Digging for gold 





























Giulio Cornelli is a Senior Financial Market Analyst, Sebastian Doerr an Economist, Leonardo Gambacorta is Head of Innovation and the Digital Economy, all at the Bank of International Settlements, and Ouarda Merrouche is Professor of Economics at the Universite Paris-Nanterre and EconomiX The rapid growth of innovative companies that use new technology has the potential to transform the financial sector fundamentally. This column shows that regulatory sandboxes – a prominent and widely adopted regulatory tool to spur innovation in the financial sector while staying alert to new risks – help these fintechs raise capital. They do so by reducing informational frictions and regulatory uncertainty. The rise of fintech poses a formidable challenge to policymakers. On the one hand, the rapid growth of innovative companies that use new technology has the potential to transform the financial sector fundamentally – indeed, financial technology companies (‘fintechs’) promise to spur competition, offer more choice for consumers, and enhance financial inclusion. And yet, the disruptive potential of these firms could threaten financial stability, and requires new approaches to consumer protection (Petralia et al. 2019). In consequence, policymakers around the world are stepping up their efforts to foster innovation in the financial sector while remaining alert to emerging risks. A landmark initiative in the regulation of financial innovation was the creation of the ‘regulatory sandbox’ by the UK’s Financial Conduct Authority in November 2015. Sandboxes offer fintechs a controlled testing environment in which they can try out their products on a limited set of customers under close regulatory supervision. Firms receive advice to help them navigate the complexities of regulations and to ease the route to authorisation. Meanwhile, regulators learn about new financial technologies and emerging trends, and hope to identify associated risks before products are launched for the mass market. A key objective of sandboxes is to facilitate fintechs’ access to financing at early stages of development. Since fintechs offer new products in an environment of high regulatory uncertainty, they face serious challenges of asymmetric information and often struggle to raise enough capital (Lesher 2020). By now, around 50 countries have followed the UK and introduced their own regulatory sandbox (Ehrentraud and Garcia 2020). Nevertheless, despite the widespread adoption of sandboxes and significant attention from the media and policy circles, little empirical evidence exists as to whether sandboxes actually help fintechs raise funding. Nor is there any evidence on the underlying channels that could be at work. How sandboxes affect fintechs’ ability to raise capital In a new study, we analyse how entering the FCA’s regulatory sandbox affects fintechs’ ability to raise capital (Cornelli et al. 2020). We collect unique data on capital raised by fintechs in the UK for the period from 2014q1 to 2019q2. Granular data on funding raised, broken down by individual investor, as well as background information on firm age, size, industry, location, and CEO background allow us to investigate different channels through which the sandbox affects firms’ access to capital. We find a highly significant and economically meaningful effect of entry into the sandbox on capital raised. Relative to firms that enter the sandbox at a later date, entry into the sandbox is followed by an average increase in capital raised of 15% (or $700,000) over the following eight quarters. This ‘sandbox effect’ is shown in Figure 1. The horizontal axis plots the time dimension, with a value of zero denoting the date at which a firm enters the sandbox, and the axis ranging from 8 quarters before to 12 quarters after sandbox entry. The vertical axis shows the total funding raised per quarter (left-hand scale), as well as the cumulative funding raised over time (right-hand scale). The amount of capital raised by sandbox firms increases sharply around time zero, ie. when firms enter the sandbox. The increase is particularly pronounced in the first year upon entry and stabilises after eight quarters. Not only the amount of funding raised increases, but also firms’ probability of raising capital it increases to 9.2 % upon entry into the sandbox, relative to an average 6.1% probability of raising capital in a given quarter. In other words, entry into the sandbox is associated with an increase of about 50% in the probability of raising capital. After establishing that entry into the sandbox improves firms’ access to funding, we investigate the underlying mechanisms. Our results suggest that the sandbox reduces information asymmetries and regulatory costs. As a first piece of evidence, we show that the positive effect of sandbox entry on capital raised is particularly pronounced for smaller and younger firms, ie. firms that are usually considered more opaque and hence subject to more severe informational frictions. We find