The technology challenge

Thank you. It’s a great pleasure to join everyone this afternoon and my thanks to Lansons for inviting me back.

Last year, I set out some of our key ambitions for the year – particularly around the importance of promoting good conduct in the financial sector, and its link to priority issues like trust and confidence.

The industry has responded positively I think. Most firms have change programmes in place, and we’ve seen welcome steps in areas like incentives and interest-only mortgages.

So, on the former, firms have generally responded well to FCA concerns over the link between sales and poor reward structures for frontline staff.

On the latter, the forward-looking work we did last year to remind interest-only customers to have repayment plans in place, also seems to be having a positive impact. In fact, we saw the CML publish figures this morning suggesting there’s been a 12% drop in interest-only mortgage numbers over the last year.  

Front and centre of all this reform of course, has been the importance of markets working well, with consumers clearly a priority. And, with this in mind, I wanted to offer a few reflections on the technological trends that are today sweeping through the City and are, I’m sure, being closely watched by businesses here today.

A key debate I think for all of us, and my topic for this afternoon: what are the challenges and opportunities presented to firms by technology?

the pace and volume of change has raised the stakes for financial service leaders, creating very different visions for the future depending on perspective

The challenge

The UK’s financial sector has, of course, had a long history of promoting innovation.

In fact, many of the most important leaps forward in the industry over the centuries have been incubated on our shores: the first regulated stock exchange; the first exchange for trading derivatives; underwriting; bank cards; cash points; NatWest piggy banks, you name it, all were products of the City’s ingenuity.

But what is different today from yesterday, I’d argue, is the pace, volume and origin of change. It’s of an entirely different order: transformational and global.

High Frequency Traders (HFT) seeking nanosecond advantages; money transfer; payments technology; peer-to-peer finance; big data; portfolio analysis and many others. All being pushed through simultaneously, and often at break-neck speed, alongside the linked rise of other global trends like mobile banking. 

So, here we have a technology introduced and popularised in Kenya (where Masai herdsmen have been taking their phones to market, along with their cattle, for years) now expanding out across the financial world at electrifying pace.

In fact by 2022, mobile payments in the UK alone are expected to total some 1.5bn – up from 356m in 2012.

What I think is so interesting here, in the midst of this change, is that all these big financial trends galvanising us today, almost without exception, are technology-led.

And this, in turn, is fuelling increasing concern within the sector over the impact of technology more broadly. Around the world, senior executives now see it as the 4th most serious ‘banana skin’ threatening the future of their firms . Two years ago, it barely registered at 18.

Why this sudden escalation? Because the pace and volume of change has raised the stakes for financial service leaders, creating very different visions for the future depending on perspective.

So, for some all this global technology and innovation opens up a new wave of possibility in financial services. A 21^st century answer to all that the industrial revolution accomplished in the UK, or the Edison-inspired electrification of the US achieved at the turn of the 20^th.

For others, the skies look darker. The concern here is that financial services become a kind of tech-led Wild West, if you like. Full of cybercrime; data losses; runaway algos; flash crashes and hash-crashes of the type we saw last year, when hackers took over the twitter feed of AP.

From the regulatory perspective, the challenge here is clear.

Effectively, you want oversight that’s able to reduce the risk of the latter, dystopian scenario without damaging the possibilities presented by the first. A delicate balance that will no doubt hinge on a multiplicity of complex questions and assessments in the years to come.

So, for example, where are the technologies that are benefitting consumers and markets – and how do you then support them?

On the other hand, at what point does the risk of disruption or damage simply become too high?

Or, more tricky still, if reward comes with risk, how then do you balance the one against the other?

This afternoon, I want to offer a few reflections on all three points on this spectrum the good, bad and mixed, and give a sense of how the FCA is looking to help technology flourish safely.

A key objective, as many will already know, is to make sure positive developments by which I mean the ones that genuinely promise to improve the lives of consumers or clients – are supported by the regulatory environment.

Benefits for consumers

On the first point, so the question of how to supportive positive tech developments it’s fair to say governments and agencies have been slow in the past to react to technological change.

But it’s too easy, I think, to claim that regulation is always to blame when creativity or innovation slows in financial services. 

It’s no secret that regulators are sometimes used as a shield for firms who simply don’t want to take the risk, so prefer to say that we’d probably stop them anyway. Or, alternatively, you’ll find those who try to innovate, find problems and then have the regulators taking action against them. 

