FCA announces new Regulatory Sandbox

 

The Financial Conduct Authority (the “FCA”) has set out its to expand Project Innovate by implementing a “regulatory sandbox” – a “safe space” in which businesses can test innovative products, services, business models and delivery mechanisms without immediately incurring all the usual regulatory consequences of engaging in those activities.

 

You may remember that Project Innovate is an FCA initiative to foster competition and growth in financial services by supporting both small and large businesses that are developing new products and services that could genuinely benefit consumers.

 

It is hoped that a regulatory sandbox will help to deliver more effective competition in regulated financial services in the interests of consumers by:

 

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• reducing the time and, potentially, the cost of getting innovative ideas to market;
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• enabling greater access to finance for innovators;
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• enabling more products to be tested and, thus, potentially introduced to the market; and
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• allowing the FCA to work with innovators to ensure that appropriate consumer protection safeguards are built in to their new products and services.
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The FCA has suggested three possible approaches to building the sandbox:

 

1.Expanding Project Innovate to include a Sandbox Unit: this team will be responsible for considering sandbox applications and monitoring the testing process;

 

2.Developing an industry led virtual sandbox: an environment to enable firms to test their solutions virtually without entering the real market (e.g. by testing with publicly available data sets or with data provided by other firms through the virtual sandbox); and

 

3.Supporting the creation of a private sector led sandbox umbrella: a not-for-profit company set up by industry and authorised by the FCA, which would allow unauthorised innovators to offer their services under its regulatory shelter as appointed representatives.

 

 

As well as potentially opening up the route to market for unauthorised firms, authorised incumbents may also wish to use the sandbox to test new products and ideas. The concerns and challenges faced by these two groups differ and, accordingly, the FCA has proposed different solutions to try and address these concerns and challenges:

 

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• Unauthorised firms: It is proposed that the FCA will set up a tailored authorisation process to allow testing by firms who need to become authorised to trial their new products or services. Sandbox firms will first be authorised with restrictions, allowing them to test their ideas but no more (restricted authorisation). Once the firm is able to meet ‘full’ requirements, restrictions can be lifted.
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• Authorised firms: Authorised firms are mainly concerned about the risk of the FCA taking enforcement action at a later date. In response to these concerns the FCA has proposed (i) issuing no enforcement action letters (NALs) stating that no FCA enforcement action will be taken against testing activities where the FCA is reasonably satisfied that the activities do not breach its requirements or harm its objectives (ii) issuing individual guidance to a firm on the interpretation of applicable rules in respect to testing activities the firm may be carrying out and (iii) waiving or modifying particular rules for sandbox firms where it is in the FCA’s power to do so.
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In both cases, the proposals effectively lower the regulatory barriers currently faced by firms. As a result, additional safeguards will need to be put in place to ensure both customers and the regulatory system are appropriately protected during the testing process. Four potential approaches have been outlined in the FCA’s paper:

 

1.Informed consent: sandbox firms can only test their new solutions on customers who have given informed consent to be included in testing. Customers are notified of the potential risks and the available compensation;

 

2.Case-by-case basis: the FCA agrees on a case-by-case basis the disclosure, protection and compensation appropriate to the testing activity;

 

3.Existing rights: customers have the same rights as customers who engage with other authorised firms (e.g. the right to complain to the firm, then to the Financial Ombudsman Service (FOS); and access to the Financial Services Compensation Scheme (FSCS) if a firm fails); or

 

4.Compensation: businesses undertaking sandbox trials are required to compensate any losses (including investment losses) to customers and must demonstrate that they have the resources to do so.

 

The FCA’s preferred model is for safeguards to be agreed between businesses and the FCA on a case-by-case basis, ensuring that protections are sufficient but at the same time not unnecessarily burdensome on the businesses considering their sandbox activities. This reflects the overarching view that the sandbox should be flexible but, as yet, it is not clear where liability will fall if there is a detriment to consumers using products in the sandbox. There is likely to be criticism of the FCA if things go wrong and so it may be that conditions / thresholds will be high.

 

The impact of the sandbox remains to be seen and its success may turn on what level of conditions or thresholds the FCA imposes on companies wishing to use the sandbox. Financial services incumbents may be concerned that the sandbox will lower the barrier to entry to the financial services market meaning that the time and money spent obtaining authorisation and staying compliant may not give incumbents a competitive advantage. On the flipside, unauthorised firms will be concerned that, before being able to test, they still need to obtain authorisation, albeit at a restricted level, and meet relevant requirements which will require time, resource and potentially significant one-off costs.

 

Nonetheless, the idea of a regulatory sandbox is welcomed and the FCA has outlined a number of case study areas where the sandbox approach may add value, including FinTech innovations such as robo-advice (automatic investment advice business models), blockchain technology and the adoption of Regtech (technologies that facilitate compliance with regulatory requirements).

 

In due course, legislative changes may be implemented to better address some of the challenges faced. Proposals include (i) introducing a new regulated activity of ‘sandboxing’ for testing; (ii) changing the waiver conditions in FSMA to make it easier for the FCA to waive rules for a firm within the sandbox; (iii) amending the Financial Services and Markets Act 2000 (Exemption) Order 2001 to introduce an exemption from authorisation for sandbox firms; and (iv) amending the Financial Services and Markets Act 2000 (By Way of Business) Order 2001 to provide that a sandbox activity is not to be regarded as carried out “by way of business”, so it would not be a regulated activity. However it has been noted that (iii) and (iv) are likely to be unfeasible due to limitations set by EU legislative requirements.

 

The FCA is hosting events in December 2015 to discuss its plans for implementing the sandbox and intends to open its sandbox in spring 2016 with the industry led arrangements following later.

 

At least the FCA is not burying its head in the sand when it comes to innovation in finance!

 

 

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Jonathan Segal, Partner at Fox Williams LLP

 

Jonathan is a partner in the FinTech and Alternative Finance team at Fox Williams, a City-based Law Firm. He advises clients across the FinTech and Alternative Finance spectrum, from start-ups disrupting existing markets with innovative technology to financial institutions looking to invest in new technology.

 

He has particular expertise in peer-to-peer and crowdfunding platforms, drawing on his extensive experience in the banking and finance sector gained both in-house at major financial institutions and in private practice. His experience spans a variety of financial products, including loans (both corporate and consumer), real estate and development finance, asset-based lending, receivables financing, asset finance, trade finance, capital markets, derivatives and repos. A regular speaker at industry events both at home and abroad, Jonathan is also heavily involved in next generation disruptive financial products such as virtual currencies (including Bitcoin), blockchain technology and the use of Big Data in financial predictive analytics and disruptive insurance models.

 

Fox Williams LLP are experts at advising entrepreneurs and FinTech businesses. For more information as to how Fox Williams can help you (including arranging a free consultation) or for further information on the issues discussed in this article, please liaise with either  or .