Open Banking

Open banking is a game changer. Having already taken place in the UK, and with the US forging ahead with its own restructuring of the financial system, we think that it has huge potential in Canada.

With offices across key global banking hubs, including North America (Toronto, Montreal, New York), Europe (London, Paris), and Asia (Singapore, Tokyo), White Star Capital has leveraged its global lens to identify the trends, opportunities, and pitfalls that might appear in Canada’s future open banking ecosystem, following several years of debate.

Applying years of experience investing within markets that have live open banking infrastructure, our team has collaborated to develop a robust understanding of:

a) how open banking ecosystems can develop, and

b) where there are opportunities for success in Canada.

This piece covers:

This is an abridged version of a longer report. If you’d like to receive a copy of the extended version please get in touch with our team!

Open technology is a government policy designed to ease the flow of information between two systems. It improves speed, tightens security, and smoothens the user experience.

Open banking applies this to digital financial services. The information is financial data; the systems are your bank and the fintech you want to use.

Source: Fintech R&R

Without open banking, using a fintech means giving up sensitive login information in a process called “screen scraping”. Fintechs log in to your bank on your behalf and scrape your data to integrate into their tool. This opens a can of privacy and security worms for users. With no way to control how the fintech uses or stores customer data, sensitive financial information is constantly at risk of being compromised.

With open banking, users no longer need to provide their login information to fintechs. Instead, financial institutions can relay data to fintechs via a secure API. This is beneficial for consumers and businesses alike.

The Open Banking Tech Stack (Source: Nordigen, PitchBook)

Open banking was first introduced in Europe in 2016 through the Payment Services Directive (PSD2). In 2018, the UK implemented its own version of open banking, adjusted to include a more standardized policy on API specifications and security profiles.

This standardization proved to be a critical factor in its success.

Since 2018, more than 4 million consumers and over 600,000 small businesses in the UK use open banking-powered applications. It also sees strong traction with approximately 1 million new active users added every six months.

Critically, growth has not been limited to users. While open banking in the UK began with the CMA9 (the nine largest banks in the region), the provider ecosystem has rapidly expanded, reaching 330+ regulated firms, 230+ third-party providers, and 90+ payment account services. New entrants are constantly emerging, enabled to innovate financial services using open banking technology.

Market Map: Open Banking in the UK sourced from PitchBook

The UK succeeded from a technical standpoint. It developed the required architecture to launch the technology, continues to iterate on an as-needed basis, and has seen all parts of its open banking ecosystem grow. However, operational gaps led to several challenges, many of which could have been avoided with increased oversight and controls.

As the UK continues to develop its open banking infrastructure, and its ecosystem experiences sustained rapid expansion, governance and controls will likely become a primary objective.

Sanjay Zimmermann (Partner, White Star Capital) moved back to Montreal from London in 2017. This was right at the beginning of the explosion in consumer fintech application and neobank popularity in the UK which were launched on the back of open banking that came live through the European Union’s Payment Services Directive (PSD2). At the time, there was a general sense of excitement in Canada about recreating this potential here and high hopes that went into fintech and insurtech investments in 2017 and 2018, but progress has unfortunately been much slower.

Timeline of progress made in Canada to date

Policy process: Groups are independently researching and submitting recommendations to the committee. Towards the end of 2022, the Financial Data and Technology Association of North America turned in a report to Tachjian outlining a plan to create the governing entity. More recently, Fintechs Canada tapped the think-tank Institute of Governance to draft a report on governance models for open banking in Canada.

Market players: The delay in open banking regulation has pushed fintechs and banks to enter private data-sharing agreements.

Canadian banks and their fintech partnerships (Source: BetaKit)

Fintechs have valuable software that can improve the financial health of Canadians but are limited to unsafe screen-scraping because the government has been slow to provide a secure API channel to banks. Big financial institutions want to offer their customers adjacent products to drive revenue growth, and fintechs are a great way to make quick bets on the next unicorn.

In the US, partner banks see high returns (Source: Andreesen Horowitz via ibanknet.com)

Fintechs Canada is particularly concerned that open banking is going to materialize in Canada in a competitive utility model: a bank-owned entity, at the center of open banking, through which all data is shared with anyone who has permission to access it.

Vronces points out that problems arise when banks have complete control of critical financial infrastructure.

Today, no fintech can directly access Interac’s email money transfer system. Investment startups (e.g., robo-advisors) cannot instantly fund trading accounts from user banks, but banks can instantly move money.

Fintechs are restricted two-fold, both by federal legislation that bars them from accessing the national payment system, as well as being stonewalled by banks from accessing instant payment rails.

To be clear, there is nothing wrong with banks partnering with data aggregators, owning a data platform, or choosing a preferred provider, says Vronces. The problem is when those partnerships displace the role of policymakers in creating a level playing field in the market.

