Innovation, technology and legal change: where to next?

Financial services sector head John Salmon and the Pinsent Masons financial services sector team bring you insight and analysis on what really matters in the world of financial services.     

Recently, the Financial Conduct Authority (FCA) announced its decision to begin consulting on proposals to regulate 'loan-based' crowdfunding.

Almost immediately the plans were criticised for misunderstanding the issues. 'FCA crowdfunding plans oversimplify matters badly', read one headline. Others read: 'FCA wrong to lump P2P lending and crowdfunding together', and 'Keep the crowd in crowdfunding: fears financial watchdog will make investment only for the wealthy'.

There are two issues here, one of substance and one of principle. When critics said that the FCA failed to acknowledge and address the differences between crowdfunding and peer-to-peer lending they were right. Labelling peer-to-peer lending as 'loan-based crowdfunding' did not create the impression of a well-informed regulator in a position to produce well-thought-out rules.

Underlying the criticism though was also a more general sense of a regulator jumping in on too specific a level without first having taken the time to acquire the necessary understanding required. As a matter of principle, the FCA's proposals formed another chapter in the book of tension between technology and the law.

How to keep up with change?

Almost daily, someone somewhere questions whether the law can keep up with technology. The answer often given is a resounding 'no'. Technology by its nature is progressive, while the law requires durability, certainty and stability. Surely the two will always be in conflict with each other?

It is important to shake off this view of lawmaking if innovative services are to thrive. The alternative is that which currently hampers legal change at the higher levels of lawmaking. The EU's ordinary legislative process, for example, as mandated by the Lisbon Treaty, typically requires between 26 and 32 steps to be taken before a regulation or directive is formed. In practical terms this means that after a need for regulation arises, there generally must be a waiting period of at least five years. By design it creates a legal change process unresponsive to innovation in technology.

It may be though that innovation in technology and responsive legal change can co-exist if market participants become more involved in the lawmaking process at an early stage, helping to craft more specific, more informed laws.

The challenge is getting clearer and deeper engagement from those organisations that are in the best position to articulate how legal change can respond to technological change. These organisations need to act as enablers of pre-legislative consultation processes that highlight key benefits to individuals created by new technologies and not just the risks to existing interests which they represent. Regulators need to be just as informed about these benefits as they are about the legal and compliance issues on which technology at times has an impact, such as privacy, intellectual property ownership and ensuring that customers are kept fully informed when engaging online.

If a proactive approach is taken, regulators will be less likely to react to innovative ideas by assessing only how well they fit in with current regulation. Businesses therefore need to provide regulators with evidence as to why existing regulation may no longer strike an appropriate balance between the public and private interests which they were initially designed to serve and the conduct which they now unexpectedly restrict, due to changes in technology.

But, who wants to alert regulators to innovative visions that may or may not leave a firm in breach of regulatory rules? The experiences of the peer-to-peer lending industry suggest that despite the fears of enforcement which engagement on that level may cause, it is exactly what is needed.  

The peer-to-peer lenders' experience

For some time, the peer-to-peer lenders have recognised the need to engage actively with the regulator. Rhydian Lewis, chief executive of RateSetter, who we recently spoke with, told us that as far back as 2010 the peer-to-peer lenders had identified that both providers and customers of peer-to-peer lending services would benefit from introducing regulation where none existed.

“We had formed a self-regulating body in 2010 called the Peer to Peer Finance Association which set out some minimum standards for the industry and we were keen for this to be recognised and scrutinised by the regulator," he said.

That didn't mean though that they immediately received the response hoped for. "Initially the government were unsure because they felt the industry was too small to warrant formal regulation. They were also cautious about over-regulating at a time of such technological innovation", Lewis said.

But further engagement by the peer-to-peer lenders about the benefits of introducing new rules eventually led to regulatory change. "We suggested [to the regulator] that the industry would soon grow to a size where people would expect regulation and also that appropriate regulation would have the positive effect of harnessing the innovation and clearing up much of the uncertainty that inevitably surrounds a new financial activity," he said.

The peer-to-peer lenders understood that without explicitly understanding the issues regulators will continue to be left in the dark focussing only on interests that are at risk and not the benefits that well-thought-out regulatory change can bring about.

Perhaps in a more forceful manner than the peer-to-peer lenders, we have seen technology companies in the US pushing for greater involvement in respect of European data protection laws where their interests were at stake. All financial services organisations need to do the same whenever regulatory change or a lack of regulatory change could hamper their ability to innovate and better service their clients.

The alternative, the current state of affairs, is not attractive. As it stands businesses have to account for not just general legal risk, but also the unexpected and usually impractical consequences of laws that are unfit for new purposes to which they are directed. These represent a major risk, and an unpredictable one.