So, not a one-sided story here; but regulation clearly should be fleet-footed enough to support progress, which is why the FCA last week launched Project Innovate.

A key objective, as many will already know, is to make sure positive developments by which I mean the ones that genuinely promise to improve the lives of consumers or clients – are supported by the regulatory environment.

So, priority areas here might include the likes of mobile banking; P2P (now a £500m business); online investment; money transfer; wearable tech; big data; and next gen data processing – in many of which London is already a leader.

In fact, the UK and Ireland are today the fastest growing fin-tech incubators in the world, developing at an annualized rate of some 74% since 2008 – as against 23% in Silicon Valley.

Key potential opportunities to explore here, as I see it, include: more direct interaction for consumers with products and services; customised offerings; greater efficiency; better information; and of course the possibility of increased convenience.

The most immediate priority here for us – and the most pressing I think – is to ensure these tech-led improvements to customer experience can be safely fast tracked into the UK.

And to help this happen, the FCA is working closer than ever before with financial service firms who are developing innovative approaches to service that aren’t explicitly covered by regulatory rules – or where the guidance looks ambivalent. 

As I said last week, this engagement has already begun through initial conversations with a number of start-ups and organisations like Tech City UK and Level 39.

Following on from this, we’ll be pulling together a scoping document exploring how innovation can be supported more broadly. That paper will focus on FCA expectations of firms, as well as specifics around advice and support for bringing new models of financial service to market.

In the meantime, we’re opening up a hub that will provide more bespoke FCA support to innovators in a few key ways:

First, by providing compliance expertise to firms developing new models or products so they can navigate regulation.

Second, launching an incubator to support innovative, small financial businesses to get ready for authorisation.

And third, by looking for areas where the system itself needs to adapt to new technology or broader change – rather than the other way round.

One area I’d include here as a priority, automated advice, where we’ve seen some significant leaps forward in related technology over the decades.

So, just thirty years ago, science journals were full of articles about the ‘AI Winter’, the fear that post-war hopes for Artificial Intelligence had stalled.

Ten years on, and those warnings were being reassessed as technology become more powerful and capable. Gary Kasparov’s famous defeat by IBM’s Deep Blue computer, in particular, was a defining moment. A machine that was, at the time, capable of calculating some 200m individual chess moves per second.

And today, once again, we’re having our expectations raised.

In fact, we may yet look back on June 2014 as a defining moment in financial service history, with The Royal Society yesterday revealing a computer had passed its iconic ‘Turing Test’ for the first time. In other words, a machine has become indistinguishable from a human. 

An important question: what, if anything, does all this mean for dispensing investment advice in the years to come?

And can it be automated to deliver returns and security for consumers with straightforward needs? Tackling the so-called ‘advice gap’ between those with large investments pots, who are willing to pay for financial support, and those with smaller investments, who might be more reluctant to put a value on advice.

We’ll be publishing a consultation paper looking at some of these key questions next month.

Risk and benefit equation

On the second area I wanted to look at today, so the more conflicted tech-related issues, two key priorities to mention. First, high frequency trading, second, peer-to-peer.

On the former, the Flash Boys’ issue if you like, we’re effectively talking here about major wholesale issues like market fairness; efficiency and safety.

Now, in one sense there’s nothing much new here. As far back as the 18^th century, pioneer arbitrageurs were racing horse drawn carriages between New York and Philadelphia to speculate on shorts and futures.

Today, those horses have been replaced by fibre-optics, yes, but the broad challenge for regulators is much the same. We’re simply seeing old problems resurfacing through new mediums.

But for me, despite all the fierce debate and challenging headlines over HFT, this is a classic technological risk/reward equation.

So, actually, there are undoubted benefits to HFT. Most notably, the link between competition and market efficiency, as well as liquidity from reductions in bid/offer spreads and reduced transaction costs. 

On the other hand, there are, of course, clear risks to mitigate in areas like market fairness, market cleanliness and market resilience.

The first point to make here is that the UK risks are different from those described by Michael Lewis in the US.

The fact is that the American equity market is generally more geographically dispersed than it is in the UK and EU. Investor best execution requirements are also handled differently.

And, finally, dark trading in the UK is comparatively low as a percentage of trading compared to the volumes we see on Wall Street.

Nonetheless, there’s no doubt the technology here is a risk to be managed. And the implementation of MIFID – which is bringing in a long and complex list of technical rules from Europe – will mitigate many of the risks associated with HFT.

