The Financial Conduct Authority (FCA) is moving with the digital times by playing a key role in creating a regulatory environment for fintech to thrive. As part of the FCA’s Project Innovate – an initiative introduced in late 2014 to promote competition through disruptive innovation – the FCA recently introduced the regulatory sandbox to offer new entrants to the market a chance to test their products in a safe environment.
The three lines of defence: a threat to innovation?
When collaborating, the biggest challenge that banks and fintech companies face is the regulator’s traditional approach to compliance. At the moment, most banks are using the ‘three lines of defence’ approach to demonstrate and structure roles, responsibilities and accountabilities for decision making in order to achieve effective governance, risk management and assurance.
The first line of defence is made up of the business operations function, where responsibilities include directly assessing, controlling and mitigating risks within the business. In order to execute tasks accurately and seamlessly, frontline staff must be adequately skilled and must have a complete understanding of what is expected from them when it comes to creating risk definitions and subsequently assessing the risks found.
The second line is made up of the compliance and risk management teams, which together make up the oversight function. This function is responsible for designing policies, setting direction, introducing best practice, ensuring compliance and providing assurance oversight for the business. The third and final line is an independent function, made up of internal auditors who provide assurance to board members and management over the first and second line of defence.
As every organisation is different and specific situations vary, there is no “right” way to co-ordinate these three lines of defence. However, it is essential that all three are able to work effectively together to create the right conditions – or else risk becoming disjointed with regard to what they are defending and from what threats.
For innovation, the second line forms the biggest threat for both fintech and the banks, but for opposite reasons. For the banks, innovation has been hindered by regulatory rules, but for firms operating within the fintech space, the problem is that the lack of guidance and tailored regulatory framework has stalled their ability to flourish.
Both positions have their own dangers and regulators are recognising that they play an important role when it comes to educating and bridging the gap between banks and fintech. That said, to ensure that the right balance of innovation is implemented while simultaneously protecting the consumer, the regulatory sandbox was introduced.
Sandbox: eliminating fears
The FCA’s sandbox initiative aims to support innovation in financial services. The thinking behind the scheme is simple: new entrants to the market are given the opportunity to test their creative ideas without the fear of upsetting regulators if their products do not follow current rules.
The existing regulatory process requires firms to have an infrastructure in place before the authorisation process even begins. As Christopher Wollard, Director of the FCA, previously acknowledged, this process can be an expensive one and firms that currently require authorisation from the FCA can incur “significant costs”. Many start-ups do not have the resources or the initial funding to meet the obligations required by the FCA, but what the sandbox does is give firms the platform to prove the functionality and profitability of their model, which could result in them obtaining further funding for a full launch.
Promoting dialogue and collaboration
The sandbox is currently open for both regulated and unregulated firms. Unregulated firms taking part in the initiative will go through a tailored authorisation process, granting them restricted authorisation. Regulated firms, on the other hand, will go through individual guidance on how the regulator interprets current rules within the context of the test.
With the help of the FCA, fintech developers will be able to gain the knowledge and expertise they need to introduce their new innovative products whilst ensuring the risks are not transferred onto consumers. For this reason, we expect to see the sandbox promote more dialogue, collaboration and openness for the banking, fintech and regulatory sectors.
That said, for firms to reap the full benefits of the sandbox and understand what is required in practical terms, the FCA should also think about releasing some case studies. This method could help firms and regulators outside the sandbox put real life context around many common processes and challenges and find out how they were overcome.
The industry must recognise that this is unknown territory. As a result, there is a sense of ‘trial-and-error’ and there may be hiccups along the way. However, the FCA should be applauded for this flexible, forward-looking approach and for grasping the opportunity to drive innovation through continuous developments.
By Shaun Ledgerwood, Chief Executive Officer at Niu Solutions.