The Role Of Regulatory Sandboxes In Fintech Innovation

According to KPMG’s latest The Pulse of Fintech report, 2018 is set to be another record-breaking year for Fintech investment. After only two quarters, it’s already reached $57.9 billion, less than $5 billion shy of 2015’s highs of $62.5 billion.

Europe and Asia are particularly hot Fintech areas at the moment. With $26 billion and $16.8 billion respectively, these regions attracted almost three-quarters of total global investments, while VC funding specifically got a significant boost during Q2 2018.

The report also pointed out that regulatory issues continue to be a hot topic within the industry, especially in Europe, where both the General Data Protection Regulation (GDPR) and Payment Services Directive 2 (PSD2) have been implemented in 2018.

Oleg Boyko, Chairman of Finstar Financial Group, said “The most progressive regions – such as the UK or Singapore – put a lot of emphasis on supporting Fintech and the startup community in general. I think finding an equilibrium will take some time. However, early initiatives – such as PSD2 in Europe – clearly show the direction regulators across the globe will eventually be taking. This creates exciting opportunities for newcomers who can look five or 10 years ahead and visualise the new business models that will transform the financial services industry”. Mr.Boyko is a Founder of a Private Equity firm that focuses on Fintech investment to leverage the latest industry technologies which enables global financial inclusion and the deliverance of compelling financial products and services to customers currently underserved by traditional financial institutions.

Regulations are put in place to establish a healthy balance between maintaining stability in the market and protecting customers while providing enough wiggle room for companies to develop and implement the latest innovations.

Understandably, in order to protect customers, regulatory bodies tend to err on the side of caution, which can sometimes lead to overregulation and make it challenging for Fintech startups to develop new innovations.

Regulators do, however, realise that Fintech innovation is an important part of the global financial system and the establishment of regulatory sandboxes created by national and international bodies is a growing initiative around the globe.

What is a regulatory sandbox?

A Fintech regulatory sandbox can be defined as:

“A framework set up by a financial sector regulator to allow small-scale, live testing of innovations by private firms in a controlled environment (operating under a special exemption, allowance, or other limited, time-bound exception) under the regulator’s supervision.” (CGAP)

When an industry rapidly evolves, including the businesses and technologies within it, it can be unclear if any regulation should be applied, and if so, to what extent.

A regulatory sandbox is, therefore, a structured and controlled environment within which regulations can be formulated at a fast enough pace, while giving companies some breathing room to develop new innovations.

Common areas of focus include payment systems, the tracking of physical as well as digital assets, customer databases, identity verification procedures and transaction recording.

Why do we need regulatory sandboxes?

A primary aim of a sandbox is to align compliance and regulation with the rapid growth of Fintech companies without drowning them in rules, but at the same time, without compromising on customer security. 

Another goal is to attract the attention of different players like banks, private equity and venture capital funds in the hopes of securing investment.

Regulatory uncertainty discourages investment. Investors are hesitant to invest in a company that is working in an unregulated landscape as regulatory bodies can swoop in at any time and deem its operations illegal, either forcing it to drastically change the business to comply or shut it down.

Similarly, investors don’t necessarily want to invest in an overregulated market either. We’ve mentioned that overregulation can hinder innovation, affecting a company’s growth rate and ability to achieve a worthwhile return on investment.

Fintech startups participating in regulatory sandbox initiatives can therefore potentially convince investors, who previously have been hesitant to invest, that they are working on both their regulatory obligations as well as their product or service innovations.

Regulatory sandboxes benefit customers, Fintech startups (innovators), regulators and investors.

Companies get the opportunity to work with regulators while testing their products in a live market. Regulators, on the other hand, can develop more appropriate regulatory policies through greater visibility into new innovations.

Customers get better protection, firstly because company products are tested in a controlled environment before official rollouts, and secondly, because regulatory bodies are able to implement more focused policies.

Finally, banks and other investment funds are afforded more confidence in an entity’s ability to comply with regulation while still being able to develop truly disruptive products and services.

Examples of Fintech regulatory sandboxes

Oleg Boyko has noted that the material increase of complexity in regulation is, in fact, an opportunity for Fintech startups to bring even greater disruption to the banking industry as traditional financial services often struggle with rigid processes that dilute their focus in delivering fresh solutions. Mr. Boyko states that working closely with regulators and ensuring strict regulatory compliance to stay ahead of regulatory changes is key to future-proof Fintech startups.

And regulatory sandboxes are the ideal environment in which to foster this close working relationship between regulators and Fintech companies.

Most of the Fintech regulatory sandboxes today are launched in European and Asian countries.

Back in 2015, the UK Financial Conduct Authority (FCA) launched the first regulatory sandbox for Fintech startups, called Project Innovate. The program is rolled out in phases (or “cohorts”, as they call them), with companies applying to be part of each stage. The sandbox seeks to provide firms with:

• the ability to test products and services in a controlled environment
• reduced time-to-market at potentially lower cost
• support in identifying appropriate consumer protection safeguards to build into new products and services
• better access to finance.

The Monetary Authority of Singapore (MAS) launched their Fintech sandbox in 2016 to encourage more Fintech experimentation and innovation.

“The regulatory sandbox will enable FIs as well as Fintech players to experiment with innovative financial products or services in the production environment but within a well-defined space and duration. It shall also include appropriate safeguards to contain the consequences of failure and maintain the overall safety and soundness of the financial system.”

In fact, perhaps on the back of 2015’s breakout year for Fintech investment, a whole host of Asian nations and agencies announced their plans for Fintech sandboxes at the end of 2016, including:

• Australia - Australia Investment and Securities Commission (ASIC)
• Hong Kong - Hong Kong Monetary Association (HKMA)
• Indonesia – Bank of Indonesia Financial Technology Office (BI-FTO)
• Malaysia - Bank Negara Malaysia (BNM)
• Thailand - Bank of Thailand (BOT)

Back over in Europe, the Authority for the Financial Market (AFM) and De Nederlandsche Bank (DNB) in Holland, combined forces for a regulatory sandbox, while Denmark’s Financial Supervisory Authority (Finanstilsynet) launched the FT Lab.

Apart from Britain, these are the only two European countries that offer a Fintech sandbox program. With Britain’s decision to leave the EU, the European Union’s banking watchdog indicated that there is an urgent need for a cross-border sandbox and innovation hub that will nurture the continued growth of Fintech startups in the EU.

As such, the European Banking Authority (EBA) has said that the watchdog will publish guidelines in December that will include recommendations for the core design of a cross-border regulatory sandbox.

Further west, Canada launched the CSA (Canadian Securities Administrators) Regulatory Sandbox to support innovation while Arizona became the first US state to announce plans for a Fintech sandbox in March 2018.

These are just some of the Fintech sandboxes across the globe. And although each of these initiatives is different in their approach and structure, the end goal is the same. They play a vital role in the growth, adoption and investment of Fintech innovation, while providing adequate protection for customer and investor interests.