Children play with toys in the sand. (Photographer: Gabby Jones/Bloomberg)

Fintech Regulation: Innovation Sandbox Or Cramped Pit?

BloombergQuintOpinion

Rapid technological developments and giant strides in innovation have stimulated spectacular growth in the financial technology or fintech sector. While this phenomenon has considerable benefits such as financial inclusion in an economy like India, it carries risks such as the lack of adequate consumer protection, excessive risk-taking, and possible implosions, thereby raising the spectre of systemic problems if the risks were to materialise on a large scale. This puts the spotlight on financial regulators who must engage in a tightrope walk by deploying appropriate regulatory tools to protect various stakeholders and, at the same time, encourage financial innovation.

Fintech Regulation: Innovation Sandbox Or Cramped Pit?

Financial regulators around the world have established regulatory sandboxes, which are essentially experimental spaces or controlled environments within which fintech companies may test their products or services using the benefit of temporary relaxations granted by financial sector regulators. While the United Kingdom’s Financial Conduct Authority pioneered the concept of a regulatory sandbox in 2015, several other financial regulators have followed suit using different models, thereby creating some level of heterogeneity. India too has sought to jump on to the bandwagon. In November 2017, a Working Group on FinTech and Digital Banking constituted by the Reserve Bank of India issued its report recommending that the RBI launch a regulatory sandbox for Indian FinTech companies. Accordingly, on April 18, 2019, the RBI issued a draft framework that seeks to operationalise a regulatory sandbox mechanism in India.

While RBI’s efforts represent an important step in spurring the fintech space in India, the scope of the regulatory sandbox it recommends is unduly narrow compared to peer sandboxes in other jurisdictions.

The logic of such a restrictive approach belies the very essence of a sandbox regime that represents a collaborative effort between fintech firms and their regulator. As a result, it is hard not to be pessimistic about its impact and success. 

Also read: Are RBI’s Regulatory Sandbox Proposals Too Restrictive?

Scope Of Participating Firms

The RBI’s proposal adopts a highly restrictive approach in determining which firms can participate in the regulatory sandbox. The fintech sector is populated by varied kinds of firms, from incumbent financial institutions that are already subjected to full-blown regulation, to startups that focus on niche areas of technology. But, the RBI’s regulatory sandbox is being made available only to startups that meet the criteria laid down for the purpose by the Government of India through the Department for Promotion of Industry and Internal Trade. Moreover, eligible companies must have a minimum net worth of Rs 50 lakh and their promoters and directors must satisfy prescribed criteria as ‘fit and proper’ persons.

By microscopically defining the eligibility requirements, large swathes of firms in India’s fintech space run the risk of being denied entry into the regulatory sandbox. On the one hand, large firms in the financial sector that do not qualify as startups cannot utilise the sandbox mechanism even though they may engage in technological and financial innovation.

One does not have to be a startup to innovate: the label should not matter.

On the other hand, very small companies are excluded too, due to the minimum net worth and other requirements. The quintessential facet of a regulatory sandbox is to enable participants to shed the burden of regulatory constraints through relaxations from onerous conditions, but it is rather paradoxical that access to the sandbox itself is ridden with regulatory impediments. In that sense, RBI’s proposal turns the principal objective of the regulatory sandbox into its Achilles heel.

Notable Exclusions

A regulatory sandbox should ideally adopt a blue sky approach that helps generate ideas for products and services in fintech without any limitations. However, RBI’s proposal is constraining on this count as well. Although treated as an “indicative list”, RBI is rather prescriptive regarding the ground-breaking products and services as well as innovations in technology that can be brought under the ambit of the regulatory sandbox.

More intriguingly, RBI stipulates a negative list of products, services, and technology that are kept out of the sandbox.

These include matters such as credit registry and credit information: with data playing an essential role in the financial sector, this exclusion is unfathomable.

The more controversial exclusions relate to cryptocurrency (whether trading, investing or selling) and initial coin offerings. While leading regulators around the world have enjoyed a mixed relationship with crypto assets, several have adopted a more lenient approach that would bring them within the sandbox. The RBI’s stance has instead been to exclude them at the outset. This is consistent with the RBI’s longstanding suspicion on crypto assets. After issuing a series of warning to investors in such assets over the years, the RBI effectively sounded their death knell when it last year barred entities it regulates from dealing in cryptocurrencies in any manner. A petition challenging this decision is pending before the Supreme Court.

Understandably, the RBI seeks to steer clear of the controversy by treating cryptocurrency as an exclusion from the sandbox, and much of it may have to do with the fact that the decision regarding the legality of such assets is awaited from the Supreme Court. It is, however, precisely these types of situations that a regulatory sandbox is expected to address. The legal and market-oriented issues surrounding such assets are capable of further analysis in the sandbox environment, albeit subject to any guidance that might emanate from the Supreme Court.

The RBI has missed an opportunity by feeding its premonitions on the matter and relying on a conventional regulatory approach.

Also read: Singapore Regulator Would Consider Certain ICOs for Sandbox

Unavailability Of Legal Waivers

Since a regulatory sandbox allows firms in fintech to operate in controlled conditions, it is crucial that they are granted relaxations, dispensations, and waivers from certain legal regulations. This will enable them to test their innovative products and services without fear of legal sanctions. Regulatory sandboxes the world over are premised on such relaxations and waivers: while some regulators grant blanket waivers, others permit specific relaxations with regard to identified legal regulations or through waiver or no-action letters on a case-by-case basis. No fintech firm will be willing to enter the sandbox without regulatory assurance that safeguards it from adverse legal action while in the controlled environment.

There is a stark oddity in RBI’s proposal in that it does not spell out the relaxations that it would offer. On the other hand, the RBI is categorical in its inability to provide waivers when firms are in the sandbox. Understandably, such a cautious approach is attributable to RBI’s powers, or the lack thereof, to grant such waiver, but it will render the sandbox approach rather frail. Why would a rational manager of a fintech firm carry the risk of legal sanctions when it does not enjoy any legal latitude when it enters the sandbox? Similarly, the RBI expressly disclaims any liability arising from the sandbox experiment, and states that firms cannot use the facility to “circumvent legal and regulatory requirements”.

The tenor of these proposals preserve a traditional regulatory control-oriented mindset rather than a collaborative approach between the regulator and the regulated firms that contemporary scenarios pertaining to the regulatory sandbox mandate.

Also read: Accreditation Of Investors In Startups: Will It Work?

In all, the RBI’s recommendation for setting up a regulatory sandbox is welcome and would catapult India among the leading jurisdictions that train their focus in harnessing innovation in the Fintech sector. The restrictive nature of the RBI’s proposals, however, leave considerable doubt on whether the sandbox would be subject to much utilisation at all instead of merely remaining in the books.

Umakanth Varottil is an Associate Professor of Law at the National University of Singapore. He specialises in company law, corporate governance and mergers and acquisitions.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.