Is it still playtime in the sandbox?

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To support the growth of UK fintech – and to ensure that London retains its fintech crown against stiff foreign competition – the Financial Conduct Authority (FCA) launched ‘Project Innovate’ in 2014. In November 2016, as part of this project, the FCA announced the creation of a regulatory sandbox: a world-first ‘safe space’ designed to allow businesses to test new products and services in an environment with lighter regulatory obligations. The aim of the sandbox is to bring together innovators and regulators, helping the FCA to keep its finger on the pulse of developments in the sector.

But one year on, the question is: is it still playtime in the sandbox?

To start with, we ought to commend the FCA for the speed with which it acted, for by 8 July 2016 the application window had already closed. Of the 69 applications, the FCA judged that 24 had successfully met the criteria for entry, the main being that firms must be ready to begin testing; the sandbox is not an incubator. That criterion has enabled the FCA to maintain the pace, with the first cohort of firms completing testing by the end of April 2017.

Testament to the regulator’s desire to promote UK fintech, the FCA soon announced plans for a second cohort, with applications closing on 19 January 2017. The names of the 31 successful applicants have since been published, with 77 firms having applied. There is no standing still, however, with the regulator having only recently closed the window for applications to participate in the third cohort in July 2017. Although the outcome of the first cohort is not yet known, that the enthusiasm remains high is very much a positive.

That said, we are able to observe some noticeable differences in the inclusions and absences between the cohorts.

For instance, consistent with the FCA’s declared interest in the possible role that distributed ledger technology (DLT) may play in regulated areas, including in an April Discussion Paper, the second cohort includes at least eight firms basing their offerings on the technology. This is encouraging: the application of DLT to financial services has been explored for some time and firms are offering well-considered consumer-facing platforms, such as Otonomos, a first cohort firm. There are three artificial intelligence (AI) firms in the cohort, with interest in how AI can improve the tailoring of financial products and choices for consumers. Again, this is leading-edge technology and its inclusion is commendable. Insurance firms are also prominent, perhaps in recognition that this traditional sector is ripe for disruption.

A London-centric regulator could be potentially damaging when it comes to promoting UK fintech, so it is equally encouraging to see greater geographical diversity in the second cohort. Firms and talent are now drawn from across the country, particularly along the Edinburgh-Glasgow and Leeds-Manchester corridors, evening out any initial geographical imbalance.

What’s more, where the first cohort contained a number of banks, the second does not. Exclusivity, be it in the form of location, offering or type of firm, is not desirable for the sandbox. And whilst the money invested by large financial institutions in developing fintech offerings and moving the regulatory conversation along is valuable, the sandbox is intended, in part, to assist those businesses who need to test their products before spending money on obtaining permissions. Large banks do not seem to be the most natural candidates for such accommodation.

Members of the first cohort are currently compiling their final reports, though the general expectation is that most of the products tested in the first cohort will be taken forward. For the time being, it is hoped that the sandbox lives up to its stated aim of helping disruptors through the highly complex world of financial regulation, both protecting consumers and increasing competition.

Ultimately, the reports should clarify whether the companies found their time in the sandbox productive and enjoyable. As well as whether the FCA provided the necessary guidance to help them deliver their products.

As an initial indication, one cohort firm has provided very positive feedback about the experience, even stating that the supportive environment exceeded expectations. Through weekly consultations, the FCA provided the firm with guidance through the process, to the extent that the guidance accelerated the development of the product to an earlier launch that would otherwise have been possible. Ahead of those consultations, the firms would provide weekly metrics which would also be discussed. This generated a sense that the FCA was onside and invested in the process, a perhaps unexpected feeling described as “liking your mother-in-law”.

Overbearing or poorly conceived regulation emerging from the sandbox may stifle the appetite for innovation in the sector. Applicants to the sandbox are guided towards regulation in the application form itself. The expectation is that all of the sandbox firms will become regulated. Given that some cohort firms do not fall neatly within existing categories of permission, it will be no surprise to see newer regulations emerging with the benefit of the understanding gained from the sandbox collaboration.

Commentators have called for certain areas to be off limits to the FCA’s purview. The presence of the FCA, even as an interested observer, may stifle innovation. On the other hand, the FCA’s Christopher Woolard is concerned to protect consumers and also to ensure that the FCA is far savvier that it has been in the past. Mr. Woolard argues that greater understanding of technology and processes used in financial services will enable it to be nimbler and more likely to prevent the fragile post-2008 financial sector from taking more body blows.

Both views have merit. It is true that the FCA should not be straying into other sectors. However, given the pace at which developments happen, it seems futile to try to identify areas now which should be left to their own devices. Technological developments have impacted on sectors that might never have been contemplated when the technology was first conceived. Tech companies pivot, after all. The regulator must be agile enough to know when to step in, when to step out and when to stay away altogether. It is a minefield where the mines keep moving.

Instead a balance must be struck; regulation itself is not bad. It is bad regulation which is the problem. If the FCA is able to tread carefully and considerately, it may find more firms willingly applying for regulation rather than spending time and money with lawyers devising platforms and strategies that avoid regulation. It is a virtuous circle, a progressive regulator providing proportionate oversight and inspiring consumer confidence will encourage firms to work with them. It is also a utopian dream, but if you don’t aim for the stars you’ll never clear the trees.

Sam Pearse is a Partner in Pillsbury’s corporate corporate and securities practice.