Thu. Oct 17th, 2019

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Innovation & Regulation in Finance

Innovation Hubs v Regulatory Sandboxes and the Future of Innovation Facilitators

13 min read

The ESAs joint report on innovation facilitators analysis the different kinds of innovation hubs and regulatory sandboxes that have been established in European member states. What better time to take stock, compare the two and confront some of the major argument as well as think about a way forward?

Recently, the European Supervisory Authorities (ESAs) set out a comparative analysis of the innovation facilitators established to date in the EU. Therein, the European regulators define innovation facilitators as either ‘innovation hubs’ or ‘regulatory sandboxes’. According to the ESAs, “innovation hubs provide a dedicated point of contact for firms to raise enquiries with competent authorities on FinTech-related issues and to seek non-binding guidance on regulatory and supervisory expectations, including licensing requirements. Regulatory sandboxes, on the other hand, are schemes to enable firms to test, pursuant to a specific testing plan agreed and monitored by a dedicated function of the competent authority, innovative financial products, financial services or business models.”

Innovation Hubs

Most EU member states have established innovation hubs and it is hard to see why they shouldn’t. They provide necessary guidance for companies “on the conformity of innovative financial products, services, business models or delivery mechanisms with licensing, registration and/or regulatory requirements”. So, pretty much what they already should be doing for more traditional financial institutions. While the innovation hubs are open to established players and new entrants alike, the ESAs analysis shows that it is the latter that benefit the most from these points of contact. According to the report four areas can be summarised as:

1) whether a certain activity needs authorisation or not;

2) whether or not anti-money laundering issues arise;

3) the applicability of consumer protection regulation and the means to secure conformity; 
and

4) proportionality issues in the application of regulatory and supervisory requirements (e.g. systems and controls).

 

Regulatory Sandboxes

Slightly more interesting is the part of the report that looks into regulatory sandboxes. As opposed to a large number of member states with an innovation hub are still rare in the EU: five member states reported operational regulatory sandboxes though out of these five for most it is still early days (Lithuania and Poland only started in September and October 2018 respectively). At the same time, other member states are contemplating setting up regulatory sandboxes or are in the process of doing so. Why do we see a different picture compared to the establishing of innovation hubs? There are a number of reasons: firstly, innovation hubs are in a way an extension of existing services while sandboxes require the commitment of significant resources. The report identifies four distinctive stages of the typical sandbox – application, preparation, testing, and evaluation – and all of them require staff at the authorities to focus on the various aspects.

Secondly, there are a number of arguments to be made against the use of regulatory sandboxes and we will get to this in more detail in a minute. It is suffice to say though that not everyone is convinced that it is the way forward.

And thirdly, some authorities are limited by their mandate or choose to fulfil this role in a different manner, e.g. through less-formalised workshops, industry discussions and roundtables. The German regulator BaFin, for example, stressed early on in the FinTech conversation that the German setup differs from regulatory authorities in other countries. Unlike the UK’s FCA, for instance, the German financial watchdog has no mandate to promote innovation in the same manner. This also explains why a regulatory sandbox would be unthinkable in Germany given the current circumstances and legal structure. The FCA’s commitment to encouraging innovation in the interest of consumers is in Germany traditionally more a matter of research and development centres.

Nonetheless, the FCA has engaged in in the promotion of financial innovation early on and in terms of export the concept of regulatory sandboxes has been a successful one. Australia, Canada, Singapore amongst other jurisdiction have so far formed their own regulatory sandboxes and even the US has one in the state of Arizona though federal solutions remain absent.

But an issue with regulatory sandboxes often experienced especially in a space with common legislation such as the European Union, initiatives limited to a jurisdiction have a fundamental flaw. All the more important is therefore international collaboration and again the FCA has been a pioneer in striking agreements to collaborate closely with international financial services regulators.

With a consultation document launched by the Global Financial Innovation Network (GFIN) in August 2018, the idea of a global sandbox was born. With 12 regulators participating a structure was created that serves three functions: act as a network of regulators to collaborate, sharing experience and best practice, and communicate to firms; provide a forum for joint policy work; and provide firms with an environment in which to trial cross-border solutions (business to consumer (B2C) or business to business (B2B)).

Regulatory Sandboxes present opportunities and risks alike and the ESAs report concludes with an analysis of these.

Opportunities and Risks

The ESA report lists a number of upsides for competent authorities to establish one form or another of innovation facilitators.

Regulators gain a better understanding of innovation in financial services, and firms understand better the regulatory and supervisory expectations against the backdrop of rapid technological advancement.

“In particular, innovation facilitators can help competent authorities to keep pace with developments by gaining near ‘real time’ insights into emerging technologies (such as distributed ledger technologies, big data analytics, artificial intelligence and machine learning) and their application in the financial sector. Competent authorities can apply these insights for the purposes of anticipating regulatory and supervisory issues and responding proactively.” On the other hand, it makes regulators more accessible to firms and in particular start-ups that lack resources and experience in regulatory matters

However, the report also summarises some of the risks that are perceived by competent authority regarding the operation of innovation facilitators in general and with regulatory sandboxes in particular. We already mentioned the need to commit resources and with a view to the technical advancements, regulators face the issue of not only finding staff but people with the necessary background and expertise to be involved in these activities. In many cases innovation facilitators also require an element of domestic coordination between different agencies and cross-border cooperation with other jurisdictions. And lastly the report also makes reference to the impact on the level playing field: “Some competent authorities queried if the active guidance and close monitoring of the participants in the regulatory sandboxes could give rise to level playing field issues, creating two tiers between those firms in the sandbox and those outside it. As for innovation hubs, the need for the public articulation of general policy stances adopted by the competent authorities and wider lessons learned from sandbox test outcomes (e.g. regarding the applicability of a specific EU legal instrument to an innovative service) is underlined to ensure that all firms can benefit. It is also emphasised that the objective of the regulatory sandboxes and the entry criteria should be clear and made public in order to ensure a high degree of transparency in the entry process.” While that is some good advice, it is only half the truth as we will see further down.