It should not, however, disrupt the potential benefits. 

Now, on the second priority, peer-to-peer lending and investment-based crowdfunding, the technology challenge while retail, is nonetheless analogous. So, the key question is the effectively same:

How do we achieve equilibrium between supporting the benefits, without creating unacceptable risk, particularly for so-called ma and pa investors?

At the moment, the numbers are still relatively small. But the sector is clearly growing significantly. Something like £1bn was raised through all types of crowd funding in 2013, with around £480m of that raised through peer-to-peer lending alone.

In this context, it is important to offer some level of protection for smaller investors.

The balance the FCA has struck seems sensible to me. So, for example, we require lending platforms to assess the creditworthiness of borrowers and meet minimum capital requirements. And for investment-based crowdfunding platforms, we require firms to ensure ordinary retail clients are not invited to commit more than 10% of their assets, unless they receive advice.

It’s also worth noting it’s been broadly welcomed by industry.

FCA now employs gifted quantitative analysts and technologists, with expertise in areas like maths and statistics, to spot unusual trading patterns

Risks

Finally, a word on some of the tech-risks we’re facing that seem to bring little or no upside: so, physical loss of systems or data for example; jurisdictional issues for regulators; fraud; possible misuse of personal data; and of course – probably the most pressing issue – cyber-crime.

Already, something like half the world’s securities exchanges have fought off cyber attacks. Nine in ten firms have suffered security breaches in the last year. And 70%of chief executives now list it as a key risk to growth.

Adding to the difficulty – a range of motivations for attack. Potentially from those seeking profit, yes, but also from those disenchanted with, or disenfranchised by, global structures.

So, we’re talking here about ‘hactivists’ and the like, as well as new forms of criminal operations across Europe. Gangs coalescing across multiple criminal networks, in multiple jurisdictions, with 60 or more nationalities among their memberships.

So, a challenging picture. And arguably a particular risk in the UK, where we have the added vulnerability of legacy systems in many firms. Vernon Hill famously described IT in the UK as being ‘one step up from the quill’.

Two points here to end with. First, I think it was a very important move in June for the Financial Policy Committee, with support from the FCA and PRA, to give a recommendation to the sector to improve and test resilience to a cyber-attack.

Second, it’s worth reminding ourselves that technological sophistication is not simply a weapon. It is one of our most important defences.

The FCA offices in Canary Wharf may seem a country mile from the tech-led businesses mushrooming-up in areas like Kings Cross, but the reality is that data and computers are playing an ever-increasing role in our own authorisation, policy, supervision and enforcement work.

We are currently working, as an example, on individual projects using computer networks with hundreds of gigabytes of RAM - and hundreds of computing cores, capable, in turn, of crunching many millions of data entries per second. Enabling us to run through significant amounts of sophisticated econometric modelling in previously impossible ways.

Likewise, in the wholesale space, the FCA now employs gifted quantitative analysts and technologists, with expertise in areas like maths and statistics, to spot unusual trading patterns in the mountains of so-called ‘blue-sheet’ data we collect every day.

Some 2.7bn detailed transaction reports are processed through our analytics servers every year, as well as our surveillance software from Nasdaq OMX.

A useful stat to include here I think to demonstrate impact: pre-2008, the FSA had never criminally prosecuted insider dealing. We have since secured 28 convictions.

Conclusion

So, to finish then, a very sophisticated equation here in the debate between risk and benefits.

And this complexity is, undoubtedly, amplified by the great unknown of our technological future. The world has been notoriously poor at predicting future trends over the years, with expert analysis ranging from the science fiction all the way through to gross underestimations of progress.

In 1899, the director of the U.S. Patent Office, Charles H. Duell, famously asserted that “everything that can be invented has already been invented.”

In 2014, the debate is a question of degree. Just how far and fast will the financial world move? The years ahead may not turn out to be as space-age as some imagine. Nor as similar to today as others might hope.

But it now seems inevitable that the future of financial services will not be exclusively shaped by business or economics graduates. But those studying science, maths and computing. Digital experts in Shoreditch, software developers in Silicone Valley, computer programmers in Budapest and so on and so forth.

It is a regulatory responsibility to make sure this is handled the best it can possibly be. To confront the challenges, to take hold of the advantages and ultimately, to create a better future for our financial services and their customers.