Financial technology (fintech) companies are breaking commercial banks' paradigm as they seek to adapt to customers' needs, rather than the other way around, and solve problems through innovative solutions. Developments last year were key for Mexico's fintech sector, as they brought a clear regulatory framework through the Fintech Law and subsequent publication of additional provisions. The new law and provisions provide legal certainty about the sector (for customers, investors, and other market participants) and help fight money laundering and fraud. Mexico's Ministry of Finance (Secretaría de Hacienda y Crédito Público [SHCP]), the central bank (Banco de México [Banxico]), and the banking regulator (Comisión Nacional Bancaria y de Valores [CNBV]) will enforce the country's Fintech Law.

Two types of fintech entities will be under the umbrella of the Fintech Law: crowdfunding and e-money institutions. The law defines minimum capital requirements for companies to operate as crowdfunding entities and e-money institutions ($160,000-$224,000, depending on certain transaction characteristics). It also establishes requirements to acquire shareholding interests in fintech companies' capital stock and sets limitations on the cash that crowdfunding and e-money companies can receive. Moreover, the law institutes that crowdfunding entities cannot guarantee returns on investments or guarantee the result or success of such investments. The law also includes virtual assets, establishing that fintech companies can only use cryptocurrencies authorized by the central bank. Finally, according to the law, the Mexican government doesn't guarantee or support customers' financial resources that are saved or invested in fintech companies.

In S&P Global Ratings' view, digital transformation is essential for Mexico's banking industry, and adopting financial technology will improve Mexican commercial banks' long-term business and financial profiles. While competition from fintech start-ups could threaten the profitability of existing financial institutions, we expect to see a collaborative relationship between commercial banks and fintech companies rather than a rivalry. The mix of commercial banks and fintech companies' strengths could offset their respective weaknesses and result in a more efficient and deeper financial system. As of Dec. 31, 2018, access to banking in Mexico--measured by credit to the private sector to GDP--was about 30%, one of the lowest in Latin America, reflecting Mexico's low financial inclusion (measured by the percent of adults with a banking account, at 47%). In our view, mutual efforts from banks and fintech companies could result in a turning point for financial inclusion in Mexico, with more sectors of the population able to use financial services.

Mexico Plans To Take Advantage Of New Technology For Greater Financial Inclusion

On Jan. 8, 2019, Mexico's President Andres Manuel Lopez Obrador (AMLO) announced measures to further develop the Mexican financial system in order to promote higher economic growth and reduce income inequalities in the country. The Ministry of Finance and the central bank will work together with representatives from the banking sector, pension funds, and stock market to implement these measures, which have been well received by the market.

With these measures, the government plans to take advantage of the new digital technology era to let financial services become cheaper and more accessible to low-income population segments. The government plans to promote the use of electronic transactions to reduce cash transactions--which we estimate make up over 90% of transactions in Mexico; high compared to other developed countries like Singapore with 40%--and tackle money laundering and corruption. The Ministry of Finance and the central bank are collaborating with Mexican banks to develop a new electronic payment platform--better known as "cobro digital" (CoDi). CoDi will allow consumers to pay quickly and securely using their smartphones, using QR (quick response) codes. We expect this platform to be ready in the fourth quarter of this year. Consumers must have a bank account in order to access CoDi.

In our view, the adoption of financial technology in Mexico will face challenges such as infrastructure capabilities (connectivity) and access to smartphones. However, we believe the development of the platform is a positive step in harnessing the potential from partnerships and synergies between banks and fintech companies, which we believe will result in more access to banking and higher financial inclusion in Mexico.

Chart 1

Mexico Has Second Largest Market For Fintech Start-Ups In Latin America, Although Growth May Slow

In 2018, Mexico had over 300 fintech start-ups--according to Fintech Radar Mexico, published by Finnovista in collaboration with the Inter-American Development Bank (IDB)--making it the second-largest fintech market in Latin America, just behind Brazil with 377 new start-ups as of June 2018. Colombia is the third-largest market with 124 start-ups.

In Mexico, most fintech start-ups (about 54%) have between one and 10 employees. About 45% of them are less than two years old and just 15% are more than five years old. Mexican fintech start-ups mainly focus on two business segments: payment and remittance services (23% of fintech start-ups) and consumer and business lending (22%). Other fintech companies offer enterprise financial management (13% of start-ups), personal financial management (11%), crowdfunding (9%), and enterprise technologies for financial institutions (7%). The remaining Mexican fintech start-ups offer insurance, wealth management, digital banking, etc. Last year, we saw the appearance of five fintech start-ups offering digital banking services (there were none before). We see a similar distribution by segment in Brazil and Colombia.

Latin America has emerged as an opportunistic market for foreign fintech players, coming mostly from Europe (65% of foreign fintech companies operating in the region), the U.S. and Canada (31%), and Asia (4%). According to Finnovista Fintech Radar, Mexico is the most significant market for foreign fintech companies--74% of fintech companies with international operations operate in Mexico, while Brazil is the second largest market with 46%.

We expect the pace of growth of new fintech start-ups in Mexico will decelerate. We may even see the sector consolidate because of the new Fintech Law. In our view, the minimum capital requirements and other regulatory requirements that the law establishes represent a heavy cost for start-ups, making it more difficult for new players to enter the sector.

