Fintech Sandboxes and Regulatory Interoperability

Carlos Muñoz Ferrandis is a PhD Researcher at the Max Planck Institute for Innovation and Competition (Munich). He is a RegTrax Contributor (Wyoming jurisdiction) and collaborates with the “Blockchain for Societies” SIG (Utrecht University). He is also the Co-Founder of HIGH (HIGH Technology Law Forum).

Fintech regulatory sandboxes represent a hybrid and flexible regulatory paradigm based on experimentalism and focused “on innovation as the driving principle of regulatory action.” These mechanisms started to emerge five years ago as a response from national regulators to the fast-paced technical development taking place in the fintech field. However, although a vast array of firms are now seeking to operate transnationally, the scope of fintech sandboxes rarely goes beyond the relatively narrow national level. Consequently, there are still no harmonized international legal standards on the legal frameworks governing sandboxes. Thus, companies and firms seeking to test their innovations in several countries’ sandboxes might incur considerable costs. This quest for clearer and harmonized legal standards enabling applicants to smoothly drive their testing processes in several countries at the same time also requires an assessment of the promises and pitfalls of sandboxes. This assessment may be conceptualized as an examination of the incentives or blocking stones for states when designing regulatory tools to secure cross-sandbox interoperability.

The bright and dark sides of regulatory ‘innovation boosters’

Fintech regulatory sandboxes are double-edged instruments. While complex and not without inherent risk, they create a safe testing framework whereby both the regulator and companies are able to experiment with laws, technologies and new business models by articulating a tradeoff between calibrated regulatory leniency and the adoption of consumer safeguards. As a result, from the perspective of the regulator, such a policy might provide an opportunity to evaluate the initial suitability of the current legal framework. Hence, allowing for a sandbox might prove crucial in deciding whether (or to what extent) to amend the current provisions within a given framework, based on the regulatory, economic and technical assessment that has taken place within the sandbox. Such data can save a state massive amounts of time if the existing legal structure is able to handle new technologies relatively easily. From the perspective of the companies willing to enter into the sandbox, they might benefit from a combination of several factors. For instance, they might benefit from a waiver – or other exemptive tools – on some specific provisions which are usually a considerable regulatory burden in a given market, i.e., the time and capital required to enter the market are reduced. Moreover, regulatory sandboxes have the potential to foster investment in fintech companies participating in the testbeds. Notwithstanding the above-named benefits, regulatory sandboxes might prove to be delicate and risky regulatory instruments. Such a structure may create legal uncertainty, excessive implementation costs, lack of harmonized interpretation and guidelines, ‘forum selling’ practices, and/or harm to consumer welfare.

Fragmentation and lack of clarity

The myriad of existing sandboxes and a lack of cross-jurisdictional cooperation risk creating fragmentation among the regulatory frameworks that govern these sandboxes. This is mainly due to the many distinct types of sandboxes that exist, and the fact that they differ according to the industrial and economic policy of the country. Both the lack of clarity and the inconsistent jurisdictional interpretations of the controlling frameworks can lead to divergent processes. A pertinent example where a clearer and harmonized international interpretation would prove beneficial is the criterion of innovativeness – or ‘genuine innovation’, in words of the UK’s FCA – of the applicant’s technology. How ought one measure the degree of innovation of an application? For instance, according to Andy Chen, the Financial Supervisory Commission of Taiwan can deny applications implementing a patented technology that is already implemented or owned by another firm selected for the sandbox, due to a ‘lack of innovativeness.’ There is not sufficient clarity and guidance on the interpretation of the application’s essential criteria. Due to a lack of concrete requirements (which also help companies fight unfair discrimination) and existing legal uncertainty, the authority might play the role of a gatekeeper, arbitrarily deciding upon innovation and the creation of new markets.

Risks of ‘forum selling’ practices and inter-jurisdiction competition

Today, jurisdictions around the globe openly compete to become a major fintech hub. The main rationale behind this is the attraction of investments from the fintech industry and related benefits, e.g., the establishment of firms, job creation, etc. Despite these positives, fintech-friendly jurisdictions may pay the price in the long run by compromising consumer protection. The risk of consumer harm and associated consequences is just one such tradeoff between regulatory leniency and related risks. Moreover, inter-jurisdictional competition might stifle any inter-jurisdictional collaboration aimed at creating cross-sandbox interoperability. Blind competition is likely to lead to friction between legal frameworks and a blanket reluctance to abide by any set of globally harmonized standards that purports to advance the interactions between different sandboxes. Ultimately, one consequence could be the formation of jurisdictional ‘factions’ competing between each other and setting different legal standards. Despite (potentially) risking to harm consumers and foreclosing innovation at the international stage, the net positives of regulatory sandboxes are difficult to ignore. Once clearer and harmonized legal frameworks are set, these sandboxes have the potential to become beneficial and dynamic regulatory tools capable of fostering both market and policy innovations. Naturally, these instruments deserve further considerations from an international perspective. The overarching challenge, then, is figuring out how to juggle all of these considerations and set out a cohesive landscape.

