The Definitive Guide: Mexican FinTech Law, a look 3 years after its publication
Author: Carlos Valderrama (more information here)
Nowadays there are multiple fintech regulation and based on that fintech start ups have obtained approval to operate as a financial technology institution, that have had an exponential growth and have generated a greater financial inclusion, but Do you know how it all started?, What is a financial technology institution, a crowdfunding institution or an electronic payment fund? What was the influence of the Mexican Banking Association (ABM) or our central bank in the process?, Which financial entity has been authorized and what do they think about the process?, What happens if you carry out activities regulated by the so called FinTech Law in the FinTech industry? What is the status of the collaborations between a FinTech company or FinTech firms and a financial entity or traditional banks or a financial institution or Mexican Banks?, What kind of technology can be applied in a FinTech institution through an innovative model? Find out the answer to these and other questions in connection with the Mexico's FinTech law in company of Legal Paradox®.
Was a FinTech Law necessary?
Although the FinTech Law was published on March 9, 2018 (more information here), its drafting started back in 2016. Even if we go further, the related work actually started since 2014 with an intense collaboration between the FinTech ecosystem and the financial regulator.
It all started once upon a time when players such as Prestadero (disclaimer, Prestadero is a client of Legal Paradox®), Bitso, the Mexican Crowdfunding Association (AFICO also a client of Legal Paradox®), among others, recognized that the activity they were performing could be found in a gray a rea since it was possible to argue that it was actually a regulated financial activity reserved to authorized financial entities.
The implication of the above could be brutal and the consequences fulminant for a FinTech sector that was just starting and that in 2016 had only 158 participants in its ecosystem according with the FinTech radar of Finnovista, but that was already positioned as the largest FinTech market in Latin America (more information here). The above, since the consequences could result in million dollar fines and even the real possibility of up to 15 years in prison which, for Startups led by entrepreneurs recognized in other countries as great innovators, implied a real risk since they were being investigated for possible illegal money raising.
Indeed, during 2017, around 35% of Mexican FinTech were being investigated for the possible performance of regulated transactions or financial activities that were reserved to authorized financial entities. Given the situation, there was an obvious need for self-regulation, which is why AFICO, together with Legal Paradox®, built regulatory criteria from the sector for the sector itself in order to generate a system based on international best practices. Moreover, we were convinced that it was of vital importance to have legal certainty and to know what could be done and what could not be done. Therefore, as a guild, we approached the financial regulator and asked, almost begged, to be regulated.
Fortunately, we had a responsive financial regulator who patiently took more than 270 meetings with us as a ecosystem to explain what we were doing, what were the risks, how they were mitigated and why our activity represented something different within the financial regulatory world, financial intermediaries and more importantly, why it was desirable and even necessary to allow these activities to generate greater financial inclusion, competition, as well as greater penetration of financial products and services in Mexico.
At the end of the day, our aim was to establish how to leave the gray line and move into the major leagues, as well as to what extent regulation was going to help us and not to kill us in the process.
In that context, we should remember that in 2018 we were starting from a reality in which Mexico displayed a highly concentrated financial services market where the supply of products and services was largely dominated by the traditional financial sector, in particular by BBVA. Because of this, evidently the influence of the banks, and in particular the Mexican Banking Association and our Central Bank, was tremendous as they were concerned that regulatory arbitrage would be generated, i.e. the possibility of FinTech competing with them with lower rules and barriers of entry.
On the other hand, and like the rest of the international financial sector, Mexico has a strong financial regulation that in many cases inhibits the generation of disruptive innovation in the sector, imposing a strong barrier of entry and inefficiencies in the system that are reflected in a lack of competition and high cost for the user of financial products and services.
It was under such environment that the Law to Regulate Financial Technology Institutions (called the FinTech Law) was interestingly signed in the framework of the inaugural session of the 81st Banking Convention and published on March 9, 2018. The Mexican FinTech Law was one of the first regulatory bodies created specifically to promote innovation, the transformation of traditional banking and credit financial services that would even allow the possibility of incorporating exponential technology such as Artificial Intelligence, Blockchain, collaborative economies and peer-to-peer financial services in secure regulatory spaces.
The FinTech Law was based on the following principles:
1. Financial Inclusion, which seeks to bring financial services closer to people and sectors that have not traditionally been part of the financial system.
2. Principle of innovation, to provide tools to increase the use of financial services.
3. Principle of consumer protection, in order to take care of the client by establishing defense mechanisms and verification of minimum standards.
4. Principle of preservation of financial stability, which seeks to provide a general framework for authorization and supervised operation, prudential rules for financial, operation, market, technological, corporate governance and accounting risks.
5. Healthy competition, which promotes greater diversity and new distribution channels for financial services, cost reduction and improvement in the provision of services.
