When steam-powered locomotives first appeared on public highways in the 19th century, a legislative lacuna was discovered.
These mechanically propelled vehicles – the early ancestors of our modern motor car – could not be classified as either railway engines or horse-drawn carriages. As a result, existing laws did not seem to apply to them.
There were real concerns about the dangers posed to the public by such vehicles and, of particular worry to the Exchequer, there was no basis to levy tolls on them.
Loud voices started to call for regulation. It is said the loudest were horse-drawn carriage operators and the railway industry, both of which had valuable economic interests to protect.
The resulting legislation was draconian. The Locomotives Act 1865 imposed a speed limit of two miles per hour in towns, and any road locomotive had to be manned by a crew of at least three, one of whom had to walk 60 yards ahead waving a red flag to warn other road-users of the approaching vehicle.
The Red Flag Act, as it came to be known, put the brakes on innovation in the British automotive industry for more than a quarter of a century until its stringent requirements were removed in 1896.
Nowadays it is technological innovation, notably around financial services, that is challenging the boundaries of our existing laws.
The cornerstone of the UK regulatory regime for financial services is the Financial Services and Markets Act 2000. That Act is built around the requirement – known as the general prohibition – that no person may carry on a regulated activity in the UK by way of business without being authorised by the Prudential Regulation Authority or the Financial Conduct Authority.
The regulated activities are set out in a statutory instrument made in 2001, known generally as the Regulated Activities Order. It has been amended on numerous occasions to broaden its regulatory perimeter and catch new activities.
One such example is the expansion to cover peer-to-peer (P2P) lending platforms – online marketplaces that match up potential lenders with potential borrowers.
In its early years, regulation of P2P lending largely fell between two stools. Consumers borrowing through a P2P platform had very little regulatory protection: their loan agreements were treated as “non-commercial agreements” because they were entered into with other consumers who did not need regulatory permissions in order to lend. The operators of P2P platforms were only regulated for their debt administration activities, however their core business of running an online marketplace for lending fell outside the regulatory perimeter.
The solution was the introduction, in 2014, of a new bespoke regulated activity of operating an electronic system in relation to lending, aimed at improving safeguards for lenders and borrowers.
The rise of electronic money – or “e-money” – is another case of a financial technology (fintech) innovation that has challenged existing regulatory classifications.
With traditional deposit-taking, a bank accepts money from a customer and lends it to others. However, e-money firms, which allow customers to make cashless payments with money stored electronically, do not lend out their customers’ money. Consequently, they are not classified as accepting deposits and as such do not have to be authorised as banks.
This gap in regulation has been filled by directives promulgated by the European Union and implemented in the UK by the introduction of a bespoke licensing regime for issuing e-money to sit in parallel with the Financial Services and Markets Act.
E-money firms are subject to prudential supervision and conduct of business requirements under the Electronic Money Regulations, but this is lighter touch regulation in comparison to the regime governing banks. The protection for customers is correspondingly different. For example, customer funds are not covered by the Financial Services Compensation Scheme if an e-money firm collapses. However, e-money firms are required to safeguard customer funds, for example held in a segregated account or covered by insurance or bond.
Regulators face the continual challenge of adapting to the new ways in which financial services are delivered, while also keeping pace with rapid technological advancements. While regulation and new technology have always made strange bedfellows, a supportive regulatory environment can protect against public harm and give the confidence needed for entrepreneurialism and innovation to flourish. The danger lies in enacting fintech’s own Red Flag Act. Poorly crafted, draconian legislation could undoubtedly put the brakes on innovation, and the sector’s huge potential.
Originally published in CA magazine