In 2000 the European Union published its first electronic money directive—showing remarkable foresight about the potential future growth of digital payments.
Europe’s early introduction of comprehensive rules for e-money has been credited with making the region a global hotbed of financial technology (fintech).
But the reaction of one national regulator to the recent Wirecard scandal has revealed unexpected cracks in the European fintech market.
We’ll unfreeze your funds—on one condition
On 26 June, the users of dozens of prepaid debit card services found their cards had suddenly stopped working.
The interruption came after the UK’s financial markets regulator, the Financial Conduct Authority (FCA), decided to halt the operations of a UK subsidiary of Wirecard, the German payments firm that had just filed for bankruptcy in its home country.
The Newcastle-based subsidiary of Wirecard—called Wirecard Card Solutions Limited—turned out to be a vital cog in the pre-paid debit card market. It processed card payments for a range of different firms, all issuing cards under different brand names.
the green light for Wirecard Card Solutions to resume its work came with a new condition
When halting the money flows into and out of Wirecard Card Solutions, the FCA said it was protecting the card firms’ clients. The regulator said it needed to ensure client cash could not be funnelled by the UK subsidiary back to the now-insolvent German parent company.
The FCA freeze ended up being short-lived, as the regulator reversed its stance three days later.
But the green light for Wirecard Card Solutions to resume its work came with a new condition.
Rewriting its own rules
Under European rules, e-money institutions (EMIs), such as Wirecard Card Solutions, are responsible for ‘safeguarding’ client money, such as the funds deposited on pre-paid cards by debit cardholders.
The need for a safeguarding regime comes from the fact that EMIs and payments firms do not take deposits and are not banks.
Depositors in a bank have made the bank an unsecured loan, whereas e-money is supposed to be backed one-to-one by assets held safely elsewhere.
Only banks are part of state-run national deposit insurance schemes: in the UK, for example, an insurance scheme guarantees the safety of depositors’ funds up to a limit of £85,000 for any one institution.
By contrast, EMIs and payment firms must place client money in specially designated third-party bank accounts, keeping it separate from their own funds.
The FCA was overriding its own national laws
But where exactly these funds should be held had never previously been specified in more than general terms.
The UK’s Electronic Money Regulations, published in 2011, say that safeguarded client funds can be held in any European Economic Area (EEA) bank.
According to the Emerging Payments Association (EPA), a fintech trade body, this geographical restriction was due to be relaxed after Brexit to allow any authorised bank in an OECD country to hold e-money firms’ client money.
But in a paper published on 29 July, the EPA disclosed that the FCA had forced Wirecard’s client funds to be moved from Germany, the payment firm’s home country, back to the UK, as a condition of resuming business. In effect, the FCA was overriding its own national laws.
“We understand that […] the FCA required safeguarded funds to be moved from a Tier 1 bank in Germany, back to a UK bank, before the [Wirecard Card Solutions] shutdown would be lifted,” the EPA said.
Fintech market participants have been quick to point out the potential implications of the FCA’s move.
“A number of market participants have expressed surprise and concern that repatriation was felt to be a necessary step even where the funds were held by a bank in an EU Member State, and a Tier 1 bank at that,” the EPA said.
“There’s a problem and it needs resolving”
According to the EPA, the FCA’s apparent new ‘home country first’ approach to safeguarding is legally suspect, since European rules should guarantee that e-money is protected in the case of the failure of the bank holding it.
“The Electronic Money Regulations 2011 and the Payment Services Regulations 2017 are clear that the claims of payment service users take priority over all other claims in the case of an insolvency,” the EPA said.
“These derive from the second Payments Services Directive, which, being a maximum harmonisation directive, should therefore have been implemented in a very similar way across all EU Member States.”
“As such, we therefore again question whether repatriation of safeguarded funds held in a credit institution in an EU Member State would be necessary to protect those funds from the effects of an insolvency process,” the EPA said.
The push to repatriate UK fintech firms’ safeguarded funds to UK banks may also create a bottleneck due to the lack of local service providers, the EPA went on.
“Very few of the UK’s e-money issuers hold safeguarded accounts in the UK,” the EPA said in its paper.
“They do not feel that [recent regulations] have been effective in opening up access to such accounts in the UK for this part of the market. As such, the vast majority of EMIs hold safeguarding accounts with non-UK banks,” the EPA said.
The EPA has been warning of negative consequences from a potential overreaction to the Wirecard scandal.
“There’s a problem and it needs resolving. The payments community has rallied round to help ensure that the regulator does not throw out the fintech baby with the bathwater,” said Tony Craddock, the EPA’s director-general.
But these warnings may be falling on deaf ears. The signs of a tighter UK regulatory stance on fintech have been multiplying for some time.
“Poorly designed, operated or regulated payment chains pose risks to the real economy”
The shift in stance is important since the UK—and London in particular—are Europe’s leading fintech hub.
In its December 2019 Financial Stability Report, the Bank of England pointed out what it saw as potential systemic risks as a result of the payment system’s growing complexity.
“Poorly designed, operated or regulated payment chains pose risks not just to economic activity directly, but also indirectly via confidence in the financial system and the real economy,” the Bank said.
In a set of rules introduced shortly after the Wirecard collapse, the FCA imposed intrusive new requirements on fintech firms to ensure customers’ funds are kept separate from those of the service provider.
In a ‘dear CEO’ letter published to accompany the new rules and addressed to the heads of payment and e-money firms, the FCA warned it had found widespread breaches of the existing regulatory standards for safeguarding, risk management, financial crime, advertising, governance and record-keeping.
“We have found that issues in these areas are widespread and many firms may be failing to meet the required standards. You are responsible for ensuring that the appropriate people at your firm understand the rules and ensure that your firm complies with them,” the FCA said.
And in a Payments Landscape Review, published at the end of July, the UK Treasury is opening a new debate on the potential risks resulting from the complexity of the fintech payments system.
“Changes [to payments chains] could bring risks if the end-user does not understand the protections that apply, activities fall outside of regulation, or an activity is insufficiently resilient,” the Treasury said.
Whether European fintech’s golden era is over remains to be seen.
But by putting national interests first, the UK authorities’ recent actions leave no doubt that it is prepared to fracture the single European regulatory regime that has underpinned fintech’s growth boom.
Sign up here for our monthly newsletter
Click here for a full list of episodes of the New Money Review podcast: the future of money in 30 minutes