Financial technology has already changed the finance market – it is just a question of how fast financial institutions can change to deal with this.
Technology is redefining the finance sector and in particular delivery of consumer finance. This is providing banks and traditional consumer finance providers with the difficult choice of either change fast and accept the associated costs relating to embedded technology and physical infrastructure, or lose business to more advanced technology models. A number of large institutions are already funding investment, setting up incubator businesses and tech venture funding – but is this enough?
Regulators are also faced with a stark choice between encouraging or stifling innovation in technology-driven financial products. Concepts such as the UK’s Financial Conduct Authority’s (“FCA”) sandbox may give some space for new financial products and systems to evolve.
The financial technology sector, collectively abbreviated by the buzzword “FinTech”, has seen exponential growth over recent years. Most recently valued at an estimated £20 billion in annual revenues1, it is attracting interest from investors and regulators alike.
FinTech is providing customers with quicker, direct and more convenient services delivered at lower costs. The sector is redefining the way in which consumers pay for goods and services, transfer money and apply for credit and finance. Early adopters as customers tend to be younger, higher-income individuals particularly in high-concentration urban areas such as London, New York and Hong Kong.2 Reasons for adopting include ease in setting up accounts, more attractive rates, access to different products and a better online experience. The main reasons for not adopting tend to be a lack of awareness of availability highlighting the importance of first mover advantage as established participants, or new entrants competing to establish brand recognition and loyalty in emerging FinTech services sectors.
The government’s recent report, FinTech Futures3 , indicates a positive approach towards the FinTech community, and in particular towards the start-ups behind the ‘tech’ aspect of FinTech, whom the government hopes will make the UK a hub for start-up technology companies to develop and grow. There is a need now to balance the government’s desire to encourage technological developments, with a view to making the UK a world-leader in FinTech, against the need to ensure financial electronic transactions and products are appropriately regulated. This is particularly pertinent in the wake of the widespread distrust in financial institutions following the 2008 financial crisis, and highlighted by the government’s careful approach to introducing regulation to address the FinTech sector.
IDENTIFYING FINTECH AND THE OPPORTUNITIES IN THE FINTECH SECTOR
FinTech is generally considered to include large-scale data analytics and data mining (e.g. for credit and credit scoring), digital currencies and BlockChain, online platforms, peer-to-peer lending, smart contracts, and use of artificial intelligence for financial planning, asset management and trading. By far the element of FinTech which has seen the most success is in relation to e-payments. A recent report by Statista highlighted that electronic payments currently account for over 90% of the FinTech market. On the other hand, comparison sites and use of lead aggregation are not considered to be true FinTech. Put simply, FinTech relates to activity that is likely to result in the technological disruption of the traditional banking model.
There are many ways in which institutions both large and small can innovate and make use of FinTech to develop product offerings, and to better serve widespread consumer types, as, for example, the telecommunications providers and the retail sector have already done for many years. Financial services providers need to concentrate on applying FinTech to improve their business model and profitability, rather than focusing on negative implications of disruption to existing business.
RESPONSES OF FINANCIAL SERVICE PROVIDERS
Financial service providers are playing catch-up to more technologically advanced par tners in the tech sphere. Banks are naturally risk-averse, and historically have been reticent to give up on established infrastructure and systems. It is easy to see why banks have little appetite to replace their current expensive infrastructure, particularly where this has not yet been significantly impacted by FinTech competitors in the market4. The danger is, however, that by waiting for FinTech to be developed enough to be considered a secure investment, they may react too late. Successful banks will be those which adapt and utilise more advanced and increasingly inexpensive technology to compete more effectively in the marketplace.
The most successful FinTech products are those focused on single products targeting previously under-serviced areas of the market. The FinTech companies making the most mainstream progress are those which are utilising technology, and in particular automation, to provide services to consumers who would otherwise be unable to access similar services and products using traditional banking models. Successful FinTech start-ups have been able to offer competitive prices in contrast to established financial institutions. TransferWise and TransferGo are prime examples of this, offering services to transfer money abroad at a tenth of the price of banks by focusing on peer-to-peer transactions and circumventing the high fees usually charged. Larger financial institutions have seen the benefit of this, and have used advances in technology to reduce costs and streamline products. We see this with the move towards a digitised banking system involving a much reduced face-to- face banking experience. This removes expensive branch and staff costs, but there is significantly more progress that can be made. Certain financial institutions such as Barclays and Visa have already taken steps by setting up, respectively, their Accelerator and Collab programmes, with an aim to ‘harness FinTech talent and foster a culture of innovation’5. This limited initial action, however, is still seen by some as evidence of banks reacting too slowly and taking too conservative an approach, with these innovation “hubs”, for example, strategically placed outside the organisation.
In its March 2015 report6, The Government Office for Science predicts that established financial service providers are unlikely to disappear or be beaten out by FinTech competitors, but rather will identify high-value ways to participate in the new system. Germany is an example in this respect, as recent statistics show that 28.2% of FinTech companies in Germany co-operate with banks, and four out of the top five German banks have co-operated with such companies, with two of those banks operating their own investment incubators.