These are only a few of the arguments that are made against regulatory sandboxes and in reality the following are often considered pulling more weight:

 

Risky Business

A common argument against regulatory sandboxes is that it could lead to catastrophic consequences similar to the Global Financial Crisis of 2007/2008 (“GFC”). One of the main reasons for the crash of 2008 was the use of innovative financial products like CDOs and Credit Default Swaps that went hand in hand with increasing complexity. Fostering innovation would therefore mean that regulators are unwittingly endorsing and promoting risky technology that could in a similar manner have comparable consequences.

While it is true that the use of new products played a key role in the build up to the GFC, it is quite a step to say that all forms of financial innovation are equally dangerous. In the case of CDOs and CDSs, it is more the ignorance (or greed, depending on whom you believe) of regulators and management at financial institutions that was responsible that this form of financial innovation could play its part.

 

Stamp of Approval

Another argument made by opponents of Regulatory Sandboxes is that the participation in such programmes is often exploited by involved firms. In this sense, being admitted to a sandbox equals the regulator’s approval of the participants’ activity and is as such used by these companies to promote their services. Even if we were to disregard the fact that participation does not mean outright authorisation in any of the sandboxes in the different jurisdictions or that admittance cannot be as easily be achieved as, for instance, the participation in an accelerator programme (which is often only subject to sufficient payment). Taking part in a sandbox requires a significant investment in terms of time and resources for these companies. Considering that these resources in most of these firms are already chronically strained, it is a rather expensive way to obtain some publicity that could be gained at a fraction of this price in different ways.

 

Crypto madness

The argument that sandboxes promote risky innovation has also been at the centre of a recent articleon Financial Times Alphaville column on regulatory sandboxes citing that in the last cohort of the FCA’s sandbox “almost half of the 29 firms’ business models were based either crypto or blockchain”. Yes, it is true that 14 of the 29 firms in the last cohort of the FCA’s sandbox are using DLT, blcokchain technology or smart contracts. However, after closer analysis, it becomes apparent that only a small part of this group of companies is working on crypto applications. Thus, statements like this are not helpful for two reasons: firstly, it confuses blockchain technology with cryptocurrencies and initial coin offerings with the latter having a negative reputation. Instead, as the example of the last FCA sandbox shows, blockchain or Distributed Ledger Technology is used by the other firms for a number of other activities such as trade payments and settlements, the issuance and management of regulated bonds, fully automated and decentralised flight delay insurance, governance models, payment services and digital identification.

This shows the possibilities of blockchain technology and underscores the potential that should rightly be explored. And if it is in a framework that allows the regulator to gain valuable insights, it is all the better. Secondly, while there are many reasons why cryptocurrencies and ICOs have a bad reputation, treating them generally as the devil’s instrument achieves the opposite as it makes the wrong people to use them to finance dubious projects. We have long been calling for a regulatory framework that would allow ICOs and cryptocurrency to be used in a rightful way. So exploring these kinds of blockchain projects in a sandbox environment could actually be a good thing. One could even say that if the authorities had had a more hands-on approach with regard to the crypto industry much of the fraudulent behaviour that has taken place in the ICO space could have been averted and consumers/investors would have been protected more efficiently. In any case, it would have contributed to solving some of the main issues of the crypto industry such as insider trading or conflicts of interest, especially given the existing regulatory models for traditional finance.

 

Regulatory Arbitrage

In the early days of the FinTech revolution (as recent as two years ago though) it became apparent that various jurisdictions tried to promote themselves as FinTech hubs, places that would foster innovation better than others to attract the next big thing taking place in their country.

Singapore has aggressively tried to establish itself as the world’s leading FinTech hub, which in respect of its treatment of ICOs has seen some rather interesting back and forth movement in its regulatory analysis. It highlights the problem however that regulators around the globe face when striking a balance between attracting interest from FinTech firms whilst at the same time maintain a regulatory regime that lives up to its name. As a consequence there is the risk that a jurisdiction may be tempted to lower its guard (as we have already witnessed) in order to remain competitive.

This isn’t a problem that exists for regulatory sandboxes alone but rather the overall framework of jurisdictions and that can possibly only be solved through intensified international cooperation.

The Road Ahead

Which takes us to the question of what lies ahead. The ESA report states that the three agencies “will continue to monitor developments regarding national innovation facilitators in the EU and take such further steps as are considered appropriate to promote an accommodative and common approach towards FinTech in the EU. The ESAs will explore the options available for enhancing cross-border coordination and cooperation between national innovation facilitators, in conjunction with the European Commission’s and the ESAs’ further work on FinTech and define further steps”. The report also proposes the creation of an EU network of innovation facilitators could be established, with participation open to all competent authorities in the EU.

In any case, international collaboration seems to be a key element for us and it is also a point made often by other defenders of the concept of regulatory sandboxes. The inherent difficulty and time it will take, however, can be seen in many examples where the European agencies as well as international bodies try to even establish common standards and does not bode well. The creeping progress that is made with regard to international anti-money laundering standards for cryptocurrencies and the EU’s dance around the categorisation of crypto-assets are just two examples that immediately spring to mind.

However, hope springs eternal and innovation facilitators in the form of innovation hubs, regulatory sandboxes or in any other form or shape can be powerful tools to foster innovation and protect consumer as well as investors alike.

 

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