You'd likely be forgiven for thinking that blockchain means Fintech and Fintech means blockchain, but the technologies underpinning the phrases 'Fintech' and 'Insurtech' go far beyond that.
Let's get this straight– Fintech means financial technology (and yes, you've got it, Insurtech means insurance technology) and together they are the commonly used terms to describe the use of software to provide financial and insurance services. In this article we'll refer to Fintech and Insurtech collectively, by using the phrase Fintech.
There are few other subjects that have been written about and commented on by journalists, technologists, venture capitalist, lawyers and even central banks, as Fintech has. And now not only have the clearing banks and insurers woken up to the fact that both the money and the talent are being drawn to Fintech firms, so too have the UK's regulators.
In this article, Brett Carr a financial services solicitor at Bond Dickinson looks at what is currently exciting both firms and regulators, drawing on the experiences from a recent financial technology forum Bond Dickinson hosted at the London Stock Exchange, at which industry experts and CEOs described how blockchain, smartphone apps, consumer wearables and claim acceleration tools looked to be revolutionising their industries.
So long as the transaction meets the participant's pre-agreed validation criteria of that particular ledger, the other participants will, by way of the agreed consensus protocols, approve the transaction and all participants will simultaneously update their version of the register. This transaction becomes immediately time-stamped and encrypted, becoming embedded in the chain of transactions that took place before it. This immutable record (a single version of the truth) means (in theory at least) that no transactions can fall between the gaps, rendering fraud practically impossible. Each participant has perfect knowledge.
It's hoped by many that distributed ledger technologies will reduce transaction costs (by getting rid of middle men) and provide methods for eradicating fraud. For example, by providing an immutable record of ownership of assets, such as dematerialised shares or even diamonds.
The current regulatory landscape for Fintech
What became clear from the Bond Dickinson Fintech Forum is that innovators are still coming to terms with the potential of these technologies and that can only mean that regulators are some way behind in their understanding of (i) the functionality of the technologies and (ii) the markets that will be created by those technologies.
Fintech businesses start in the same place as everyone else – having to determine if and then how, regulation applies. This can be difficult if you need to be authorised, but don’t yet know where your development and testing will take you. Again, Fintech firms operating in the UK will, like everyone else, have to work out which regulated activities they will carry on and what their scope of regulatory permission should be. From this flows, not least, their financial resources, senior management, organisational and conduct of business requirements.
Getting things right
No matter how small, cool and entrepreneurial, a regulated Fintech firm and its senior management has to implement appropriate compliance policies and procedures. This can sometimes prove difficult for a start-up still looking for funding. To name just a few responsibilities, firms and senior managers will need to be:
- organising and controlling their affairs responsibly and effectively, with adequate risk management systems
- maintaining adequate financial resources
- having regard to financial promotions rules and guidance
- protecting clients assets
- operating complaints procedures
- setting reward and incentive structures that don’t promote excessive risk-taking
- dealing with their regulators openly and in a co-operative way, providing them with notice of anything they might reasonably expect notice of
- maintaining systems, controls and contingency plans to address a myriad of risks such as bribery, money laundering, hacking, data losses or technical failures.
So whether you're a Fintech firm, or a bank/insurer looking to partner with such a firm, there will need to be a period of reflection on the viability of the technology once it becomes clear how it is intended to be used and how it fits, or will fit, with your systems and controls. More specifically, when partnering with Fintech's, banks, insurers and other authorised firms will need to be acutely aware of the PRA and/or FCA's requirements around outsourcing.
Getting things wrong
Getting these things right from the start are vital. Whilst the rules and guidance may seem to be a drain on resources, money and time, getting it wrong can have severe consequences:
- scrutiny and public censure
- legal and regulatory sanctions: criminal penalties, fines, prohibition orders, restrictions on activities and even business closure
- impairing the business value
- hampering regulatory approval for investment or sale of the business.
Fintech firms shouldn’t be put off by what looks like a one-size-fits-all regulatory approach. At its heart, the FCA (the likely regulator for Fintech firms) has a consumer protection objective supported by an outcomes-based regime. This approach, arguably, leaves the door wide open for creativity and innovation which is aimed at benefiting the consumer. This point was hit home at the Bond Dickinson Fintech Forum, where Mark Mullen, CEO of all-digital challenger bank, Atom Bank plc, remarked that these advancements in financial technology are "shifting the focus of control away from the manufacturer to the customer." A shift, he hopes, will result in the destruction of the universal banking model. Having guided Atom Bank plc from inception to authorisation as a bank, Mullen is well placed to comment on the FCA's ability to work with Fin-Tech firms and there was no mincing of words when he claimed that "the FCA is one of the most far-sighted regulators on the planet… and the direction of travel is pretty encouraging."
