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John at the WIRED Money conference 2013

Disruptive Entry and Regulation in Financial Services

On 1 July 2013, John Fingleton spoke at the WIRED Money conference in Canary Wharf, London.


You can watch the speech here.

Ronald Reagan described government’s view of the economy as; “If it moves, tax it. If it keeps moving, regulate it. And if it stops moving, subsidize it.”

Regulation affects businesses across all industries, but it has a special place in the heart of the financial services sector. This industry’s regulated more than most. And we’re entering a phase in which the Thatcherite/Reaganite faith in market outcomes Is reducing slightly, and government is increasingly happy to intervene.I’m going to focus on the ways in which regulation can materially influence innovative companies, and the development of new business models.

Although ‘regulation’ and ‘innovation’ aren’t obvious bedfellows, this is a hugely important relationship. Regulation has more impact on the fate of innovative businesses who want to disrupt the status quo than it does on traditional players, who are much more suited to living within the rules as written.

Broadly speaking, when innovators interact with regulation it tends to fall into one of three scenarios:

  1. Firstly, anachronistic regulations that were designed in another era can turn out to be significant obstacles for companies that are trying to bring new ideas to a market. I’d liken this type of regulation to the unexploded bomb from the blitz you find in your garden, or hopefully don’t; you probably didn’t know it was there in the first place, when you found it you assumed it was harmless, but there’s a risk it could blow up.
  2. Secondly, regulation can be used as a defensive weapon by incumbents to inhibit competition from new entrants. To continue with the military theme, this is regulation as barbed wire; something laid out by people trying to defend their territory from invaders.
  3. Thirdly, and more positively, regulation can be an enabler, providing a bridge between ideas and customers, and helping new entrants penetrate the market. In this case it’s the reinforcements. You’re a pioneer in enemy territory, you’re holding down a position, but things get much more comfortable when the tank battalion turns up. I’m going to describe what these three scenarios looks like in practice, and I’ll then give you some thoughts on how companies can best manage them. I should also add that I’m going to draw on examples that go much wider than financial services, as I think the parallels are very useful.

1. Anachronistic regulations (hidden landmines)

The simplest way to characterise the first scenario is that the regulations that can trip up innovators are often those written at a time when nobody envisaged your business model. The constraint they create isn’t deliberate, just inadvertent and anachronistic. But by enshrining the existing ways that things are done, they can provide serious obstacles to companies with new ideas.

  1. It can foil new entry completely – even for big companies. Tesco’s dabble in the property market is a case in point. In 2007 it entered the market with a service that offered to directly connect buyers and sellers for £200 – taking traditional estate agents completely out of the transaction. Although Tesco was very different from estate agents, the Property Misdescriptions Act meant they had to be regulated like one, which would have meant sending someone out to validate the details of every property listed. It completely undermined their low cost model, and effectively forced them to withdraw after just a few months. An important point to note about this case was that it was the OFT who enforced the Property Misdescription Act ‘against’ Tesco, and who did a market study into this sector which led to the ultimate removal of the PMA. But whilst the enforcement of the law had to be immediate in 2007, and the market study was launched in 2008, the PMA won’t be repealed until later this year. Although it wouldn’t be that damaging to a company the size of Tesco, it’d probably be terminal for most startups.
  2. Zopa encountered a similar problem when trying to work out how to navigate through the regulation.The lenders on Zopa’s P2P lending platform generally didn’t need regulation, because they weren’t lending in the course of business. But in an attempt to make sure that their larger lenders didn’t fall foul of this rather vaguely-defined principle, anyone lending over £25k was asked to become licensed though the OFT’s Consumer Credit Licensing process. Having done so, the OFT wrote directly to some of the newly licensed lenders threatening imprisonment because they hadn’t personally conducted money-laundering checks on the multitude of borrowers that each of them was lending to. Now it turns out that they may not have actually been lending in the course of business, so probably don’t need a license after all. I say probably because it still hasn’t been resolved. In both of these examples, it wasn’t a case of regulators opposing innovative ideas – they were just working with rules that were written at a time when peer-to-peer platforms hadn’t even been envisaged. The law simply didn’t have a box that was the right shape or size for this business model. And even in situations where the regulation doesn’t prevent a new business model, regulatory uncertainty can be damaging to a business and discouraging to potential investors.

2. Regulatory attack (incumbents erecting barbed wire)

While these examples are unfortunate and frustrating, my second scenario is more cynical. This is where regulation can be used, and regulators ‘captured’ as a defensive weapon by incumbents to neutralise the innovators.

