Embedding Encouragement of Innovation Across the FCA

In short, innovation in the financial services market – and the FCA’s view of what is appropriate in that market - is constrained by regulation that is not aligned with the evolution of collaborative business models throughout society. Unless, the FCA re-aligns its rules and approach, innovators and investment capital will flow to where the cost of innovation is lower and market access less constrained. The FCA may perceive regulatory arbitrage at the perimeter of the regulatory sphere from time to time that may carry risks to the FCA’s objectives under the then current framework. But the FCA could perhaps be more explicit about those perceived risks and engage more openly with HMT, innovators, consumers and other stakeholders at an earlier stage in understanding the relevant activities and their benefits and how best to manage the risks.

1. Innovation in financial services is of course part of a much wider context. Society has been steadily

evolving more open, transparent models of ‘collaborative consumption’ at a rate that is accelerating in line with developments in technology; shocks in the mainstream financial system that has constrained access to credit and interest income (to which poorly diversified consumers have been particularly vulnerable); and declining in faith in society’s traditional institutions.

2. Other drivers for collaborative consumption in the financial services market in particular have been the

high cost of intermediation, a preference for short term speculation in financial assets rather than longer term financing for genuine economic activity. Policies may partly obscure issues with old models, while innovation could help with more transparent identification of their failings and the management of the attendant risks. While it is possible that not all the risks in these collaborative models have emerged, this creates a real imperative for a more collaborative approach to risk than we have seen to date, so that all stakeholders can develop appropriate and proportionate controls suited to the new models, rather than trying to shoe-horn the models into existing controls more suited to other activities.

3. However, the FCA seems to have taken the view that there are no unregulated aspects of retail financial

services, with regulation governing collective investment schemes and other ‘non-mainstream pooled investments’ being a key area of friction with collaborative business models and a catch-all for anything that is not otherwise specified. Yet typically NMPIs can only be marketed to wealthy investors1, while everyone is suffering from side effects of low yields and poor diversification. The FCA could work with industry to develop a strategy that is more open to genuine input from outside in order to reduce regulatory cost, ensure proportionate risk mitigation and yet consistent treatment of different products with similar risk.

4. Ironically, given Brexit, the FCA’s current approach is more European or civil law view of how regulation

should operate. In common law jurisdictions, like the UK and Ireland the law tends to follow commerce; whereas in civil law jurisdictions on the continent there is an expectation that the law

1 (a) a unit in an unregulated collective investment scheme; (b) a unit in a qualified investor scheme; (c) a security issued by a special purpose vehicle, other than an excluded security; (d) a traded life policy investment; (e) Rights to or interests in investments that are any of the above.

SEL 4.3

should stipulate what can and cannot be done. It is also true, however, that political and media reaction to perceived regulatory failures often implies that there should be a more comprehensive framework in place. But a more collaborative regulatory approach to innovation would enable innovators to proceed with certainty that they will not be unduly constrained or stopped in their tracks as the rules follow; while demonstrating to politicians and the media that enabling innovation and competition with some risk is part of a comprehensive approach to financial stability.

5. The UK government’s eventual support for crowdfunding, for example, has been constrained by the

application of traditional consumer credit regulation on the borrower side; and a desire to prevent perceived ‘regulatory arbitrage’ by reference to rules governing banking, investment funds or NMPI’s on the investor side. Yet, while there have been some advances in the regulation of those older banking and investment business models, their structure, culture and focus remain the same as in previous decades (as continuing fines demonstrate). The crowdfunding industry – and various European authorities since – suggested using payments regulation as the basis for regulating crowdfunding platforms in view of the similar operational risks, but that approach was not accepted. Both approaches reveal an instinct to look at innovative services for similarities with existing services, rather than differences, which tend to get shoe-horned in; which in turn prevents fresh analysis, from first principles, about how new services should be regulated.

6. Accordingly, there are important lessons for all stakeholders to learn from the crowdfunding

experience to date; and those lessons need to be learnt if the UK is serious about embracing Fintech and innovation:

• Rather than resisting calls from the industry for proportionate regulation, the government could have recognized crowdfunding as part of the longer term trend and engaged more positively and effectively at an earlier stage;

• This could have given HMT and the FCA sufficient time and resource to set up small, dedicated teams that understood in detail how platforms worked, enabling officials to do a better job of assessing and defining the relevant regulated activities: the ambiguities, complexities and gaps in the drafting have led to many of the current problems, while the protracted authorisation process has really been a process of education and awareness raising.

• Equally, platform operators would then have been obliged to invest more resource in legal and regulatory support to work with HMT and the FCA on the detailed rules, whereas they eventually found themselves unprepared to become educated in the numerous sections of the FCA Handbook where the relevant rules were added (rather than in a single place, as for payment services).

7. The FCA has offered an ‘Innovation Hub’ and ‘Sandbox’ by way of an early opportunity to check how the FCA will view an innovative service offering that the existing rules do not fit. However, this results in a firm proceeding on the basis of its own legal advice and only informal comment from the FCA innovation staff; and experience has shown that authorisation and supervisory staff may either remain unaware of any contact with the innovation staff or freely ignore any exchange of correspondence, with the result that a business may be engaged in fresh set of very expensive discussions with the FCA and may be obliged to alter its activities, obtain extra permissions or potentially cease trading altogether. To change this, the FCA could develop a consistent view of a new activity from the start,

SEL 4.3

with either Policy staff engaging with Authorisation and Supervision staff; or by ensuring that the Innovation Hub etc., are actually run by Authorisation or Supervision.

8. In summary, the cost of innovating in the retail financial markets is far higher than in other markets,

yet constrained by unduly tight marketing rules. Unless this equation is reversed, innovators and investment capital will flow to where the cost of innovation is lower and marketing less constrained.

Simon Deane-Johns Consultant Solicitor