Estonia builds its fintech muscle

Estonia is frequently referred to as ‘e-Estonia’ due to its early adoption of electronic processes for many aspects of public life, from engagement with public services in 1997 to delivering electronic residency in 2014. However, despite its cultural embrace of technology, it still faces a fight to become a fintech hub.

And yet, as a country, it has enormous potential; economic growth is projected by the Organisation for Economic Co-operation and Development to reach 3.5% in 2019, before slowing to 2.3% in 2020, which would be in line with predicted weakening external demand. Its financial services sector is active and innovative, with Estonia having ranked first in Europe for alternative finance volume per capita for the past two years in research conducted by the Cambridge Judge Business School’s Centre for Alternative Finance, which includes crowdfunding, peer-to-peer lending and other alternative finance intermediaries.

Strong potential

A 2018 report by the European Bank for Reconstruction and Development (EBRD) and the European Commission's (EC’s) Structural Reform Support Service (SRSS) found good conditions for the country to deliver greater capital market development, particularly in the context of pan-Baltic synergies. It recommended:

• enhancing access to finance for small and medium-sized enterprises (SMEs) via capital markets, using public and private capital, across the regions, underpinned by the Capital Market Union Action Plan backed by the EC;
• encouraging firms and government groups to tap capital markets, along the lines of the initial public offering by the Port of Tallinn;
• improving the ecosystem for SMEs to access the capital markets, noting that the depth of public markets is limited; doing so would provide private equity and venture capital funds that invest in SMEs with exit options. It also supported alternative financing platforms such as crowd-funding;
• expanding the offering of listed securities to bridge the investment gap for local long-only pension funds that otherwise have to invest abroad, as local markets have limited liquidity and a small number of securities.

To further its cause to become a centre for fintech, as part of the wider ambition to boost its capacity to support its finance sector, Estonia has engaged in a series of projects that will accelerate or grow its native talent in such a way that it can be supported in country. For example, the EBRD is working with Estonia’s Ministry of Finance in establishing a regulatory sandbox.

Combined with its natural capabilities, Estonia has the potential to take these developments and become a strong originator and destination for fintech start-ups.

The right size

The first of Estonia's advantages is its size. With a population of only 1.3 million, any native fintech start-up must think about a cross-border approach from the outset. “Estonia’s markets are limited, so basically there are natural restrictions to how successful a company can be only in Estonia, leading firms to think internationally,” says Kaido Saar, member of the management board and head of fintech at trade body FinanceEstonia.

“If you are founding a company in a bigger country, you might be very successful purely in that one country,” he continues. “If you want to [expand your business outside] of that country, you might realise that there are too many or too dramatic changes needed. Changing the architecture of the technology or building new systems are barriers. In Estonia, however, you have to do it right at the beginning.”

However, the small country size can also present challenges. Although it has proven capable of nurturing the talent to create the likes of Skype and TransferWise, and more recent fintech firms such as online identity verification start-up Veriff and blockchain-based marketplace Funderbeam, there are size limits to the talent pool.

“For historical reasons Estonia has protection regarding immigration. It is written into our constitution that we have to protect our language and national heritage,” says Anne Veerpalu, attorney at law and associate partner at law firm Njord. “For that reason we have a quota today, which is hampering the non-start-up businesses because it is difficult for them to hire from outside Estonia and the EU.”

Skill demand

Estonia’s immigration quota, of 0.1% of the population per year, applies to non-EU/European Economic Area citizens. In 2018, this was less than 1500 people and the quota is often filled quickly. However, there are several exemptions from the quota, including nationals from the US and Japan, for employees in the information communication and technology sector, and for employees in start-ups.

There is such a high level of demand for the right skills in Estonia, especially in the technology sector, that as new companies get the funding they then start poaching from other tech companies, which is pushing up salary levels.

“This is increasing the quality of life for all the local talent, especially programmers and developers,” says Ms Veerpalu. “But at the same time this means that there is growing demand to bring in staff from other countries, especially Asian countries and Ukraine. We can see the poaching is increasing demand to have good developers brought into Estonia, and then they can stay here and work on their own start-ups.”

Lean government

The relatively small size of Estonia is also reflected in the size of its government and bureaucracy. Liudas Kanapienis, CEO of Lithuania’s Ondato, a provider of digital identity verification services, says that Estonia’s size has proven advantageous. “Estonia is really open because the structure in the government in Estonia is quite lean,” he says. “The way the government is reacting to everything is really good. Of course, it is a tech-savvy country.”

At a practical level, this is manifested in both access to and the responsiveness of authorities when interacting with businesses and legal issues. “You can call them up or write them a letter and – to the surprise of French and Italian colleagues – they actually respond. They respond quickly and with thoughtful questions,” says Ms Veerpalu. “They are our partner in this sense. During the hype around initial coin offerings [ICOs] in Estonia, every single person who wanted to do an ICO sent a letter to the regulators. The regulators were exhausted but wanted to respond to every single one – and they did.”

Supporting innovation without placing consumers at risk is key for small countries, who are often able to use regulation for competitive advantage but must be wary of just who they let into the market.

