Fintech needs more regulatory 'sandboxes'
Regulatory “sandboxes” for financial services are now becoming more widely adopted, but they are not without controversy.
Arizona became the first state to enact a fintech sandbox last month and Illinois lawmakers are currently debating a pair of bipartisan bills to establish a similar system. The models follow a 2014 U.K. initiative, Project Innovate, which is the oldest and most active of the regulatory sandboxes for fintechs.
The general concept of a sandbox is to create a special relationship between a company and the applicable regulator where innovations can be tested with real customers without the full burden of regulation. If you stop there, it is easy to see why consumer advocacy groups and incumbent regulated entities often cry foul. The Southwest Center for Economic Integrity, Arizona Community Action Association, Children's Action Alliance, and Protecting Arizona's Family Coalition all came out against the Arizona Regulatory Sandbox bill under the belief that it would open up vulnerable populations to predatory lenders. That isn't an unreasonable concern, however, the program is overseen by the attorney general, which makes it unlikely that predatory behaviors would go unnoticed. The emphasis should be on the frequency and depth of oversight, not creating strict definitions and controls upfront that would prevent open dialogue from taking place.
The purpose of a sandbox is not to covertly deregulate the market, nor is it to write a blank check to innovators — in fact, it’s quite the opposite. As technology and business models rapidly evolve, it is can be unclear which, if any, regulations apply. As an example, I was recently approached by a state bank supervisor who shared how his state was grappling with cryptocurrency. The closest applicable regulation predates the Civil War and concerns the transport of private currencies by steamship across state borders. A sandbox allows a regulator more options than simply saying an innovation isn't compliant with existing regulation. Admission into the sandbox is a meaningful reason for new companies to come out of the shadows and for incumbents to explore innovative ideas without fearing it would impact the oversight of their existing businesses. The alternative is to wait until something bad happens before assessing the suitability of existing regulation or the creation of new regulation.
At the same time, most sandboxes, like those in the U.K and Arizona — and the one being debated in Illinois — are quite specific that products that are analogous to existing products or that fit within existing regulation do not qualify as innovation and are there ineligible for the sandbox. A check casher can’t launch a mobile application and circumvent existing check cashing regulations. A lender that begins using machine-learning algorithms to do their underwriting isn’t freed from ensuring Equal Credit Opportunity Act or Fair Housing Act requirements are met. Yet if they find during supervised time in a sandbox that this is an unintended result of their modeling, they must resolve the issue as well as ensure it doesn’t happen again.
The purpose of a sandbox is to start a dialogue early, bringing more innovation into the purview of regulators at a stage where potential calamities can be avoided. This is particularly important for institutions that are already regulated. It’s easy to believe that the sandbox concept is unfair to those organizations that invested heavily in building compliance regimes and must now compete with new entrants using a regulatory fast-pass. And it’s true that new entrants benefit from the sandbox — but incumbents also benefit, because often their innovation efforts are stymied by being held to the same standards as their core business activities. The sandbox framework allows incumbents to explore new products, business models and partnerships that likely would never be examined if they had to be treated as production-ready endeavors.
Ultimately, without innovation, customers lose. Innovation, particularly when it is customer-driven experimentation, creates better products, lowers costs and promotes access. Not all innovation is good, whether intentionally or unintentionally. People and entire economies have been hurt when “innovation” runs amok and unchecked, which is why we need new models and innovation to happen alongside regulatory oversight.
Regulation and innovation are typically viewed as being at odds with each other. There is significant precedence to support that conclusion, but it doesn’t have to be that way. A sandbox solves one of the primary problems of government oversight: We wait until something really bad happens and then overregulate a market or product. The concept enables a commonsense, data-driven approach to regulation that promotes forward progress.