The Consumer Financial Protection Bureau is moving quickly on a fintech sandbox to remove the regulatory cloud from new firms, but the effort is about more than just fostering innovation.

It's not just startups that need a testing ground, observers say. For it to be successful, a CFPB sandbox must also help the agency correct an obvious flaw: Fintech is moving forward without an adequate regulatory regime to monitor risks.

"Fintech firms have an advantage by operating outside of the constraints of regulatory requirements that allows them to be very rapid, hypercompetitive and capture a large consumer base," said Shelley Metz-Galloway, a managing director of risk and compliance at the consulting firm Protiviti.

Acting CFPB Director Mick Mulvaney
"There's been a real hesitation to innovate in the banking sector because they've all been told don't do anything risky, don't do anything that isn't safe and sound and lawful," said acting CFPB Director Mick Mulvaney. Bloomberg News

Acting CFPB Director Mick Mulvaney has shown clear interest in expanding the agency's efforts to promote tech innovation. He floated the idea of a sandbox in May, and has repeatedly said he wants to reorient the bureau's fintech unit begun under previous leadership. In July, he announced the hiring of an Arizona lawyer, who had led creation of the first-in-the-nation sandbox in the state, to also lead the CFPB effort through the bureau's new Office of Innovation.

The advantages of a sandbox — like the one already flourishing in the United Kingdom — are twofold. Startups can experiment without fear of punishment. But regulators like the CFPB also benefit by learning more about firms that up to now have been on the regulatory fringes.

"Regulators are trying to get out in front of a problem that they haven't yet solved for, which is very rapid change in the financial services market," Metz-Galloway said.

But others say the CFPB, by promising not to impose consumer protection rules during a product testing period, runs the risk of giving fintech firms an unnecessary giveaway.

"I disagree with the framework that the regulations are overly stringent such that innovation cannot happen," said Tim Chen, the CEO of NerdWallet, a San Francisco-based personal finance website and a former member of the CFPB's now-disbanded consumer advisory board.

"What startups should be doing is building a better mousetrap to help consumers that doesn't break the law rather than trying to arbitrage the gap between the law and what the big banks feel comfortable doing and what [a fintech firm] can do because they're tiny and no one will come after them," Chen said. "That isn't the right type of innovation."

Last week, the Treasury Department issued a report on the fintech industry directing the CFPB, the Office of the Comptroller of the Currency and other regulators to create "regulatory sandboxes" and "to pursue robust engagement efforts with industry."

The CFPB's initial attempt under former Director Richard Cordray to create a carve-out for fintech firms — alleviating them from certain regulatory requirements — was largely seen as a failure. Through the effort, then known as Project Catalyst, the CFPB designed "no-action" letters for interested firms. The idea was to encourage contact between startups and the regulator, while reducing the threat of enforcement actions for participants.

Under Cordray, the CFPB issued only one such letter — to the online lender Upstart Network. But many in the industry said the agency's efforts were insufficient and the CFPB still planned to pursue enforcement actions against fintech firms.

Mulvaney has essentially ended Project Catalyst, renaming it as the Office of Innovation and hiring Paul Watkins, a former head of fintech initiatives at the Arizona attorney general's office, to head it.

"This is an avenue for legitimate and properly capitalized companies to bring products to market — there's been a real hesitation to innovate in the banking sector because they've all been told don't do anything risky, don't do anything that isn't safe and sound and lawful," Mulvaney said of the renewed effort at a recent conference.

Proponents say the biggest benefit of a sandbox is for firms that have prioritized their product development over regulatory compliance.

"What the CFPB is doing is allowing fintechs to test their products in a controlled environment where regulators are looking at what they're doing and can give advice along the way," said Scott Pearson, a lawyer at Ballard Spahr. "The sandbox option makes it possible to test a product at lower cost because the company would not have to have a fully developed compliance system."

The CFPB is expected to start reissuing traditional no-action letters under Mulvaney that provide immunity from private litigation and enforcement actions, Pearson said.

Metz-Galloway said a sandbox could also ease the regulatory risk for firms that already know they have committed regulatory errors.

"Regulatory compliance is an afterthought for financial technology firms," she said. "They are looking to make money, and these are not people with 20 to 30 years of traditional banking experience. Their interest in coming in out of the cold is because they know they are already in violation and can demonstrate to regulators and plan to address the gap without penalty."

Watkins is expected to create a program at the CFPB that mirrors what he launched in Arizona. The fintech sandbox in the state recently started accepting applications.

One significant risk with a fintech carve-out is that digital-based firms using newer underwriting and marketing models, with which they can potentially cherry-pick their customer base, make them particularly prone to consumer protection violations.

"A lot of the fintech models are premised on using big data and new underwriting methods, like utility payments or social media posts, to bring in people outside of the traditional financial system," said Todd Zywicki, a law professor at George Mason University. "When a company starts using different data like that it becomes a highly tailored credit offering and tailored offerings can end up with disparate impact fairly quickly."

Zywicki said concerns about fair-lending issues were a major reason Project Catalyst failed to make more headway under Cordray.

"That has always been the problem, taking innovation from the drawing board to implementation," Zywicki said.

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