Harnessing the digital revolution: the Fintech challenge

Technology applied to financial services (“Fintech”) is big business. Across the globe in 2015, we saw a dramatic increase in the way that our clients (and indeed our own business) use technology in their products and services, general operations, and in the way that they interact with their customers, and we expect that trend to continue throughout 2016 and well beyond. The most pronounced change is in the financial services industry where we have seen institutions:

• evaluating the potential of new technology to create innovative digital banking products and services, as well as the development of smart payment technologies and applications (for example, banks evaluating the potential of blockchain technologies/ crypto-currencies for digital cash; use of big data in fraud reduction, etc);
• exploring the use of innovative data-hosting services, such as cloud technologies, as data warehouses;
• transforming how they communicate and engage with their customers, as well as considering the conduct risk and regulatory challenges associated with such communications (i.e. data privacy issues, automated advice, financial promotions via Twitter communications, etc); and
• remodelling their back office functions to create more automated processes to drive greater efficiency and quality control in their business.

Investments in Fintech continue to grow rapidly. It is thought that global investment in Fintech was over US$12 billion in 2014. According to UK Trade and Investment figures, deal volumes in the UK in relation to Fintech have been growing at a rate of nearly 75 a year since 2008. The UK Government has estimated that over £20 billion of revenue was generated by Fintech related businesses in 2014.

Figures such as these illustrate why governments are rushing to support this burgeoning industry, and are actively encouraging businesses to promote and invest in products and services which utilise Fintech.

But there is a glaring issue which may hamper the development of Fintech solutions: the regulatory framework.

The opportunity/threat

The demand is being driven by a combination of factors, the principal of which are as follows:

• customer demand: The number of people globally who have access to the internet is growing considerably. In 1995, only 1 per cent of the world’s population had access to the internet. In 2014, that percentage had increased to over 40 per cent. It is estimated that this figure will continue to increase and it is estimated that by 2020, 7.5 billion people will have access to the internet. In addition, the number of users of smartphones is forecast to nearly double to over 5 billion by 2020. As a result customers are becoming increasingly connected and tech-savvy, and are more likely to use internet- based channels to access products and services (including financial products).
• cost synergies/efficiencies: Fintech products and services whilst having reasonable cost in research and development, are likely to be less costly over time as they do not rely on expensive infrastructure (for example, a retail bank based entirely online will not require costly branch networks, etc, the ‘internet of things’ being used by insurers to gather data used in the underwriting process). As well as revenue costs, it is possible that Fintech brings about a reduction in balance sheet cost (for example, the potential for reduced capital requirements for institutions who clear transactions using distributed ledger technology, etc); and
• competition: new and innovative service providers (or ‘disruptors’) competing for business that was traditionally the preserve of banks and financial services providers (for example, the recent introduction of Apple Pay as a new entrant into the payment services market).

In response to these demands, we have seen several banks either develop their own offerings (for example, Barclays), or establish their own funds to invest in new technology (for example, Santander’s incubator fund). 2015 also saw Goldman Sachs filing a patent application for a blockchain-based securities settlement system, which would eliminate the need for a central clearing system.

The potential obstacle to Fintech use and growth

It is encouraging that regulators have generally responded positively to innovation. In the UK, the FCA launched ‘Project Innovate’ in 2014 which is responsible for assisting nascent Fintech businesses negotiate the UK financial services regulatory framework. One initiative that the FCA has implemented which is clearly aimed at assisting innovation is a process by which small businesses can test their products and services in a ‘safe’ environment with retail customers (similar to a clinical trials in medicine) through the use of a regulatory ‘sandbox’ which will also allow the regulator to supervise and provide feedback on firms’ proposals before they go live. There is also a subset of Fintech that is being supported by the UK Government (and as a consequence the regulators) and that is ‘Regtech’, which is seen as new technologies that will help facilitate the delivery of regulatory requirements. For example, regulatory reporting technologies. Like Project Innovate, the FCA plans to support the adoption of RegTech by providing regulatory expertise to RegTech firms, collaborating with accelerator programmes, academia, FinTech firms, financial services firms to identify appropriate areas of interests and themes, developing standards and guidance; and addressing barriers to entry, innovation and adoption of RegTech.

However, in general, the regulatory framework is cumbersome and relatively rigid when compared to innovations in technology. In Europe, many of the legislative requirements relating to financial services are the result of European Union directives which must be implemented to their fullest extent (i.e. ‘maximum harmonisation’). There is little scope, therefore, for the FCA, the PRA or any other regulator in Europe to adopt an approach that is flexible when it comes to enforcement of these rules. Indeed in a recent FCA paper on firms’ obligations in relation to cloud outsourcing, the FCA made it very clear that existing regulatory requirements applied equally to cloud outsourcing as it did to any other type of critical outsourcing. This creates difficulties where some of the key outsourcing providers apply a ‘one size fits all’ approach to their customers. Thankfully, at least financial services firms are now able to point to a clear and unambiguous statement from the regulator on what their position and obligations are, rather than struggle through the quagmire of regulatory rules, which the Fintech providers would otherwise have to try to grapple with. That stated, there are some promising signs coming out of Europe (although such signs are at a very embryonic stage). Recently (December 2015) the Joint Committee of the Three European Supervisory Authorities (ESMA, the EBA and EIPOA) launched a discussion paper in relation to (technological) automation relating to financial advice. Reading between the lines it appears that there is a genuine wish to allow for innovation, and this may include expressly reducing perceived regulatory hurdles where possible. We wait in hope!

Responding to the challenge – the future of regulation?

Technology generally moves at a pace that is incomparable to financial regulation. The world’s financial centres have built their reputations on systems of regulation which have evolved over many years of business and commerce. The timescales over which these rules and laws have developed have been, in some circumstances, centuries (there is no acknowledgement of Moore’s law in the financial regulatory world). Does this mean that the world’s financial centres cannot expect to maintain their advantage if their respective regulatory frameworks are incapable of adapting at the same pace as technology could (and is) changing the environment for financial services?

Clearly a principles-based approach to regulation would allow for more scope to accommodate some of the technological advances that are being made in Fintech. However, we accept that it is unlikely that this will ever be completely embraced by the jurisdictions in which the main financial centres operate. Principles-based regulation was largely discredited following the global financial crisis. There is also argument that principles-based regulation erodes the rule of law (i.e. that elected governments create the legislative framework which is enforced by the relevant authorities rather than authorities being empowered to interpret (and enforce) broad statements of principle). It is also true that a more rigid regulatory framework is required to ensure that the general imbalance of power between large institutions and retail customers is properly restricted (particularly true where customers are more vulnerable). For London, the Fintech providers may well be supportive of a Brexit if it meant loosening the regulatory shackles which the PRA and FCA are subject to (although, for the reasons set out above, those businesses should not expect a complete free rein even if Britain was to leave the European Union!).

In our view, there will likely remain a tension between the needs of a nimble and agile Fintech sector and the statutory objectives of the financial regulators of the world’s leading financial centres. The need for regulation of the financial system, and the social objective of protecting consumers, mean that wholesale reduction of regulation (whether for Fintech or other financial products or services) is unlikely. Perhaps the situation as it stands is the best that we can hope for: financial regulators willing to adapt their methods to provide a safe environment for Fintech to be developed – the regulatory equivalent of a Fintech moratorium – set against the backdrop of regulators’ clearly set out expectations of what their requirements are on firms. This might not be what Fintech firms are hoping for, but it is certainly better than some of the worst case alternatives in a sector besieged by rules.