Predicted to be one of the fastest-growing sectors, the regtech start-up eco-system has expanded rapidly to match that expectation. Regtech entrepreneurs are driven by the US$100 billion market opportunity that compliance spending represents. This has brought about a market of more than 300 regtech start-ups (compared to 7,000 FinTech start-ups), which is fuelled by a cumulative US$1 billion investment by venture capitalists since 2012.
To better understand the start-up eco-system let’s start with some context. With the United States setting the tempo of global regulatory changes and characterized by fragmentation of supervisory bodies, most compliance spending will occur there. Although the United States represents a strong natural client, the start-up activity is predominantly based in Europe. Asia, as a region, represents one-third of regulatory spending but is underserved, for now, by start-ups, leaving the market to traditional vendors.
The 2008 financial crisis represented a strong catalyst for regulatory changes across the world. The combination of fines (over US$321 billion), regulatory changes (tripling from 2015 to 2018), and post-crisis reform implementation (e.g., Dodd-Frank, Basel III) has forced the banks to increase their operating cost as a response to their new regulatory obligations.
To provide a sense of scale, a financial institution like JP Morgan has added 14,000 legal and compliance staff since 2012. It is not unusual for banks to have 20% to 30% of their employees working in compliance-related functioning, meaning that a Tier 1 Universal Bank such as HSBC has more compliance officers and lawyers than Facebook has total employees. However, the number of recurring fines occurring post-crisis is challenging the effectiveness of simply adding human resources to meet compliance obligations. Indeed, for each US dollar spent on compliance, three are spent on regulatory fines. It seems that the compliance industry has difficulty learning from its mistakes.
A decade has passed since the crisis, and at that time, most of the regulatory changes have been implemented. Financial institutions are now starting looking at how to automate new compliance obligations and decrease the added-recurring cost that has built up post-crisis. Regtech start-ups are answering these demands.
Regtech companies can be classified into three categories, each of which will be illustrated below.
- Regulatory Compliance: Learn about the effect of regulatory changes on the business logic of a bank.
- Risk Management: Identify conduct risk to prevent another LIBOR scandal.
- Financial Crime: Identify the ultimate beneficiary of a shell company.
Most of the regtech start-ups are concentrated in the regulatory compliance space, reflecting the fact that this represents a low-hanging fruit for success (e.g., data availability, limited integration, and lower risk in case of error).
As with FinTech companies, the majority of regtech companies are B2B providers selling to financial institutions. Although the demand from this client base is strong, it appears that that sales cycle remains long, on average 12 months, on par with what is witnessed in the FinTech industry. Certain exceptions are noted, especially in the context of the upcoming regulatory deadline, such as MiFID II or General Data Protection Regulation (GDPR), which fast-tracks the sales cycle.
Additionally, regtech start-ups can be found in two other areas worth mentioning.
• The first area is the regulators. The B2G space is growing. Regulators globally are engaging regtech start-ups via various channels, from hackathons to accelerators, to find solutions to enhance their supervisory or regulatory function. Similarly to financial institutions, regulators are driven by the cost benefits provided by regtech start-ups, which can reach a factor of x10; these savings are especially important when because taxpayers’ money is used to financial regulators and their operating costs, making for a strong public policy case. Although having a regulator as a client brings legitimacy, the lengthy procurement process is extended by additional tendering rules relative to sourcing suppliers for the public sector.
• The second area is FinTech companies. Certain FinTech companies are directly adding regulatory compliance processes into their products. For example, in the context of the wealth management space, fund products are now being sold and marketed only to pre-qualified investors by leveraging their data to access suitability, location and investment profiles. Although for consumers this provides a level of personalization of services, for a financial institution this embeds regulatory compliance into the sales cycles and avoids fines relative to mis-spelling which previously occurred because compliance and sales functions were operating in silos.