Vronce’s argument — at its core — is that one of the players should not also be the main enforcer. Instead, a new entity, designed by an impartial third party, should be created with public policy goals that are rooted in legislation.

Distrust between banks and fintechs limits the competitive utility model: fintechs do not want a bank-owned entity to be the referee of open banking. However, a government-developed entity can move too slowly and lead to bloated setup costs, as seen in the UK.

A hybrid model can incentivize banks to partake in building open banking infrastructure (faster implementation) without maintaining ownership (leading to an advantage, according to fintechs).

This could entail a government contract for a private company to build the infrastructure and a government-appointed third-party regulator for data accessibility, thereby keeping ownership impartial to both banks and fintechs.

In Canada, the government has an opportunity to learn from what worked in the past, such as funding the development of the wireless number portability infrastructure (telecommunications) and portability of electronic medical records (healthcare).

Canada’s regulatory environment is proving to be a tough roadblock in the policy design process.

The two main parties that need governance are 1) financial institutions (e.g., big banks), and 2) fintechs & data aggregators. Large banks are federally regulated by the Office of the Superintendent of Financial Institutions (OSFI) and the Financial Consumer Agency of Canada (FCAC). However, fintechs and payment providers fall into both federal (e.g., Retail Payment Activities Act) and provincial (market tactics, consumer protection) regulations.

Ensuring that every party is equally governed, monitored, and empowered is proving to be a difficult task. Part of the reason is that the federal government cannot simply create a new OSFI, entirely for open banking, that applies to everybody. While the federal government does have the jurisdiction to regulate banks, it cannot reach credit unions and fintechs as they are provincially regulated.

So how can the government level the playing field and make players equal, all without infringing on the jurisdiction of provincial governments?

Through a statutory corporation that regulates both fintechs and banks, says Vronces.

Open banking is generally discussed as a transformative piece of technology, set to propel tech and finance to greater innovative heights wherever it appears, accompanied by a burgeoning ecosystem of SMEs and fintechs to create a seamless consumer experience.

Yet, the US has consistently produced payment giants that reach far beyond its borders (without a PSD2 equivalent..). Some of the most innovative fintechs have emerged from the US — a country with an extremely complex regulatory system, deeply fragmented across 50 states (not just 10 provinces), that lacks any plans for open banking even remotely close to what exists in Canada.

So, is data accessibility the only reason for Canada’s stunted fintech innovation?

Canadian banks and their (mostly US-based) fintech partnerships source from BetaKit and PitchBook

It is hard to say why the US excels how it does. It could be because of strong talent pools, an immense amount of liquid capital, unique market dynamics, or more nuanced differences.

US fintech sees significantly more capital invested and raised than the Canadian ecosystem (Source: PitchBook)

Or it could be because of partner banks.

Banks and their fintech partners in the US, sourced from Andreessen Horowitz

In most countries, every payment company or neobank must have a partner bank to hold user funds in trust. Canada is no exception. Even if a company is regulated under the Retail Payment Activities Act — providing it with access to the payments infrastructure of Payments Canada — it still needs a relationship with a partner bank to operate. And it is hard to maintain those relationships.

For money service businesses (MSBs) in Canada — a large portion of payment providers in Canada — it comes down to risk. Banks are uninterested in MSBs because of the AML compliance headaches they bring. Small fintechs that do not bring in enough money are simply not worth the risk.

MSBs that are dropped by the big banks are forced to partner with smaller banks, sometimes entering into uneconomical agreements that constrict growth.

Gaining access to user data is unlikely to resolve these issues directly — fintechs that struggle in today’s partner bank landscape will continue to face challenges, regardless if it becomes easier to access consumer financial data.

Across the border, fintechs find an ecosystem that — despite its reliance on screen scraping and data aggregators — is flush with partner banks, and potentially in consequence, titans of fintech.

The number of partner banks in the US has grown more than 5x between 2010 and 2020, reaching 90+ in 2022. More players create more competition, likely increasing risk tolerance in the hopes of partnering with the next unicorn fintech, regardless of AML pains. But even the US is starting to show signs of stress in its partner bank ecosystem.

Since 2020, the US Office of the Comptroller of the Currency (OCC) has been increasing its scrutiny of partner bank-fintech relationships. In August 2020, Blue Ridge — the partner bank for Unit — was heavily regulated by the OCC, largely due to AML risks.

The bank was required to intensify its risk assessment and monitoring practices, AML strategy, and liquidity, and be approved by the OCC before signing any new fintech partners.

These stipulations led to other partner banks pausing onboarding and new account creation for existing fintech partners. Tighter compliance requirements have increased due diligence and product launch timelines, spiking costs for banks who then offload them to smaller and higher-risk fintech partners.

