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Fintech: letting the little boys kick sand
Lucy Frew examines the FCA’s proposals for making innovation in financial services products easier with the introduction of a regulatory “sandbox”.
In its 10 November report, the FCA set out plans to introduce a regulatory sandbox and asked for views on the proposals. The sandbox will be a “safe space” where businesses can test innovative financial products, services, business models and delivery mechanisms without immediately incurring all the normal regulatory consequences. It will be aimed at innovator firms (both authorised firms and new entrants), accelerators, software firms and technology companies, subject to criteria similar to the ones for requesting support from the FCA’s Innovation Hub. The aim is to launch the FCA’s sandbox in the spring of 2016 and the FCA is also looking at authorising a fintech umbrella company to run a “virtual”, umbrella sandbox. The timing for the latter is unclear. The products in the sandboxes would be tested on the general public. As part of the regulatory sandbox, the FCA will implement a "restricted authorisation" regime for some unauthorised, innovative firms".
Overall, the aim is to promote competition in the interests of consumers, with the assumption being that there is a close connection between competition and innovation. The FCA believes that potential benefits of a regulatory sandbox could include:
- reduced time-to-market at potentially lower cost
- better access to finance; and
- more innovative products reaching the market
The FCA rightly identifies regulatory uncertainty as the key obstacle to these benefits. It relies on data from the pharmaceuticals industry to argue that a regulatory sandbox will reduce regulatory uncertainty, though it is not clear that this will work in a financial services context. First, unlike the pharmaceutical industry regulators, the FCA primarily authorises firms, not products. Second, it is the FCA's firm authorisation process, not product performance, which creates the greatest regulatory barrier for firms.
The FCA will not grant authorisation until a firm has mobilised capital, hired staff and put IT and other infrastructure in place. Start-ups have difficulty attracting investment without authorisation yet cannot afford to mobilise for authorisation without it. Product testing in a regulatory sandbox does not solve this problem. However, there may be analogies between the way in which the FCA has sought to rationalise the authorisation of challenger banks, which were faced with a ‘Catch 22’ of not being able to raise capital without approval and not being able to get approval without capital, though this does not seem to be what the FCA is proposing. (Banks, unlike other firm types, can obtain restricted authorisation before mobilising capital, personnel, IT and other infrastructure.) Still, the sandbox will allow firms to run pilots without triggering the full panoply of legislative and regulatory consequences.
Legislative change: Options that require legislative change are limited by EU legislation. The FCA cannot exempt firms that must be authorised or registered under EU law – the majority of firm types – from authorisation requirements.
Restricted authorisation: The FCA will be able to authorise sandbox firms with restrictions, allowing them to test their ideas but no more. However, before being able to test, firms still need to become authorised, which requires time and resources. EU legislation imposes onerous authorisation requirements in relation to most types of firm, severely limiting the FCA's flexibility.
Virtual sandbox: This would be an environment to enable firms to test their solutions “virtually” without entering the real market. The FCA does not propose to set up the virtual sandbox itself. Rather, it believes that the industry, acting collectively, is well placed to do this. The FCA indicates that the virtual sandbox route would not allow testing on consumers that are not aware of being involved in a test, but would facilitate collaboration between businesses, academia and other interested parties when innovative products or services are being developed.
Sandbox umbrella: This would be a not-for-profit company set up by industry, acting collectively, that allows unauthorised innovators to offer their services under its shelter as appointed representatives. The umbrella company would need to be authorised with appropriate permissions and then supervised by the FCA along with other authorised firms. The umbrella company would monitor its appointed representatives. Many firms already operate as appointed representatives, albeit under non-collectively operated umbrellas.
A sandbox umbrella would need significant in-house expertise to supervise its innovative appointed representatives and would bear the risk associated with regulatory responsibility. This would be a costly enterprise, so "not-for-profit" would not necessarily mean fee-free for innovator-appointed representatives. The appointed representative regime is only available for a limited range of regulated activities, so not all innovative businesses would be able to use the sandbox umbrella. The sandbox umbrella proposal also requires industry to act collectively to encourage disruptive competition.
The FCA has identified a number of approaches that it can take to protect customers that participate in sandbox testing. One would allow sandbox firms to test their new solutions only on customers who have consented to being included in testing.
Another would require businesses undertaking sandbox trials to compensate customers for any investment losses and to demonstrate that they have the capital resources do so. However, this could make the sandbox an unaffordable option for firms. Both approaches also appear likely to distort testing outcomes. In the absence of any clear solution, the FCA's preferred approach is to agree on a case-by-case basis the disclosure, protection and compensation appropriate to the testing activity. It is not obvious how long determining a bespoke agreement would take in each firm's case.
The FCA is hosting an event in December 2015 to discuss its plans for implementing the sandbox. The FCA's aims are laudable. Hopefully its report will stimulate dialogue that leads to genuine reduction in regulatory barriers to innovation.