Towards cross-sandbox interoperability

The inherent transnational aspect of fintech demands a delicate ‘extra yard’ from regulators. The main goal is the avoidance of duplication of efforts and legal uncertainty by, as much as possible, safeguarding the eligibility of a firm participating in one sandbox to easily and cheaply participate in the sandbox of another country—either simultaneously or sequentially. The primary mechanisms put into place by a plurality of fintech regulatory sandboxes have been more traditional international agreements such as Memoranda of Understanding (MoU), or more formal cooperation agreements. Australia, UK, France, or Singapore provide some illustrative examples. In a similar vein but taking a step further, some US states such as Wyoming (see HB 0057 40-28-106[g] ) or Arizona (see HB 2434 41-5611[f] ) have integrated specific ‘reciprocity provisions’ into their laws. These provisions allow the states’ sandbox participants to operate in other jurisdictions integrating the same legal standards. From a regional perspective, the EU has been making ground towards the setting of an EU fintech regulatory sandbox for the last three years. Institutions such as the European Commission (EC) and the European Forum for Innovation Facilitators aim to set coordination mechanisms that enable cross-border testing among EU members. According to the 2017 ‘Public Consultation on FinTech: a more competitive and innovative European financial sector’, a number of respondents were adamant about the development of regulatory sandboxes with harmonized criteria. However, most public authorities were not in favor of an EU sandbox and preferred national initiatives, citing instability and a lack of consumer protection as their main deterrents. Additionally, the current fintech regulatory sandboxes in the EU are largely different when considered from different angles, e.g., in terms of goals, design, and operational models. Still, the late policy developments in the EU positively point towards a harmonized framework in the short/mid-run – see, for example, a recent EC proposal and the Proposal for Regulation on Markets in Crypto-assets COM(2020) 593 (p. 148). In terms of a global perspective, the Global Financial Innovation Network (GFIN) aims at enabling cross-border testing among sandboxes from different jurisdictions – effectively creating a global sandbox. The promotion of collaboration and coordination among regulators has proved to be a gigantic challenge, as the main objective is to set an international regulatory platform whereby adherents might have the opportunity to test their technologies and business models simultaneously in a plurality of countries while fulfilling a single application and set of conditions. This is, at heart, the challenge present in any attempts at regulatory interoperability. Despite these efforts, there is still a lack of harmonized criteria, and further cohesion is needed, particularly in terms of widespread agreement concerning a common set of legal standards for sandboxes’ frameworks and applications’ criteria. This might be a considerable deterrent to firms who may otherwise be willing to test their innovations across jurisdictional lines, as it undoubtedly adds both costs and legal uncertainty (whether surrounding eligibility criteria, or even the scope of the sandbox itself). Benefits of cross-sandbox interoperability mirror those of sandboxes at a national level: faster entry into the market, a reduction in the amount of required start-up capital, and scalability.

The way forward

Ultimately, when considering both risk and reward, the singular policy goal should be abundantly clear: set common principles and international legal standards in order steer the path towards cross-sandbox interoperability. As implied by the analysis carried out above, closed and narrow national approaches to regulatory sandboxes have a high likelihood of foreclosing innovative business models which depend on a transnational approach. Therefore, solid cross-jurisdictional cooperation is the best way to mitigate the risks of ‘regulatory arbitrage,’ or the creation of confronted competing ‘factions’ derived from geopolitical interests. The greatest argument in favor of interoperability, however, is the ability to immediately capture the enhancements and benefits brought by national fintech regulatory sandboxes, and distribute these significant positives on an international scale.

Carlos Muñoz Ferrandis is a PhD Researcher at the Max Planck Institute for Innovation and Competition (Munich). He is a RegTrax Contributor (Wyoming jurisdiction) and collaborates with the “Blockchain for Societies” SIG (Utrecht University). He is also the Co-Founder of HIGH (HIGH Technology Law Forum).