What Is a Regulatory Sandbox and Can It Help Your Fintech Business?

March 27, 2019
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Government Agencies Are Increasingly Turning to the Use of Regulatory Sandboxes to Promote Innovation in Fintech While Maintaining Oversight…

Regulatory uncertainty remains the primary roadblock for the financial technology (fintech) industry and other disruptive business models that don’t fit neatly into existing regulatory structures. The good news is that government agencies are increasingly turning to the use of “regulatory sandboxes” to promote innovation while maintaining oversight.    

What Is a Regulatory Sandbox?

A regulatory sandbox is supervised yet flexible regulatory framework that allows startups and other businesses to experiment with new technology, products, business models and other innovation that may exist at the fringes or even outside of the existing regulatory framework. Regulatory sandboxes can take a variety of forms. The common thread is that businesses and regulators maintain a continuing dialogue, which is then used to craft regulatory actions that strike the right balance between enabling innovation and managing risk.

In cases where businesses participating in a sandbox, they often are eligible to obtain waivers of specified statutes and rules under certain conditions, such as not being required to obtain licensure for a designated period of time. While rigid regulations may not exist, regulators don’t take a completely hands off approach; regulatory sandboxes still have eligibility requirements, operating rules, reporting mandate, and other safeguards under which businesses must operate. Businesses must also typically apply with consumer fraud and criminal laws.

For businesses, regulatory sandboxes make it possible to test out innovative products and services in the real world and reduce regulatory barriers and costs. For regulators, the framework can be used to gather valuable information that can then be used to inform future regulatory action.

Who Is Using Regulatory Sandboxes?

The majority of existing regulatory sandboxes involve the fintech industry. Because the body of financial regulations was largely adopted decades ago – in many cases prior to the Internet revolution – the fintech regulatory regime has been slow to adapt to use of technology in financial products and services. Regulators are seeking to change that.  As regulators work to determine how to best supervise financial technology innovators, regulatory sandboxes are filling the gap.

The United Kingdom launched the first prominent regulatory sandbox for this space in 2015. At the beginning of 2018, there were more than 20 jurisdictions actively implementing or exploring the concept, according to United Nations Secretary-General’s Special Advocate for Inclusive Finance for Development.

In February of this year, Wyoming became the second state in the U.S. to establish a regulatory sandbox for the fintech industry. Arizona created one last March. Under Wyoming’s Financial Technology Sandbox Act, businesses can test innovative financial products and services, including those involving blockchain and cryptocurrencies, for up to two years before they need to seek formal licensure.

On the federal level, regulators have not yet adopted regulatory sandboxes. The Securities and Exchange Commission (SEC), Commodity Futures Trading Commission (CFTC), and the Office of the Comptroller of the Currency (OCC) have all considered the concept of sandboxes, but none have moved past the proposal stage.

In December 2018, the Bureau of Consumer Financial Protection (CFPB) issued proposed revisions to its 2016 Policy on No-Action Letters and proposed a BCFP Product Sandbox. Among other changes within the proposal, the Bureau also proposed to create a Product Sandbox. Under the proposal, the CFPB would provide approvals pursuant to one of three statutory safe harbor provisions in the Truth in Lending Act, the Equal Credit Opportunity Act (“ECOA”) and the Electronic Funds Transfer Act. In addition, the Bureau will provide exemptions by order from certain statutory provisions in ECOA, the Home Ownership and Equity Protection Act and the Federal Deposit Insurance Act. The approval relief and exemption relief would be provided for two years. In contrast to recipients of no-action letters, participants in the sandbox “would be immune from enforcement actions by any Federal or State authorities, as well as from lawsuits brought by private parties.”

Interestingly, this proposal for a regulatory sandbox is to regulations largely adopted in the last 20 years. 

The proposal is somewhat controversial.  The CFPB Attorneys general from 21 states are opposing the CFPB’s proposal. They maintain it “would erode critical consumer protections under the guise of fostering innovation in the consumer financial marketplace.” According to New York Attorney General, Letitia James:

The CFPB was created to protect consumers and ensure the financial stability of this country. These proposed rule changes would have the complete opposite effect – putting blind faith in the very industries and services they are supposed to regulate and correct. At a time when so many Americans are struggling to make ends meet, the CFPB should be focused on protecting consumers, not advancing regulations that could hurt them.

The comment period on the CFPB’s proposal closed in February. However, the state AGs have called on the CFPB to rescind the proposals and conduct a more formal rulemakings subject to a notice and comment period under the Administrative Procedures Act. 

Opportunities for Fintech Startups

The fintech industry is poised to rapidly expand in the coming years, with the creation of regulatory sandboxes predicted to help fuel growth. Nonetheless, it is important for fintech businesses to recognize that additional compliance burdens will likely remain, even as the industry becomes more mainstream. As always, businesses are encouraged to consult with experienced counsel regarding how the many ongoing proposals to amend financial regulations may impact their business plans.

If you have questions, please contact us

If you have any questions or if you would like to discuss the matter further, please contact me, Jeff Cassin, or the Scarinci Hollenbeck attorney with whom you work, at 201-806-3364.