This post is authored by Chinmayanand Chivukula, a fifth-year student of B.A. LL.B.(Hons.) at the Symbiosis Law School, Pune.
Increased interest in FinTech[i], which is reflected in the growing consumer adoption and funding, has caught the attention of sectoral regulators around the world. However, they are challenged with the task of creating an appropriate regulatory environment for FinTech for two reasons: firstly, FinTech’s rapidly evolving nature makes it difficult to address the issues of cybersecurity and data protection; secondly, without an appropriate regulatory environment, the goal of financial inclusion, for which Fintech is touted in India, may be hampered.
So, jurisdictions around the world have responded with regulatory tools, such as Regulatory Sandboxes (“RS”), Innovation Hubs, and “Test and Learn” approaches, which help financial regulators identify risks to both the financial system design and customers from innovations in finance. In 2019, the Reserve Bank of India (“RBI”) proposed the creation of an RS mechanism in India by releasing the Enabling Framework for Regulatory Sandbox (“the framework”).
2. REGULATORY SANDBOX FOR FINTECH IN INDIA
According to the RBI, RS “refers to the live testing of new products or services in a controlled/test regulatory environment for which regulators may (or may not) permit certain regulatory relaxations for the limited purpose of the testing”. Clear preliminary benefits such as streamlining the authorisation process of new FinTech products, addressing regulatory uncertainties, identifying risks, and ensuring the safety of customers, have been observed.
In an RS process, eligible entities[ii] are allowed to interact with real customers to conduct field tests to collect data on the benefits and risks of FinTech products. During this process, considerations such as the absence of appropriate regulations for innovation, effective delivery of financial services are also taken into account.
The process broadly involves four stages, Application (by entities to be part of the RS), Selection (of the entities that meet all the eligibility criteria), Testing and Evaluation (of the proposed innovation with real customers), and Exit (of the entity from the RS). Here, the innovation may be granted permission, based on the test results and risks assessed, to be deployed to the public at large. Alternatively, it may be rejected for not achieving intended purposes or for violating the terms under which it has been accepted into the RS or even at the discretion of the entity by prior notice of one month.
While the United States had set up the first sandbox-like framework, the U.K. coined the term 'regulatory sandbox' where it is run by the Financial Conduct Authority (“FCA”), an independent financial regulatory body and is operated in the form of group or cohort system similar to the RBI’s proposal. The first thematic cohort was announced in November 2019 on ‘Retail Payments’ with no tests conducted yet due to COVID-19.
3. ANALYSIS OF RBI’S REGULATORY SANDBOX
The official objectives of the RS according to the framework are threefold, fostering responsible innovation in financial services, promoting efficiency, and bringing benefit to consumers. The framework also provides a design for the RS. However, there are certain issues in the framework that make it difficult, to achieve these objectives and, to create an effective RS mechanism.
3.1.Rigid requirements prescribed in the framework
Usually, criteria for entry are common and necessary. However, the framework proposes certain restrictive and rigid criteria for entry into the cohort of the RS; moreover, it is not flexible enough to account for uncertainties.
3.1.1. Restrictive and rigid criteria for entry
The entities must have a minimum net worth of Rs. 25 Lakhs. Although this may be a micro-prudential regulatory measure for risk control especially since the RS process is expensive, such rationale has not been notified. So, this requirement may be challenged under Article 14 of the Constitution of India especially since smaller entities which otherwise meet all criteria and propose sound innovations are adversely affected by it. Applying the regulatory principle of proportionate approach - taking into account risks associated - is necessary to avoid excessive regulatory burden on smaller entities and to promote competition.
Moreover, having to clearly lay down all test scenarios and expected outcomes, concrete exit and transition strategy is too rigid, are not entity friendly, and may even be counterproductive to innovation and inclusion. Most other jurisdictions do not have such requirements. The FCA, in addition to not having such requirements, plays an active role in assisting the entities in creating an appropriate transition strategy considering its regulatory expertise.
Excluded technologies from the RS such as credit registry and credit information are concerning especially with an increased interest in the use of alternative data for credit information. Moreover, such exclusions prevent the RBI from identifying and mitigating risks involved with new technologies in FinTech.
3.1.2. Lack of flexibility
The restrictive time frame of 3 months for testing for each cohort under the framework may not be enough to generate adequately reliable data to decide whether a FinTech product or service is viable for India. Moreover, for an extension to be granted, the entities have to provide additional justifications for it in addition to providing expected outcomes during the extended periods. Considering the nature and scope of an RS, Australia proposes 12 months for testing. Other jurisdictions such as Malaysia, Arizona (USA), Ontario (Canada), and Abu Dhabi (UAE) also have 12 months for testing.
