Don’t discount the importance of regulatory sandboxes for fintechs

When the UK Financial Conduct Authority introduced the concept of regulatory sandboxes in 2016, the agency was broadly lauded as forward-leaning and it wasn’t long before some U.S. regulators, including the Commodity Futures Trading Commission and the Office of the Comptroller of the Currency, followed suit with similar innovation programs.

But while the concept of early regulatory engagement with fintech innovation has spread globally — nearly 50 regulatory sandboxes are either live or in development — there is a growing chorus of voices seeming to share the view of former New York State Department of Financial Services Superintendent Maria Vullo, who once said: “Toddlers play in sandboxes. Adults play by the rules.”

As former regulators and heads of innovation programs from both the U.S. and the United Kingdom, we recognize why some observers express concern. Nevertheless, we believe in the importance of vigorously supporting such efforts, whether designed as sandboxes, labs, or related early-engagement initiatives.

To be sure, a poorly designed and managed sandbox will almost inevitably be misused. It could drive a deregulatory race to the bottom, provide unfair advantage to chosen market participants and generally prove a wasteful distraction for already stretched regulators. So, are the benefits really worth chasing?

We believe so. With innovation happening at an ever-quickening pace, new opportunities and risks are constantly being introduced into the financial system that regulators, at best, are unequipped to deal with and, at worst, unable to track. Rolling up their sleeves to engage with these firms allows regulators to better understand the involved technologies and the benefits they can bring to markets and consumers, while also identifying necessary protections and safeguards.

Participating firms also benefit. They get a dedicated point of entry with their regulator, have the opportunity to flag ambiguous areas of regulation and educate policymakers on new technologies. They may also be less likely to run afoul of rules down the track given their early engagement.

How an innovation program is designed and implemented is key to its ultimate success.

For the regulator, clarifying the ultimate objectives is crucial. At some point, and likely as a result of regulators jumping on the bandwagon, the concept of a “sandbox” became the proprietary eponym rather than being considered as one of many examples of fintech interventions. Put simply, a sandbox is one tool in a broader policy toolkit. Regulators need to consider their broader fintech agenda. They need to understand the market needs, including areas of regulatory ambiguity and friction, as well as key technologies of interest. They also need to integrate the innovation function across the entire agency and scope their budgetary and resource commitments before developing a program.

On the other side, firms need to be clear on what they want to achieve from participating in a sandbox, which is likely to be resource-intensive and time-consuming.

Notwithstanding the importance of proper design of an innovation program, there is clear evidence that such efforts are critically important to modernizing and ensuring effective global financial regulation.

Indeed, the technology gap between regulators and industry continues to grow, leaving policymakers racing to keep up. And perhaps most frightening is the potential for apathy, if not direct resistance, to genuine change if an agency does not take affirmative steps to modernize its approach to financial services innovation. As Sultan Meghji recently noted in leaving his post as chief innovation officer at the Federal Deposit Insurance Corp., “Digital decisions are being made by people with an analog understanding.” The risk is real and this is precisely why sandboxes are so crucial. Over time, they should work to plug the technology literacy and resource gap, giving rise to regulators with more expertise and capacity to supervise existing portfolios and to properly understand new entrants.

To this end, regulators should continue to adapt based on their learnings and improve their innovation engagement programs to keep them relevant. For example, the FCA has responded to criticisms that its sandbox is too limited in the business lifecycle by launching the Digital Sandbox in collaboration with the City of London Corp., providing earlier-stage “proof-of-concept” support for fintechs. It is also investigating a Scalebox to provide later-stage support for regulated fintechs in the growth phase.

Ultimately, the sandbox can be a regulatory periscope, but it needs buy-in from the entire agency. The sandbox needs to be truly embedded within an agency, with its observations impacting and informing policy and supervision. And participants need to do the same, coming to the table transparently and understanding the importance and benefit of high-quality regulatory engagement.