, with a particular focus on consumer protection.
One of the FCA’s most significant achievements is its regulatory sandbox, a controlled environment where companies can test innovative ideas, products, and services with real customers without facing the usual regulatory consequences. Since the sandbox’s launch in 2016, it has attracted international attention, with many regulators worldwide looking to implement similar programs.
The FCA has also played a crucial role in shaping the regulatory framework for open banking, another fintech subsector that has seen rapid growth in recent years. It has collaborated closely with industry stakeholders to devise a standardized set of APIs that allow customers to share their financial data securely with third parties.
The FCA’s approach to regulation is characterized by its agility, flexibility, and willingness to engage in constructive dialogue with industry stakeholders. Instead of imposing rigid rules and regulations, the FCA seeks to strike a balance between innovation and compliance, resulting in a regulatory climate that fosters responsible and sustainable growth.
Regulators across the world can learn from the FCA’s playbook to create their regulatory framework for embedded finance.
The best part, a few have already started taking steps in this direction. For example, Singapore’s Monetary Authority has set up sandbox programs for fintech start-ups, while the Australian Securities and Investment Commission (ASIC) has established an innovation hub to support fintech development in the country.
Final Thoughts
The importance of effective and proactive regulation of embedded finance cannot be overstated. As embedded finance continues to gain traction worldwide, regulators must keep pace with the evolution of the industry to ensure that it remains safe, stable, and compliant for all stakeholders.
Although the technology might still be in its nascent stages, regulators must not allow the lack of standardized practices to result in another financial crisis. Establishing clear guidelines and standards, imposing licensing frameworks, encouraging innovation, and educating consumers are important measures regulators must take to regulate the industry. By doing so, regulators will ensure that embedded finance continues to grow sustainably while protecting consumers and maintaining financial stability.
The current growth story of embedded finance is no different from how the subprime mortgages and the Wirecard saga started, but its future will surely be determined by the steps regulators take today.
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