Charles Hayter, CEO and founder of market analysis firm CryptoCompare, says: “If you are looking at the regimes on the periphery of Europe, there are countries that have created their own specific regulation to try and attract business. But it is a very complicated situation because the users are global, while the companies are operating [within] nation state [rules].”

Achieving harmony

Regulators also carry the burden of harmonising national laws with wider global or regional rules, such as EU regulations and directives in the case of Estonia. To be a competitive base for firms, authorities need to balance out these obligations.

Ms Veerpalu says: “The Ministry of Finance is mostly working on the harmonisation parts, where there is little of its own creation that doesn’t come from the EU. I think Malta was brilliant in this sense because it took the time, effort, finance and resources to work on ICO/blockchain technology-related regulation. It is a quarter of our size, but the country saw an opportunity there and attacked it, as it did 10 years ago in the gambling industry. In this sense, there is always room to do more, to be the first mover and the first one to introduce regulation.”

Such competition can also have an effect closer to home. The size of the Baltic states means that they both compete and co-operate. When one moves first, it can steal a march on its neighbours.

Mr Kanapienis notes that when e-money licensing was introduced in 2012 in Lithuania, it had an impact on the fintech development in the country. “[Regulators] changed access to the financial industry and for the companies,” he says. “Enabling the activity itself – because before that it was only banks that could conduct financial activity – changed the look of the market. The government looked at what regulation had to be changed from a legal perspective to enable competition.”

The sandbox potential

Working with Estonia’s Ministry of Finance has given the EBRD some insight into the country’s potential strengths as a fintech hub. Jacek Kubas, principal for local capital markets at the EBRD and the head of the development bank’s sandbox projects, says: “I think one of the many benefits of Estonia is efficiency in government.”

The EBRD’s collaboration on supporting fintech firms, via a sandbox, is helping to accentuate this efficiency, as well as encourage greater openness. In its initial stages, 35 market participants, including start-ups, banks and innovators, attended a workshop on supporting fintech development.

"We have started work with the EC on the sandbox, we got funding from it, and we have just had the first kick-off meeting in January, where we discussed the design and what we wanted to do,” says Mr Kubas. “There are two different types of sandboxes. One is the [UK’s] Financial Conduct Authority [FCA] model, where the regulator closely co-operates with the start-ups. The other is the Australian model where there is more of a barrier between the regulator and the participating companies.”

Work is now beginning on determining the design for the sandbox – effectively a set of rules and conditions that enable new firms that pass the eligibility criteria to operate – in order to facilitate innovation and enable firms to test their ideas while being monitored by a supervisor or regulator. As a result firms can work to the edge of existing rules without the risk of crossing over, thereby supporting the development of highly innovative projects and business models.

In this instance the EBRD-led project will support the Ministry of Finance in giving feedback on start-up business models, with access to technical knowledge and support from its testing team. It is hoped that the market will see greater competition because of the more efficient development process and removal of fear around experimentation.

Mr Kubas says: “You have to create an environment to be able to test the solutions in a very regulated way, but that regulation must not be too strict.” For example, the licence for start-ups limits the number of consumers they are engaging with while testing the solution in the sandbox.

The next stage

In the first half of 2019, the EBRD, the EC and Estonian authorities will be designing and creating the framework needed for the digital sandbox, alongside the benchmarking of any necessary technologies, and will then recommend reforms to the Estonian government to fit within the regulatory environment.

The EBRD has applied to join the Global Financial Innovation Network (GFIN), which is an international project created by the FCA to connect regulatory sandboxes, as an observer, to allow it to assist regulators and enable cross-border testing across its regions.

"Right now, the sandbox brings a start-up to a certain level within the country, but many want to expand that solution across borders, so how can we create a bigger network?” asks Mr Kubas. “I hope Estonia will participate in the FCA's GFIN to support cross-border experiences.”

He adds: “Our next milestone is to file our design reports with the FCA and we are doing that in co-operation with consultancy PwC. After that we will have a discussion where we will work on the design and eligibility criteria, to see if any changes in the legal and regulatory environment are needed.”

Retaining business

Based on the EBRD and SRSS assessment, Estonia can deliver not only the framework to support innovation but also the capacity to enhance funding for start-ups. The risk that all small countries face is to be a springboard for firms that leave to become incorporated in other countries where capital markets better enable growth. Yet Mr Saar argues that there are good reasons to develop in Estonia and only use overseas countries for funding.

“If a company is started in Estonia then you have a group of people here, the team and experience. This is your strength; you have achieved your results based on that. There is no need to move it to New York or London because the company wants to raise capital. It is more cost efficient to leave the office in Estonia, versus moving to New York or London, where office costs are much higher.”

Mr Kubas is not quite convinced but thinks things are changing. “I think it will remain a benefit for start-ups to have offices in London, for example, because it has an investor base that the firms are trying to attract but they haven’t been looking at Estonia,” he says. “However, in recent years we have seen that investors are increasingly thinking about Baltic states as a fintech hubs, bringing something new to the financial technology world.”