Chart 2

Mexico's Well Respected Fintech Law Is A Model For Regional Peers

In our view, it's fundamental that Mexican fintech companies have a strong regulatory framework that provides legal certainty (for customers, investors, and other market participants) and protects against money laundering and fraud. However, it's also crucial to avoid rigid regulations since the fintech sector is constantly changing. Therefore, we believe a flexible framework that allows for continuous revisions to the law's provisions is ideal, which is the case in Mexico.

In our view, the following factors are most important for a sound regulatory framework for Mexican fintech companies:

• The new Fintech Law's creation of a Financial Innovation Group that will set the stage for sharing knowledge, ideas, and experience from the financial technology and innovation sector with the public and private financial sectors. This group is composed of representatives from SHCP, CNBV, Banxico, and innovation specialists from different sectors such as commercial banks, securities firms, insurance, e-payments, virtual assets, and crowdfunding. We expect this dialogue between the regulatory body and the industry to keep improving the regulations for fintech companies.
• One of the positive factors Mexico's Fintech Law includes is the "sandbox" regulatory mechanism. This means that any start-up company offering financial services through digital technology in any form not yet available in the Mexican industry (and so not included in the existing regulatory framework) can request authorization to operate during the next two years, and test their business in a controlled and supervised space. Therefore, Mexican regulation for fintech companies can keep evolving with additional rules as the regulator observes new business models in operation.
• The concept of "open banking"--which allows financial institutions to share banking data with third-parties through APIs (application programming interfaces) with customers' consent--should promote increased competition in the Mexican financial system. It should result in lower lending costs and will be key for expansion of fintech start-ups in Mexico. However, we don't expect the regulator to publish open banking rules until next year. Currently, fintech companies are working on interconnecting with financial institutions.
• In terms of technology to secure digital information, the Mexican Fintech Law complies with high international standards. It adopts blockchain technology, which will help shield the Mexican fintech industry from fraud and cyberattacks.

Partnerships Between Commercial Banks And Fintech Companies Should Benefit Both

Mexican commercial banks are no longer competing just with other banks or financial institutions. In our view, competition from new service providers (such as fintech companies) that offer convenient financial services to customers could threaten the profitability of existing financial institutions. However, we believe that digital transformation is essential for Mexico's banking industry and adopting financial technology will improve Mexican banks' long-term competiveness.

In our opinion, the mix of commercial banks and fintech companies' strengths could offset their respective weaknesses and result in a more efficient and deeper financial system. Fintech companies have sound expertise about technology and innovation, they offer flexible solutions to customers (individuals, small and medium enterprises, and financial institutions), and are making financial services cheaper and more efficient. Banks cannot ignore such strengths. However, fintech companies have important limitations. For example, they are barred from taking deposits from customers (unlike banks) and, according to the Fintech Law, the Mexican government does not guarantee or support customers' financial resources that are saved or invested in fintech companies. On the other hand, commercial banks have large-scale and satisfactory management and corporate governance standards, risk management culture, and historic customer databases (which is important for the digital industry). Moreover, they can take deposits--that make up most of their funding bases--and a significant amount of those deposits are insured.

Therefore, we believe that partnerships between banks and fintech start-ups will benefit customers (through lower fees, commissions, and lending costs), commercial banks (due to lower non-interest expenses and improving efficiency), and fintech companies (based on higher business volumes). We see this collaborative trend in other countries, and believe Mexico won't be an exception. We note that the enterprise financial management segment is growing very quickly in the Mexican fintech sector. This sector represents 13% of total fintech start-ups in the country, but increased by 75% in 2018 (just behind InsureTech at 114% last year). This growth reflects that fintech companies are aiming to collaborate with commercial banks in order to obtain benefits such as higher business volumes and profits. Currently, we see several commercial banks in Mexico acquiring, doing joint-ventures with fintech start-ups, or contracting outsourcing services to develop digital business solutions. We've seen insurance companies developing similar synergies with new insurance technology (InsureTech) firms, mainly involving new features and digital solutions for auto insurance.

In other regions (the U.S., Europe, and Asia-Pacific), the tech titans--Amazon, Google, Apple, and Facebook--have entered the banking space in a limited way, mainly through payment services. In Mexico, as previously explained, the government is collaborating with Mexican banks to develop an e-payment platform (CoDi). Amazon is currently evaluating the possibility of adopting CoDi so that its Mexican customers would be able to pay using this scanning technology with QR codes. In our view, future collaboration between Mexican commercial banks and FinTech companies will be essential to compete with tech titans that possess large financial firepower and strong customer bases. The tech giants have significant reach and visibility, and have already proven their ability to quickly develop and implement technical innovations. In this context, we believe banks could face the most competition from activities where barriers of entry are low, such as transaction revenues--a business that tech giants have already entered.

In our opinion, financial technology is a necessary investment for Mexican banks to support their business position and financial profiles; failing to adopt will result in banks losing customers and market share, which could erode bottom-line results due to pressure on non-interest expenses. Therefore, a bank's failure to adapt to new financial technology could lead to weaker creditworthiness and pressure the issuer credit ratings.

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