Regulatory sandboxes and fintech funding: evidence from the UK

(November 2020, revised April 2023)

Summary

Focus

The rise of fintechs promises to spur competition in the financial sector. This could lead to sizeable efficiency gains, more choice for consumers, and enhanced financial inclusion. However, the potentially disruptive growth of firms offering novel products and services poses new challenges for financial stability and consumer protection. In response, policymakers around the world are creating "regulatory sandboxes" to foster innovation in the financial sector while keeping alert to emerging risks. One key objective of sandboxes is to facilitate start-ups' access to capital. The UK Financial Conduct Authority pioneered the world's first regulatory sandbox in 2015. To date, more than 50 countries have adopted sandboxes, but little evidence exists on whether they actually help innovative fintechs raise funding. And if so, why/how.

Contribution

This paper analyses how entering the United Kingdom's regulatory sandbox affects fintechs' ability to raise funding. We collect unique data on capital raised by UK fintechs between 2014 and 2019. Our sample covers fintechs that joined the sandbox, as well as a large group of comparable control firms that did not join the sandbox. Further, detailed data broken down by individual investor, as well as background information on firm characteristics, allow us to investigate different channels through which the entry in the sandbox could affect firms' access to capital. Our paper contributes to the current debate on public policies to foster innovation and competition in the financial sector. Sandboxes could provide regulators with an effective tool to gauge the various implications of innovations at an early stage of their development. An assessment of their effectiveness and an understanding of the channels through which sandboxes operate is hence indispensable.

Findings

Entry into the sandbox is associated with a higher probability of raising funding and an increase of about 15% in the average amount of funding raised. Our evidence suggests that regulatory sandboxes improve access to funding by reducing information asymmetries and regulatory costs for three reasons. First, the positive effect of sandbox entry on capital raised is particularly pronounced for smaller and younger firms, which are usually subject to more severe informational frictions. Second, sandbox entry is followed by an increase in first-time investors and in the share of investors that are based outside the United Kingdom. These investors are likely to face greater information asymmetries due to either geographical distance or a lack of previous relationships. Finally, we find that firms with a CEO who has a personal background in financial law benefit less from sandbox entry. This is in line with anecdotal evidence that CEOs without prior experience in financial regulation benefit more from the guidance provided by case officers during the process of obtaining authorisation.

Abstract

Over 50 countries have introduced regulatory sandboxes to foster financial innovation. This paper conducts the first evaluation of their ability to improve fintechs' access to capital and attendant real effects. Exploiting the staggered introduction of the UK sandbox, we establish that firms entering the sandbox see an increase of 15% in capital raised post-entry. Their probability of raising capital increases by 50%. Sandbox entry also has a significant positive effect on survival rates and patenting. Investigating the mechanism, we present evidence consistent with lower asymmetric information and regulatory costs.

JEL classification: G32, G38, M13, O3

Keywords: fintech, regulatory sandbox, startups, venture capital.