6. Prevention of money laundering and terrorist financing.
7. Technologically neutral, which implies that the technology is indifferent to the services provided.
It is important to highlight that the Mexican FinTech Law is internationally recognized as an example of how to achieve a regulatory framework that promotes innovation while guaranteeing adequate control for the risks that could be generated.
What is a Financial Technology Institution?
The regulatory framework created the possibility of having two new financial entities or Financial Technology Institutions, the Collective Financing Institutions known as IFC or Crowdfunding and the Electronic Payment Fund Institutions known as IFPEs or Wallets.
With the implementation of these entities, their purpose was expressly reserved for authorized entities. Therefore, if you are a FinTech created after the issuance of the FinTech Law, you will not be able to operate until you have the corresponding authorization under penalty of incurring in administrative sanctions of millions and even imprisonment of up to 15 years.
In addition to the creation of the two new financial entities, and for the rest of the FinTech world it became possible the implementation of new models or the regulatory sandbox, the use of virtual assets and APIs that will generate what is known as Open Finance, Open Data or Open Banking Initiative.
1. Crowdfunding or IFC
These institutions have the possibility of carrying out activities that are created for connecting people from the general public, with the purpose of granting each other financing through debt, equity (capital stock) and co-ownership operations or royalties (more information here).
2. Wallets or IFPEs
These entities are created for the regular and professional issuance, administration, redemption and transmission of electronic payment funds that can even use foreign currency, like a bank account without having all the functionality of a bank (more information here).
3. Innovative model or regulatory sandboxes
Although in FinTech there is still a lot to do, we can conclude that: (i) technology always comes before regulation; and (ii) it is always good to have a minimum viable product to go out and test your solutions in the market before investing millions of dollars in launching financial products or services to the general public.
Based on these premises, what is known as innovative model or Regulatory Sandbox is created, which in a basic way is the launch of financial products or services for which authorization, registration or concession is required by the financial regulator (more information here), which may operate under a determined period of time and in a controlled environment, being possible to request certain exclusions to the regulatory framework.
4. Virtual assets
Our regulation defined as a virtual asset the representation of value registered electronically and used among the public as a means of payment for all types of legal acts and whose transfer can only be carried our through electronic means, thus detonating a world of possibilities and new regulation applicable to FinTech projects or traditional financial entities using Blockchain (more information here, including the legal framework for cryptocurrency exchange and other use cases of virtual assets).
5. APIs or Open Banking / Finance
The regulation contemplates the obligation for financial institutions to generate programming interfaces for applications developed or managed to share data and thus enable what is know as Open Finance or Open Banking (more information here).
Are there incentives to encourage investment in FinTech?
While it is true that, together with AFICO, we have approached the tax regulator in order to find incentives to encourage investment in the creation of FinTech and in the massive use of their products and services, it is also true that to date there has been no response as they consider that there are other more pressing issues.
Notwithstanding the above, a strong incentive is the level of investment that angel investors, venture capital firms and other relevant actors are detonating in Mexico. Such has been the level of investment that a few months after having the first Mexican unicorn with a valuation of more than one billion dollars (more information here), exactly 7 months later, Kavak quadrupled its valuation reaching 4 Billion Dollars (more information here) sending a powerful message to the world.
Why is Mexico a fertile ground for FinTech?
As if the millions of dollars in investment were not enough, Mexico is a country with a population of more than 126 million people that includes a demographic bonus led by generation Z and Millennials full of people of productive age, of which 56% have a financial product, 52% a payroll account and 36% a savings account, which represents low levels of financial inclusion, as well as multiple segments of the population whose financial needs are not met by traditional banking.
In addition, Mexico has one of the highest bank asset concentration indexes in Latin America, where only 5 institutions control the financial destiny of millions. In the words of our economic competition regulator, COFECE, this concentration is the result of market failures and restrictions to competition generated by the overregulation of the financial sector, which brought about a disincentive in financial inclusion, creating barriers that seemed to be insurmountable... (more information here).
Given the above scenario, Mexico presents the ideal conditions to generate the perfect FinTech breeding ground since 80% of its population has smartphones and 95% of these have internet access (more information here).
From our perspective, the future of FinTech entrepreneurship is definitely being written in Mexico.
What progress has been made and what's next?
We must accept it, the FinTech Law is not perfect, but from our perspective it does allow us to generate innovation in the Mexican financial system, while controlling the possible risks that could arise.
While it is true that, to date, some FinTech have decided to withdraw from the process and others have been rejected by the financial regulator, it is also true that there are already dozens of authorized FinTech (more information here) that are growing and doing very well. Some of our clients have already submitted authorization processes to have what could be the first financial institutions in Mexico to work with stablecoins (more information here) and bitcoin, something that seemed completely impossible and that is beginning to arouse the interest of the traditional sector. So, we will watch with expectation what continues to happen.
We will definitely have to make an evaluation for the effects of the FinTech Law on the industry and whether the principles and ideals to which the explanatory memorandum of the law aspired have been achieved, and only time will tell.