  1. This is an age-old practice. In 1635 the Thames ferrymen of London successfully petitioned the King to forbid Hackney Carriages – the disruptive new entrants of the 17th Century urban transport – from operating inside the city. Fortunately the King reversed his position two years later, after he decided that the new carriages passed the consumer interest test of the day, by being “very requisite for our nobility and gentry as well as for foreign ambassadors, strangers and others.”
  2. Unfortunately, the ferrymen’s tactics persist in taxi hire, and today we see Uber being sued in cities right across the US. This isn’t just a case of regulators struggling to grapple with a new model. It’s a brazen act of mass collusion between regulators and incumbents.In Miami, for instance, regulations blatantly designed to protect taxi drivers make Uber’s business model irrelevant by requiring a minimum fare of $80 for limousines. Regulations forbidding limos from picking up a passenger less than 60 minutes after taking the reservation can’t possibly have consumer protection at heart. Equally mad cases against Uber are being pursued elsewhere; Colorado proposed a prohibition on sedan companies charging by distance or from waiting within 200 feet of a restaurant, hotel or bar. Actions like this barely even pretend to serve the public interest, but they’re often dressed up as doing so.
  3. Tesla has also experienced this kind of regulatory attack, this time from the car dealer’s lobby in response from its attempts to sell directly to the public. Regulations in 48 US states prevent or limit car manufacturers from selling directly to public. Some of this is existing regs. Some is a direct reaction to Tesla. State Senate in North Carolina recently approved a measure forbidding sales except through franchised dealers. And after Tesla opened a store near Denver, the Colorado legislature passed a law to prevent it from opening any more This results in some perverse outcomes. In Texas, Tesla has two show rooms, which are allowed. But the employees there aren’t allowed to tell customers how much the cars cost, aren’t allowed to tell them the website address, aren’t allowed to give them test drives, definitely not allowed to sell them a car. Inevitably, car dealers claim this is all to protect consumers. It’s hard to see how.

This kind of regulatory attack against new entrants isn’t always quite so unsubtle, and cases like airbnb are a little more nuanced. It’s business model completely blurs the distinction between residential property and hotels.

Regulators are understandably struggling to work out which set of rules applies. But the 3m rooms booked through AirBNB in 2012 means 3m fewer hotel reservations, which is a huge threat to incumbents who are clearly pushing very hard for maximum intervention by regulators. Not surprisingly, the bigger the impact you have on the market, the greater the opposition is likely to be from incumbents.

Now I’m going to tempt fate and say that UK regulators are pretty good compared to many other countries at avoiding the siren calls of incumbents, or time-honoured regulatory capture.

  1. We have some rather odd laws relating to how residential properties in London are let out, but they haven’t been enforced against companies like airbnb or OneFineStay.
  2. Companies like Skype can operate fairly freely in the UK, whereas in France, the regulator has just complained that they should be treated as a telecom operator, and are therefore required to allow emergency calls, and should be forced to allow French security services to monitor voicemails.
  3. The French Government has also decided that it should ban Amazon from offering free delivery of books so that traditional booksellers are protected from what it describes as “unfair competition.”
  4. And when the National Association of Estate Agents commissioned Bryan Carsberg to write a report, calling for the licencing of estate agents in 2008, at least in part motivated by the desire to slow down Rightmove, it was ignored by government.
  5. I’m certainly not aware of any recent regulatory attack in financial services. Certainly, the OFT didn’t close down Zopa but lobbied government to change the rules and accommodate a new model. That, of course, doesn’t mean that everything’s perfect, so anyone in the room’s aware of a regulatory attack I’d love to hear about it.

3. The positive effects of Regulation (a bridge to your customers)

These first two scenarios conform to the easy caricature of regulation as a stifler of innovation. However, there’s also a set of circumstances in which regulation can play a positive role in helping new entrants get a foothold in a market. It may even be the case that regulation is a good thing for new entrants! For example, a regulatory stamp of approval can play a vital role in giving customers the confidence to try out new products and services – and in setting standards that ‘keep out the cowboys’.

  1. This is highly relevant for new financial services business models, where there’s often a degree of risk involved for the consumer, so trust is vital. Peer to peer lending, is a good example of this. In the absence of proper recognition by regulators, the larger players in the market formed their own self-regulatory body to try and define minimum standards.And Seedrs, the equity crowdfunding platform took great care to ensure that it was regulated by the FSA before opening to investors – becoming the worlds first regulated equity crowdfunding platform in the process.

Another circumstance in which regulation can be an aide to the innovator is when it helps ensure access to infrastructure that’s otherwise locked down by incumbents. There is a long history of this role in industries like energy and telecoms, where key network components tend to be owned by former state monopolies.

