Time for the sandbox

The EU Commission has now (8 March 2018) published the announced   FinTech action plan. The purpose of the Commission’s plan is to provide answers to the numerous challenges presented by the rapid pace of innovations in the financial sector. It’s part of its efforts to build the capital markets union (see mid-term, Brexit).

Financial technology

The term financial technology, or FinTech for short, means technology-enabled innovation in the financial sector. Examples are artificial intelligence, big data, cloud computing and distributed ledger technologies (e.g. blockchain in securitisation and credit treasury) in particular.

These areas are growing at breakneck speed. It’s true that gloomy predictions that they will usher in the end of the banks are undeniably somewhat hasty and exaggerated. But one thing’s for certain: tomorrow’s banks will look vastly different to today. The financial services sector will definitely be or already is undergoing massive changes.

And of course the sector will have to act decisively if it wants to compete. Therefore, the Commission’s action plan is a welcome move. But it’s vital to cast a critical eye on whether the initiatives are ambitious enough. Because external forces are dictating the pace of innovations – and it’s a fast one.

Initiatives of the Commission

The EU Commission wants to create a regulatory and supervisory framework geared to the future throughout the EU to encourage the development and sale of innovative products and solutions in a standardised way. It does however admit that it’s too early for wide-scale statutory and regulatory plans in this area.

The action plan focuses on three initiatives:

1.  Enabling innovative business models to reach EU scale
2. Supporting the uptake of technological innovations in the financial sector
3. Enhancing the security and integrity of the financial sector

The mid-term review of the capital markets union has already put forward the option of licensing in other EU member states by issuing a European passport for FinTech, which the action plan consequently now includes.

Regulatory sandboxes

Happily, the sandbox principle is also being discussed, and the competent authorities in the member states are called upon to examine the possibility of establishing and operating ‘FinTech facilitators’ (innovation hubs or regulatory sandboxes).

In some countries, safe and controlled spaces in the form of regulatory sandboxes are being set up for innovative companies. These offer an environment in which supervision is tailored to innovative companies or services. The authorities concerned do, of course, have to apply current regulations. However, when it’s a case of applying the principles of proportionality and flexibility in these regulations, powers of discretion can be exercised. This could be beneficial, particularly in the context of technological innovations. The sandbox concept was supported by the industry representatives taking part in the public consultation. The national authorities were more cautious (in some cases significantly so).

Experience in the real world has demonstrated that it’s hard to get financial innovations off the ground without a protective or supportive environment. So it’s no coincidence that financial innovations are in particular launched in places where the sandbox concept is applied. Countries such as these are therefore at a huge advantage and nations like Germany at a huge disadvantage.

Considering the short development cycles of products and business ideas, it’s often impossible to wait for any changes in future legislation. As a result, the associated uncertainty about whether the product or business idea is legally watertight turns major investments into a virtually incalculable risk. Because the financial services sector is one of the most stringently regulated, time-consuming checks on the legitimacy of a particular product have to be performed beforehand based on existing legislation that’s not really geared to the innovation concerned. Consequently, it’s not possible to test the marketability of a product in the real world without complex preliminary legal checks. The same applies to technical feasibility of a project.

Companies could use the sandbox to test the feasibility and market acceptance of a product before carrying out a costly legal check or subsequent drawn-out licensing procedure (where the outcome’s uncertain). A new licensing category for financial investors or a development field requiring no licences, perhaps based on the example set by FinMa in Switzerland, would logically appear to be the method of choice.

A development area, which would at least partially require no licensing, would be open to business models that don’t operate business of a typical banking nature, but still offer services of the kind described in article 1 KWG (the German Banking Act).

In the final analysis, the licensing conditions for this type of business model could be less complex than for standard licensing because the risks are lower and the business field initially limited.

As a result, regulations that hinder competition or are unsuitable could be excluded from the outset. In this way, barriers to market entry could be lowered and international competition encouraged.

The European Commission’s action plan can be seen as a declaration of intent by the EU regarding FinTech. The Fintech roadmap of EBA specifies further procedure. Now it’s crucial that this declaration of intent quickly translates into action. The other basic conditions for financial innovations do exist – even in Germany. They just have to be allowed to develop.