The future regulatory landscape
Despite the words of praise for the FCA, there is no escaping the fact that the current law and regulations were not designed with Fintech in mind. What will become critical for Fintech innovators is understanding how their technology will be categorised by regulators. For example, at present there is no specific regulated activity that neatly encapsulates blockchain and its uses. Fintech firms and bank/insurer partners will have to assess the particular use and features of any application of blockchain and will have to examine each on a case-by-case basis to determine if it falls within an existing regulated activity, such as operating a multilateral trading facility or conducting regulated payment services activities.
A means of mitigating against such regulatory uncertainty is for Fintech's to help set the regulatory agenda. Engaging regulators and policymakers, as use cases for these technologies develop and mature, is of vital importance. The FCA's regulatory sandbox provides such an opportunity to develop products and services, whilst receiving regulatory feedback in a low risk environment. The sandbox, by the FCA's own definition is: "a ‘safe space’ in which businesses can test innovative products, services, business models and delivery mechanisms in a live environment without immediately incurring all the normal regulatory consequences of engaging in the activity in question."
To address the chicken and egg scenario alluded to above (where Fintechs must be authorised or registered by the FCA to carry on regulated activities and to get that authorisation they will need to fully understand their offerings, but might not yet know where their technology will take them) the FCA has set up a tailored authorisation process to work closely with firms accepted into the sandbox to enable them to meet these requirements. Any authorisation or registration will be restricted to allow firms to test only their ideas as agreed with the FCA.
This should make it easier for firms to meet their requirements and reduce the cost and time to get the test up and running. The FCA announced in November 2016 that the first cohort of firms had been accepted into the sandbox to begin testing. The firms included: e-money platforms, money transfer providers, insurance products with automatic claims processes, robo-advisers, cross-border payments using blockchain and even a platform that represents private companies’ shares electronically on the blockchain so that they can manage shareholdings and conduct book-building online.
The Bank of England (BoE) has also announced that it will be exploring the use of distributed ledger technology in its own core activities and will launch a Fintech accelerator as a means for the BoE to work with new technology firms to harness Fintech innovations for central banking.
It is clear that there is legal uncertainty that will need to be addressed with new legislation. But, for the time being at least, close regulatory collaboration will be key in giving Fintech firms the minimum level of certainty they need to continue developing their technologies.
Benefits of new technologies
Distributed ledger technologies have the potential to deliver many benefits, whether it's directly to the regulators by enabling direct transaction reporting by giving them access to the ledger, or to users by eradicating costs by allowing for simultaneous execution and clearing of trades in certain securities.
Richard Williams, CIO of Innovatively Digital, speaking at the Bond Dickinson Fintech Forum, described an emerging partnership between Neos and Hiscox which allowed the insurer to monitor people's smart homes via connected smoke alarms, moisture sensors and cameras. Insurtech is leading to a re-evaluation of the insurance proposition, Williams highlighted that "the insurer proposition is to pay when there is a loss, but this [technology] can reduce loss and risk."
Risks of new technologies
With any new technology and journey into the unknown, there are risks.
With distributed ledger technology, it has been discussed that the very nature of blockchain, the immutability of transactions which bind together in an unbreakable chain, means that it would be impossible to edit an erroneous trade. Rather, you would have to make a new data entry which would also have to pass through the consensus protocol to make the required change.
It is this immutability which raises yet more questions, in particular the level of reliance that can be placed on the data. Could a court determine legal title to an asset just by the data available on the ledger, or would they require other evidence of title? Until we have greater legal certainty, it is these types of question which handicap the current uses for the technology.
Regulators have come to expect authorised firms to have in place all manner of contingency plans to deal with system failures and latent defects in software. It is no surprise to those that work in financial services that banks and insurers operate with outdated IT systems and infrastructure. It will be key for Fintech firms to develop and test with this in mind, especially where they expect their services to interface with those of the bank/insurer.
Some doubters have also questioned the speed at which money is being invested in, and used to acquire, Fintech firms, with many likening the pace of change to the dot-com bubble.
Will Brexit impact on the regulatory landscape for Fintech and Insurtech?
No self-respecting contributor could get to the closing remarks of an article without mentioning the second most commonly used 'B' term after blockchain - BREXIT.
The prevailing consensus from Government looks to be that the UK will be maintaining the current regulatory regime. However, a regulatory divergence could allow the UK's regulators to form an independent regulatory perspective from Europe, in turn allowing the creation of a new regime for Fintech and in particular distributed ledger technologies. But, the regulation of Europe's financial markets have been converging for decades and major regulatory divergence would likely inhibit the ability for Fintech firms to roll out products and services (such as those based on a global distributed ledger) across one of the World's most diverse and mature financial markets.