If this spiral worsens, US banks may begin to cut fintech partnerships as the risk of AML becomes greater than any potential reward.

This pendulum swing — from extreme growth to tighter regulation — mirrors the path of crypto companies in the US. Initially, a loose set of restrictions and unclear securities rules enabled rapid growth. Crypto companies launched unregistered Initial Coin Offerings (ICOs), sold unlicensed NFTs of popular real-world handbags, marketed financial products without properly disclosing risks, and operated without any registration. As regulators catch up to speed, the rules of the game continue to shift to protect consumers and limit risks to the greater US and global economy.

Risk-sharing for AML between banks is one potential solution, and there is a precedent for bank partnerships to provide a public good. In 1984, the non-profit Interac Association was founded through a joint venture by RBC, CIBC, Scotiabank, TD, and Desjardins to create the now-famous payment rail, Interac. The group launched key pieces in Canadian financial infrastructure, including point-of-sale debit transactions (1990) and e-transfers (2003). Interac provided critical features for Canadian consumers as a non-profit, only transitioning into a for-profit organization in 2018.

39 years later and one of the biggest problems for fintechs is finding a functioning partner bank relationship. This is partially driven by high AML compliance costs due to large teams overlooking fintech partnerships, long diligence processes, and long lead time for product launches.

Similar to the Interac solution, a potential solution is for Canadian banks to pool compliance costs, enabling affordable fintech-bank partnerships. More partner bank agreements would help emerging startups avoid uneconomical agreements and enable more Canadian fintech giants to emerge.

In regions that have had open banking for several years already, such as the UK and the rest of Europe, different product layers made possible by open banking have become commoditized and saturated. Since the data itself is all the same, and building the pipes is not proprietary, the market is less attractive from an investor standpoint.

In the UK and EU, companies are starting to build in open insurance — an exciting new application of increased data access — as well as other areas within asset management.

While there may be some opportunities to build the data pipes in Canada, the open banking ecosystem will likely follow a similar route to Europe. Companies will move from moat to moat until a lack of product differentiation chases prices down. At that point, the country will have caught up to Europe.

Looking ahead to March 2024, it does not seem like much will change. On March 29, 2023, the 2023 federal budget was tabled — it made no mention of open banking. In September, the open banking committee leader, Tachijan, will return to his former role at EY.

In the meantime, banking incumbents still push for a competitive utility model. In February 2023, it was reported that a group of banks advocated for Symcor — a data-exchange company created by TD Bank, RBC, and BMO — to be implemented as Canada’s central open banking API. Banks will likely continue to advocate for an API solution that they control, enabling them to guard their customers (i.e., their moat) as tightly as possible.

As Canadian banks continue to advocate for a competitive utility model, the working committee continues to fail to deliver it, and the fintech community becomes more vocally impatient, the government may take the easy way out with a bank-provided solution.

A shift to open banking will get rid of the need for privatized data access agreements as data accessibility will be required by law. However, there are still opportunities for banks to cut costs and increase the accuracy of their services. These areas present clear investable opportunities for VC funds deploying investing in FinTech startups such as White Star Capital.

These benefits will become cheaper to implement as AI-powered co-pilots for software development will enable startups to build products in one language and easily translate it into a bank-specific language. This is already being seen in Vercel’s GPT-4 enabled code translator and Facebook AI Research’s TransCoder. Instead of retooling entire systems to integrate a new product, startups, and banks will be able to rely on AI to translate legacy code and easily bring new products to their customers.

Open banking infrastructure will relieve companies from screen scraping, and all of the security risks and user friction that it brings.

For Borrowell, a White Star Capital portfolio company, the lack of open banking regulation means relying on screen scraping. This can mean an inability to serve every customer that wants to use a product. In fact, less than 50% of Borrowell customers were able to connect their bank accounts to Borrowell’s new Rent Advantage product, allowing users to build credit with their rent payments. For those users that are successful in logging in through the screen scraping process, over 40% have to reconnect their account every month. In a statement to BetaKit, Andrew Graham (CEO, Borrowell) made it clear the fintech ecosystem requires “a real system that puts consumers in control of their data to enable them to better understand their finances.”

For Drop, another White Star Capital portfolio company, open banking could also greatly smoothen the user experience and improve the product offering. Drop enables brands to understand buying behaviour and rewards customers for providing that information. A standardised framework for connecting to a consumer’s bank account, instead of screen scraping, would provide rich, detailed data with far less friction.

White Star Capital is looking forward to seeing how its portfolio companies will leverage open banking and its impact on the Canadian fintech ecosystem.

If you’re interested in discussing the opportunities and challenges ahead, or if you’re building something exciting in this space please reach out to our team.