A new approach to the regulatory and supervisory treatment of innovative financial activities
Regulatory sandboxes are one of the possible measures to promote innovation in the fintec sector. What are the benefits and what is the regulatory landscape?
Compliance regulatory requirements are burdensome for the companies and can hamper growth. In order to promote the development of innovations, some Member States grant waivers to start-ups in the financial sector, the so-called “regulatory sandboxes”.
What are regulatory sandboxes?
A “regulatory sandbox” is a concept that enables firms to test innovative products, services or business models. Within such sandbox, regulatory obligations are partly not applicable.
In a regulatory sandbox, the competent authorities waive the application of administrative provisions that apply for larger and established firms. Compared with regular supervisory practices, the differentiating feature is that competent authorities use legally provided discretion or levers for proportionality with the intention to enhance innovation. However, regulated sandboxes do not allow the disapplication of regulatory requirements that firms have to comply with according to EU and/or national law. So far, only a small number of Member States have introduced regulatory sandboxes, namely Denmark, Poland, Lithuania, the United Kingdom and the Netherlands.
Reasons for establishing regulatory sandboxes
Regulatory sandboxes will promote innovation. On the one hand, by regulating young companies step by step and not overwhelming them with regulatory requirements. On the other hand, by increasing the knowledge of competent authorities about financial innovations, their advantages and risks. By first testing a product or service in a regulatory sandbox, competent authorities can judge much better the viability of innovative products and services. The experiences throughout the testing phase can show the need for new supervisory rules or indicate gaps regarding the protection of customers, enabling the authorities to develop appropriate solutions. Furthermore, the chance to adjust the product or service before actually entering the market will reduce the costs for firms.
Features of regulatory sandboxes
When comparing the operating regulatory sandboxes in the EU, one can identify many common features: The regulatory sandboxes are all open to different financial sectors (e.g. banking, investment activities and services, and insurance). They are accessible not only for new market-entrants but also for firms that are already present in the market. Furthermore, regulatory sandboxes may comprise not only regulated financial services, but also other products or services that, for example, simplify compliance solutions, blockchain or regulatory technologies.
4. Stages of regulatory sandboxes
The process to test products in a regulatory sandbox usually includes four stages: application, preparation, testing and evaluation.
1. Application stage
In order to participate in the regulatory sandbox, firms have to submit an application. Competent authorities examine whether the application meets the criteria for participation (e.g. the innovativeness, customer benefits, the need and readiness of the firm for testing the proposition in the regulatory sandbox) and decide on this basis if they accept the firm for testing.
2. Preparation stage
Before proceeding to the actual testing stage, firms have to acquire any compulsory licences and put in place any obligatory operational requirements (e.g. systems and controls, reporting). During the preparation stage, the competent authorities define the parameters for the testing itself. For example, they can attach limitations on the number of clients or restrictions on serving specific clients only (e.g. consumers in the local market) to the firm’s licence. A failure to comply with the testing parameters can lead to enforcement or supervisory actions against the firm. Furthermore, the competent authority and the firm agree on an exit plan. The exit plan includes appropriate measures for compensating consumers if the testing stage leads to any damages for them.
3. Testing stage
The main stage of regulatory sandboxes is the testing stage. It gives firms the opportunity to test their financial product or service and evaluate its benefits and risks. Nevertheless, firms have to guarantee an appropriate level of consumer protection throughout the testing stage. The methods to maintain consumer protection are determined by the characteristics of the product or service offered and the clients involved. The duration of the testing stage varies depending on the jurisdiction: It can last for up to 6 months (in DK and UK), be a period between 3 and 9 months (PL) or be determined on a case-by-case basis (NL). Competent authorities can terminate the testing at any time, for example, if the firm fails to comply with the testing parameters or if the continuation of testing carries a high risk of detriment to the consumer.
When the testing period is over, the competent authorities and firms evaluate whether the test was successful. Depending on the results, there are the following options: a further, extended testing stage in the regulatory sandbox, the discontinuation of the product or service (e.g. if there was no demand for the product or service) or the continuation outside the regulatory sandbox.
In conclusion, regulatory sandboxes can help both firms and competent authorities. Firms can test their provisions in a monitored space and can obtain a deeper understanding of supervisory expectations. Competent authorities provide firms in regulatory sandboxes with more dedicated resources than usually extended for monitoring. In return, competent authorities have the chance to gain insight into newly developing technologies, such as distributed ledger technologies or artificial intelligence. By using the experience gained in the testing stage, competent authorities can react faster and more effectively to regulatory and supervisory problems.
Nevertheless, there is a challenge for firms to extend their innovative products and services in more than one Member State, as regulatory sandboxes operate on a national level only and the Member States apply different regulatory requirements to the same innovations. In order to promote and bridge innovation facilitators like regulatory sandboxes in the Member States, the European Supervisory Authorities (ESAs) propose to create a stronger cooperation of the supervisory auhorities. A harmonised legal framework for regulatory sandboxes in the EU however, is not part of the proposal. The German government does currently not intend to establish regulatory sandboxes. The current system, in particular the proportionality of legal requirements and financial supervision, is deemed suitable to facilitate development in the fintech sector. However, as the German government pointed out recently, it plans to establish “practice laboratories” (Reallabore) within its approach to promote blockchain-based products.