The framework lacks an appropriate customer protection mechanism. Although the framework stipulates undiminished liability of the entity implementing RS towards the customer, it does not propose any mechanisms to enforce the liability. Besides, it does not have a consumer grievance redressal mechanism, which is essential for consumer protection. This is important for instilling legal certainty and trust in RS.
Other jurisdictions such as Kenya and the U.K. have clear mechanisms to handle customer complaints. In Kenya, the regulator monitors the fair and effective resolution of consumer complaints. In the U.K., FCA ensures the customers’ right to appeal to the Financial Ombudsman Service besides enabling their access to the financial compensation scheme. In addition, the Monetary Authority of Singapore mandates the handling of customers’ money and assets by intermediaries and not by the entity in the cohort of the RS.
The framework places importance on decision-making by well-defined principles. However, it immediately notes the inevitability of discretionary judgements. In addition, it also notes that RS may help with a reduced reliance on stakeholder which is very dangerous. Stakeholder consultation is crucial for regulatory policies to be open and inclusive in policy making which ensures that they are implemented in the public interest. Moreover, global regulatory practices emphasise on stakeholder discussions and consultations, especially in FinTech. Therefore, excluding one regulatory tool for another is not desirable.
Besides, its high-level policy statement on transparency regarding the launch, theme of the cohort, etc. is not sufficiently transparent in financial regulation. Similarly, its proposal that the entire RS process shall also be overseen by domain experts is not sufficiently transparent since they have not been defined nor identified in the first cohort released in November 2019. Therefore, it is necessary that they are publicly documented in order to ensure transparency.
Moreover, decision-making process by sectoral regulators must involve due regard to competition law, especially since the RBI notes that FinTech can increase competition in the financial sector. However, it is unclear if any competition law expert or any member of the Competition Commission of India was consulted, especially since none was included in the inter-regulatory group which recommended the creation of the RS mechanism.
Some indicative innovations included in the framework, such as financial advisory services and wealth management services, have the potential to create hybrid financial products involving insurance and investment. This creates sectoral barriers for regulation, especially since both the Insurance Regulatory and Development Authority and the Securities and Exchange Board of India have proposed their RS mechanisms, and also increases concerns of regulatory arbitrage.
So, any hybrid financial product would not be eligible for relaxations from other financial regulators limiting the efficacy of the RS mechanism offered by a single financial regulator. Moreover, innovations initially developed for banking have later been found to be more useful for insurance, increasing the need for an effective ex-ante regulatory measure addressing this issue.
A collaborative approach resulting in a cross-sectoral RS mechanism is necessary to address these concerns. Interestingly, the steering committee on FinTech notes that there is a need to create an inter-regulatory RS mechanism for hybrid financial products and services. The RS mechanism in South Africa, for instance, keeping these in mind, created an RS mechanism that covers all sectors.
Recently, the RBI proposed the creation of an innovation hub[iii] to leverage innovation to increase financial inclusion. Such flexible and less resource-intensive regulatory tool is beneficial since it is more efficient and effective in promoting and facilitating innovation in financial services in a nascent FinTech market such as India.[iv] In addition, RS in other jurisdictions, such as the UK and Australia, has developed from their innovation hubs. However, in the context of a developing country such as India, using both RS and innovation hubs can be more effective in fostering FinTech innovation.
RS is an important step towards the creation of an innovation-oriented and competition-centric financial regulatory environment. Therefore, addressing the issues raised in this post will help create a more inclusive, holistic, and robust RS mechanism that places the interests of consumers above everything else.
[i]The Financial Stability Board defines FinTech as technologically enabled innovation in financial services that could result in new business models, applications, processes, or products with an associated material effect on financial markets and institutions and the provision of financial services: https://www.fsb.org/wp-content/uploads/P140219.pdf.
[ii]Entities eligible to participate in the cohort of the RS include FinTech start-ups, banks, financial institutions, and other companies partnering with or providing support to financial service business.
[iii] “An innovation hub is a unit within the financial regulator that serves as a portal through which industry can access regulators to discuss their Fintech innovation and obtain regulatory guidance or dispensations”. It is typically staffed by regulatory experts: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3598142.
[iv] In India, most FinTech entities operate outside the core financial services space and position themselves as technology enables and service providers by offering value-added services to traditional financial entities: https://www.mondaq.com/guides/results/10/100/all/india-fintech-guide.