Financial technology has the potential to reinvigorate an industry which has been traditional in its approach, and slow to adapt to technological advances. The question is not whether or not they are prepared, but rather how quickly UK financial institutions can put themselves in the best possible position to take advantage of the opportunities FinTech brings, so that they remain competitive with new entrants and competitors on the world stage.
THE RESPONSE OF THE REGULATOR
With such change comes the need for relevant and effective regulation to promote growth, but also to protect consumers. The FCA, unlike some other similar regulators, has a competition mandate. This means that it does not only deal with the largest market players, but also assists new entrants and innovators. One way in which the FCA has promoted innovation and competition is through the launch of “Project Innovate” and its Innovation Hub, which went live in October 2014. The project looks at emerging issues and barriers to entry in the FinTech industry, and its two main goals were to support innovative firms trying to launch in the marketplace, providing them with a means to open dialogue with the regulator, and also to promote innovation in relation to FCA policy. It also has a focus on developing new technologies to help firms better manage and comply with regulatory requirements (“RegTech”). A call for input in relation to RegTech was launched at the end of 2015, and there is clearly a focus on not only ensuring relevant regulation, but also using technology to ensure effective compliance.
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The biggest development of the project was the launch of a regulatory sandbox. This provides a safe space for firms operating in the FinTech space to test out ideas. A report published by the FCA in November 2015 looked at how best to implement the sandbox. The intention is to open the sandbox to proposals from spring 2016. Interestingly, the sandbox received a cautious reception. It is not a safe harbour and only offers informal guidance and help to launch initiatives; firms could still be caught by current regulations, even if operating within the sandbox. It seems, however, to be a fairly unique idea and promotes a proactive approach on both the part of the regulator and the firms developing FinTech ideas.
What is clear is that the FCA is looking at issues facing the entire industry affecting both small and large players alike.
NEXT STEPS AND PREDICTIONS
Whilst encouraging innovation should drive efficiencies, growth, diversity and competition in the financial space, it will also be monitored and controlled through regulation to ensure stability. To the fullest extent possible, it is important that regulation promotes rather than restricts innovation. In June 2015, the FCA launched a call for input as to views about specific rules and policies which are restricting innovation and asked what other policies should be introduced to facilitate innovation. The aim is to develop effective and relevant regulation in the FinTech space, allowing companies to develop and promote ideas within an effective regulatory background.
The introduction of the EU Payment Services Directive 2 (“PSD2”) provided the means to create an EU-wide market for payments, increasing security and the ease with which cross-border payments can be made. The PSD2 will take effect in 2016 and affects e-money institutions as well as traditional credit and payment institutions. E-money and e-payments have been a key part of FinTech developments to date. The PSD2 also brings into its scope innovative payment products and services which were excluded from the original Payment Services Directive. The introduction of PSD2 could provide significant opportunities to FinTech companies by opening up access to the banks’ payment and information systems.
BlockChain ledger technology continues to develop, and there is likely to be a push in the next year to use this for launching large-scale initiatives. BlockChain is being considered by large institutions as a viable means to provide a back-bone for their digital products as they can now effectively and securely record series of transactions. This was seen most recently in the use of a BlockChain system developed by NASDAQ to document and record through NASDAQ share issuance in a BlockChain company.
Technology and regulation need to evolve at the same pace to make it easier for both small and large firms to launch new ideas and innovate in the finance space. We are already seeing large strides in the application of technology in the consumer finance sector. Innovators both small and large should be able to take advantage of the new ideas, and progress is currently being made. The onus is on large institutions to assess which technologies will work within the current and proposed regulatory landscape, and to roll out programmes to make these technological platforms work, if they are to preserve market share in an increasingly competitive finance market.
Investment in FinTech has picked up over the last few years, and confidence in the sector noticeably grew in 2015 as companies perfected their product offerings. Currently, the FCA does not view FinTech developments as a threat to the traditional banking model. The Director of Competition at the FCA, stated that “traditional financial services may be facing ‘Uber-style’ competition but not yet ‘music streaming-style’ demise.” With the increasing number of FinTech products and successful financings for FinTech companies, all current incumbents will need to remain vigilant to the speed and nature of change or risk a rapid demise.
We have advised a number of high-profile clients on a range of cutting-edge projects in recent months, in which FinTech was a key element. From this, it is clear that FinTech will challenge traditional ideas, but it is also able to improve profitability and encourage growth for existing market participants by diversifying their product range, improving efficiencies and reaching a wider consumer base. Recognition by the FCA, the EU and the UK government that regulatory support is required to ensure growth and development of ideas will allow further progress in 2016, and may be the much-needed stimulant for European economic growth.
We welcome participants of all sizes that may be interested in testing out the FCA sandbox concept for the development of new and innovative product ideas and concepts.