The financial sector feels like a relic trapped in modern times. From Medici’s double entry accounting system invented to Letters of Credit to financial accounting – the sector stuck to its fundamentals. The industrial age came, and it only elevated the importance of a strong financial sector at regional/domestic as well as global scale. The shocks of the great depression, wars and economic meltdowns throughout the modern history did not change the fundamentals of the sector but only added extra layers of buffers and internal controls to curb the shortcomings within the system. The products offered by the sector are very same in their respective cores; deposit accounts, letter of credits for international traders, sending / receiving money across borders to settle transactions etc. However, technology is about to change the course of history of financial sector. Due to advent of technological advancements, the financial sector is now experiencing a new wave of financial products. The products are not only convenient for its customers but also cost effective for both the institutions and customers. The amalgamation of Finance and Technology is known as ‘FinTech’ and it’s taking the world by storm. By utilizing new cost effective and efficient technological innovations like Cloud Computing, distributed ledger, Artificial Intelligence (AI), Data mining, Machine learning etc., FinTechs have addressed a new range of innovative financial products in the market. FinTechs provide a more seamless customer experience with lower costs and increased efficiency and transparency by utilizing disruptive technologies. Providing financial products and services through digital channels, or digital financial services (DFS), allows FinTech firms to be nimble, asset-light, and quick to adapt to changes in the market and customer preferences. FinTech Start-ups are forcing conventional financial institutions like banks to re-think their business models, and many are reacting by adopting new technologies, improving their service offerings, modifying their business models and reducing costs.
However, it’s imperative to shed light on the associated risks with the underlying technologies of FinTechs. From risks of money laundering and terrorist financing to dispute resolutions to consumer protection from possible frauds & scams to cyber-attacks, these risks lead to negative impact on customers and even may cause financial sector vulnerabilities. Regulators assert to deploy regulations and internal controls to get the optimal outcome of the potential of FinTechs without jeopardizing the public interests. On the other hand, the limited knowledge of regulatory authorities related to FinTech is also a challenge in itself. In that case, regulators resort to prudent measures like banning cryptocurrencies and Initial Coin Offerings (ICOs) in Pakistan, Bangladesh, Iceland etc. Nonetheless, regulators have realized that FinTech has a lot of potential and evolution of FinTech is very fast paced. Due to competitiveness in the industry, the products are evolving at a rapid rate, from self-executable smart contracts to credit services in remote areas of Kenya.
In order to address these concerns, regulators have come up with ‘Regulatory Sandbox’. A sandbox is a virtual space in which new or untested software or coding can be run securely whereas a regulatory sandbox is a formal regulatory program that allows market participants to test new financial services or business models with live customers, subject to certain constraints and oversights. The first sandbox-like framework was set up by the U.S. Consumer Financial Protection Bureau (CFPB) in 2012 under the name Project Catalyst. The model of ‘Sandbox’ has already been utilized by regulatory authorities as well as financial sector players around the globe like MAS, Bank of England, Bahrain, Hong Kong Monetary Authority etc.. There are three types of regulatory sandboxes; Product Testing Sandbox, Policy Testing Sandbox and Multi-jurisdiction sandbox. The line between the product testing and policy testing sandbox is a bit blurred and regulators often use the combination of two types. Meanwhile in South America, the multi-jurisdiction Sandbox is attractive for both regulators and consumers. In Latin America, approximately 20 percent of the FinTechs operate in more than one jurisdiction due to size of individual regional markets.
Regulatory sandbox provides various opportunities to the market players as well. In case of UK’s regulatory sandbox regulated by Financial Conduct Authority (FCA), the small firms assess their respective commercial viability and technological resilience regarding cyber-attacks in the sandbox. In case of Hong Kong Monetary Authority’s (HKMA) FinTech Supervisory Sandbox (FSS) has a chatroom to provide streamlined access of feedback to banks and non-bank entities in the jurisdiction. By the end of August 2018, the chatroom had 170 requests and 70% of the requests were from non-banking institutions.
In order to extract the optimal potential for such disruptive tech for financial inclusion and cost-effective solutions without compromising the integrity of the financial institutions, consumer protection, consumer privacy, cyber security and financial exclusion, the regulator has to be proactive rather than reactive. Regulatory Sandbox provides a chance to the regulators to be proactive in determining associated risks, guide and flourish the market innovation. Moreover, the regulatory sandbox can also act as a lighthouse for the FinTechs to converge the thinking minds towards a single goal, that goal can be financial inclusion, robust payment systems, cost effective cross border remittance systems, or centralized AML/KYC repository etc. Even though regulatory sandboxes are nascent in the financial sector, they can be used to steer the sectors in achieving national goals like financial inclusion.