  1. The closest thing to a fibre-optic cable or a gas pipe in financial services is the payment system. It’s owned and controlled by the big banks, and not surprisingly has been closed to new business models. It’s predictably far too slow to innovate. The Treasury’s suggestion to place it under the control of a regulator focused on promoting access and competition should be very positive. Its consultation’s just closed, but we’re hosting a round table with them [tomorrow] on this, so if anyone has thoughts about how to create a payment system that fosters innovation, you’re very welcome to join.
  2. The government’s also doing something similar with consumer data. Last month the govt created powers to that can be used to mandate that consumers are able to access transaction data from their bank and credit card accounts. This opens up opportunities for innovative companies to build new services off the back of that data that would have been impossible when it was locked away on the banks’ servers.

So how should startups approach regulation.

I’ve described three sets of circumstances in which regulation can affect an innovator’s chances of success. As we have seen, the impacts can be dramatic. Regulation can bog you down in energy sapping legal wrangling (like Uber). It can create damaging uncertainty around your business model. It can expand your credibility with consumers. And it can quite easily kill you (like Tesco). So it’s vital to get your regulatory strategy correct.

There’s no rule book here. The correct approach will depend heavily on the circumstances of your business. I’m very happy to work with individual businesses and get into the detail with them, but for now I’d just like to make a couple of generalised thoughts.

The first is to think through the regulatory question early on in the life of your business, and avoid setting off down paths that may prove growth limiting.

Take, for instance, the choice to ignore regulation, which doesn’t quite fit with your business model. This approach can be tempting, especially if a regulation is clearly out of date. It’s particularly common in the US – after all, Washington is a lot further from Silicon Valley than the FCA is from Level 39.

In the right circumstances, it can be a reasonable gamble that a new market entrant will be too small for the regulator to worry about, so long as it isn’t causing harm to consumers.

But while you may be too small for regulators to worry about now, your ambition is surely not to be. If you are successful in picking up customers, you will get onto their radar screens, and will be subject to their scrutiny.

You’ll also get onto the radar of the incumbents you’re trying to disrupt, and you can count on them to use any non-compliance they spot as barbed wire to throw in your path.

It’ll vary from case to case whether it’s better to grapple with regulatory issues early on, or to try to grow first and deal with them later. But while you need to make this choice while you’re still a plucky startup, think carefully about what the implications will be at a later stage of your growth, when you have customers, a public profile, and are a credible threat to incumbents.

The second point I think it’s important to make is that even at a very early stage in your business, you may have more ability to shape your regulatory environment than you think.

This could be through embracing alternatives to regulation, as a way of reducing the potential for imposition of regulatory burdens. Self-regulation is one such option. ABTA established itself as a strong self regulatory mechanism in the travel agents industry, a success that the P2P Association tried to follow. Radical transparency is another way to try calm any potential concerns from regulators; an approach that Wonga has adopted. And it goes without saying that having vocal consumers on your side is always a huge advantage – Uber has certainly used loyal customers to help defend itself against regulatory attack. This can also be through making efforts to define the formal regulatory environment more directly.

  1. Does your business model do things in a way that wasn’t envisaged by the regulation?
  2. Does the business model demonstrably create value for consumers in a way that avoids the harm that the regulation was set up to prevent?
  3. Does the regulation create an unlevel playing field that favours incumbents?
  4. Does policy control over the regulation sit with the UK government or with Europe
  5. Are there likely to be legislative opportunities to tidy up the rules within an appropriate timeframe?
  6. Is there a strong economic growth story, or a strong social value story to tell about your business.

If the answer to these questions is yes, then you have a good argument to make and it’s well worth considering putting some effort into making it.

Government is definitely keen to help innovators. Last year it gave a committee of ministers, the Regulatory Policy Committee, the explicit remit to listen to the concerns of challenger businesses that are being held back by out of date regulations which favour incumbents. The committee even operates with a presumption in favour of change if a decent case is made, so think carefully about whether this could be an opportunity for you.

The FCA also added a competition objective to its remit, and has taken on some very good people to implement this, which is a promising sign. Though it needs to make sure that it also has senior people inside who understand and can champion disruptive innovation, and that its processes are able to adapt and be flexible to encourage new business models that challenge the status quo.

To wrap things up, I’d like to leave you with three parting thoughts:

  1. It’s well worth taking the time early on in the life of your business to establish a strategic approach to regulation. Are there unexploded bombs hidden in the garden? Is anyone likely try and lay barbed wire in your path? Will you need reinforcements from the regulator to maintain your position? If you’re trying to disrupt the status quo, then the answers to these questions have the potential to be hugely consequential for your business.
  2. You may very well have more ability to influence your regulatory environment than you think. Make sure your voice is heard in the regulatory process. You can guarantee that the incumbents you’re competing with will have well oiled lobbying machines, but government is keen to support innovators where it can.
  3. I applaud government’s farsightedness here, and by way of a final point I’d like to call on regulators in general, and the FCA in particular, to match this presumption in favour of market entry so that we make sure that the UK is the world’s laboratory for innovation in financial services.