In the same way that neither the wind nor a sail can steer a ship on its own, technology and regulation will always work in unison to guide the financial services industry. However, the emergence of today’s FinTech solutions is redefining the way financial service providers and regulators cooperate.
Historically, both process changes and technology advancement in financial services has provoked equal and opposite responses from regulatory bodies that usually resulted in at least one of the following:
- Some form of data normalization or reporting requirements
- New operational controls and procedures
- A recommendation to exclude the technology in its current state
DIGITAL DISRUPTION REDEFINES COOPERATION
While these outcomes have served to appropriately measure adoption rates of new technology solutions in the past, the speed and impact of digital disruption has put a premium on the effective collaboration between established providers, FinTechs, and regulators. In the past few years, the industry’s technology priorities have evolved in a few important ways, including:
- Client demand for a more digital user experience
- A shift away from people and process redesign, with a focus instead on the implementation of more targeted automation technology, such as robotic process automation, machine learning, and artificial intelligence
- Lower risk, faster-paced innovation cycles due to significantly lower capital requirements for developing digital solutions
More forward-thinking regulators acknowledge that the future depends heavily on the ability to understand these drivers and to redirect regulatory response to actively promote digital technological innovation. Delivering transformational solutions will depend on the ability to level the playing field on which both regulated and unregulated entities must now compete and cooperate. For the asset management industry that creates both opportunity and challenge, around which regulators are beginning to organize.
THE FCA LEADS THE WAY WITH REGULATORY SANDBOXES
The UK’s Financial Conduct Authority (FCA) is widely considered to be the preeminent regulator in the FinTech space. In 2014, the FCA launched Project Innovate, which was an attempt to encourage innovation and promote competition through new technology development. One initiative within the wider project is the creation of a “regulatory sandbox”, which acts as an incubator for firms wishing to provide new innovative solutions that comply with the FCA’s regulatory standards. The move represents one of the first practical steps toward allowing FinTechs to test new technologies while simultaneously insulating investment consumers from the risks inherit in any startup.
At the highest level, the FCA sandbox creates a protected environment where both established and emerging providers can test innovative new products and services in live market environments. While the FCA’s sandboxes do not completely eliminate regulatory oversight, they do attempt to initially lower the ever-tightening regulatory barriers to enter today’s market. Essentially, the FCA is looking to create a protected environment in which both established and emerging solution providers can test innovative new products and services in real living ecosystems.
Sandbox providers are allowed to engage directly with clients willing to participate without immediately incurring all the normal regulatory consequences that would have been a prerequisite in the past.
REGULATORY SANDBOX ELIGIBILITY CRITERIA
The FCA has established set eligibility criteria to determine who can participate in the sandbox. In 2016, 69 firms submitted applications to participate outlining the purpose, context, and success criteria of their proposed test cases.1
Some general suitability conditions include:
- Genuine Innovation: Is the new solution genuinely novel, or significantly different from existing offerings?
- Consumer Benefits: Is there a good prospect of identifiable benefits to consumers? This criterion has to be met throughout the period of testing.
- In Scope: Is the new solution designed for or supportive of the financial services industry?
- Need for Sandbox Testing: Is there a genuine need for testing within the sandbox framework?
- Readiness to Test: Is the proposed case at a sufficiently advanced stage of preparation to warrant live testing?
As of the end of 2016, 24 projects were approved by the FCA, and 16 of those are actively working on proof-of-concept or providing services from the sandbox. The products are focused on robotics, distributed ledger technology solutions, and other regulatory software solutions.
OTHER REGULATORS EXPECTED TO FOLLOW
Long viewed as one of the more progressive global regulators, the FCA’s strategy demonstrates that it is possible for regulators to serve their objectives without artificially limiting innovation in financial services. Regulators in other jurisdictions across Europe, as well as in the US and Asia appear to be taking a “fast follower” approach when it comes to implementing schemes that actively promote FinTech integration in the regulated space.
Regardless of the course, the various regulatory bodies try to chart for the industry over the longer term. Many providers are hoping that the FCA’s initiative will prove why it is critical to sometimes skillfully loosen the jib sheet a little before tacking too hard upwind.
1 Financial Conduct Authority, FCA unveils successful sandbox firms on the second anniversary of Project Innovate, 11 July 2016
This article was originally published in the 2017 Regulatory Field Guide. The guide features insights from a number of our experts on key regulatory developments that will have the greatest impact for asset managers in the year ahead – and beyond. Visit bbh.com/regulatoryfieldguide to explore the guide.