similar results when we compare firms by type of funding. Entry into the sandbox increases deal volume especially for venture capital deals, which are more information-sensitive, compared to other types of deals. Second, we show that entry into the sandbox is followed by an increase in first-time investors and in the share of investors that are based outside the UK (see Figure 2). Previous work has identified geographical distance as an important source of asymmetric information and that informational asymmetries are generally greater for new or foreign investors. We thus interpret the significant increase in new and non-UK based investors as evidence that the sandbox reduces these frictions. Finally, we show that firms with a CEO who has a personal background in (financial) law benefit less from entry into the sandbox. This is in line with anecdotal evidence that CEOs with prior experience in financial regulation benefit less from the guidance provided by case officers. In conclusion, our results provide strong support for the hypothesis that the UK regulatory sandbox reduces informational asymmetries. Conclusions There is an ongoing debate on how to design public policies to foster innovation (Auer 2019). Policymakers would want to promote the transformation of the financial sector without compromising financial stability, market efficiency, or consumer protection (BIS 2019). Sandboxes provide regulators with a potential tool to support this process. They could unshackle fintechs’ creative potential in a controlled environment, giving regulators the time to understand the welfare implications of new products and services. The large list of jurisdictions that have introduced or are planning to introduce their own sandbox suggests that regulators see them as a promising approach. And yet, despite the widespread adoption of sandboxes, to the best of our knowledge there exists no micro-evidence on their ability to help innovative firms raise capital. We also lack an understanding of the channels through which sandboxes operate. This column provides the first such evidence by showing that the UK sandbox helps fintechs to raise capital by reducing information asymmetries and regulatory costs. It is important to keep in mind that regulatory sandboxes pursue a variety of goals, including promoting innovation and competition, increasing the consumer surplus, and bolstering financial stability. The short time span since their inception does not allow us to evaluate these outcomes (yet). Nonetheless, we believe that our findings can be seen as an encouragement for policymakers to continue their experimentation in sandboxes, share experiences and develop common understandings, for example through the regular publication of guidelines. Information sharing and transparency could also mitigate the risk of sandboxes creating an uneven playing field between participating and non-participating firms. References Auer, R (2019), “Embedded supervision: How to build regulation into blockchain finance”, BIS Working Paper no. 811. Bank for International Settlements (2019), “Big techs in finance: opportunities and risks”, Annual Economic Report 2019, Chapter III. Cornelli, G, S Doerr, L Gambacorta, and O Merrouche (2020), “Inside the regulatory sandbox: effects on fintech funding”, BIS Working Paper no. 901 (also published as CEPR Discussion Paper no. 15502). Ehrentraud, J, and D Garcia (2020), “Managing the winds of change: policy responses to fintech”, VoxEU.org, 19 April. Lesher, M (2020), “Bringing new digitally enabled products and services to market: Sandboxes and the role of policy experimentation”, VoxEU.org, 13 October. Petralia, K, T Philippon, T Rice, and N Véron (2019), “Banking, FinTech, Big Tech: Emerging challenges for financial policymakers”, VoxEU.org, 24 September. Thakor, A (2020), “Fintech and banking: What do we know?”, Journal of Financial Intermediation 41(c). Authors’ note: the views expressed are those of the authors and do not necessarily represent those of the Bank for International Settlements. This article was originally published on VoxEU.org
Sandboxes provide regulators with a potential tool to support this process. They could unshackle fintechs’ creative potential in a controlled environment, giving regulators the time to understand the welfare implications of new products and services

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Figure 1. Funding raised by sandbox firms (USD millions)

Note: This figure plots total quarterly funding raised (left-hand scale) and cumulative funding raised (right-hand scale, both in millions of US dollars) by our sample of sandbox-fintech firms. Negative values on the horizontal axis denote the quarters before entry into the sandbox, zero the quarter of entry, and positive values the quarters post-entry Sources: Cornelli et al. 2020 PitchBook Data Inc

Figure 2. The share of foreign investors increases after entry into the sandbox (%)

Sources: Cornelli et al. 2020, PitchBook Data Inc.

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