The US lags behind in financial innovation. Regulatory sandboxes are the answer.

by James · May 2, 2023

Sandbox — The authors argue that a federal regulatory “sandbox” would allow fintech innovators and regulators to work toward a responsible future in which the United States remains a leader in financial services.

Last March, President Biden signed a verdict on Digital Assets which identified six policy goals, including “supporting technological advances that promote the responsible development and use of digital assets.” Although few would object to this goal, it raises the questions of who defines and what constitutes “responsible development.” In our financial system, these questions are too often answered by regulators, who have considerable power to prevent new entrants from entering the market and restrict regulated entities from offering new products and services in the interest of preserving “safety and soundness”. But regulators are motivated not to take risks, because they know they will be blamed if things go wrong and consumers are harmed. As a result, many new financial innovations take root outside the regulatory perimeter, in the so-called “shadow banking system,” while entrenched, regulated operators see their protective moats grow wider.

To their credit, some regulatory agencies have tried to be more receptive to new technology by opening fintech or innovation “hubs,” which are designed to be the first entry point for fledgling firms looking to learn more about current regulations. The Office of the Comptroller of the Currency, which charters and regulates national banks, has gone a step further, first attempting, unsuccessfully, to launch a new charter for fintech companies without a depository in 2018, and recently established one Office of Financial Technology. But even this modest effort has been met with resistance by incumbent firms and state regulators, who are wary of losing any of their authority, even if it means consumers benefit from more choices.

America’s fragmented financial regulatory framework prevents a comprehensive and coordinated response to new financial technologies. In short, we have too many chefs in the kitchen. Congress needs to act, and they can look across the pond for an example of what to do.

In 2016, the UK’s Financial Conduct Authority (FCA) became the first agency to introduce a regulatory sandbox, and their model has since been copied by over 70 jurisdictions around the world. FCA defines their sandbox as “a ‘safe space’ where businesses can test innovative products, services, business models and delivery mechanisms without immediately incurring all the normal regulatory consequences of engaging in that activity. The FCA’s sandbox was designed to promote competition in what historically has been a highly concentrated market for financial services for private customers, and it has received over 550 applications from firms using a range of new technologies, such as distributed ledgers, artificial intelligence and digital IDs. According to the FCA, their sandbox has reduced the time and cost of bringing innovative ideas to market and facilitated greater access to capital for approved firms.

In the United States, several state legislatures have attempted to emulate Britain’s success by creating their own sandbox at the state level, but these efforts have borne little fruit. Compared to national regulators, such as the FCA, states are more limited in terms of the benefits they can offer sandbox participants. The main benefit is the ability to test a new product or service without having to obtain a full license, but there are only so many willing consumers in each state, and most states limit the number of consumers a sandbox participant can engage with. For example, Arizona’s sandbox companies can test their products for up to two years and serve as many as 10,000 customers before having to apply for a formal license. But most fintech firms are online only; they want the opportunity to operate nationwide under one rule book.

The rapid rise of artificial intelligence highlights the need for a federal regulatory sandbox that allows innovative firms to distribute their products and services on a limited basis across the country. A federal sandbox could help fintech startups better navigate the thicket of existing regulations, which in turn would make it easier for these firms to partner with established financial institutions, attract talented employees and raise capital. It can also allow regulators to learn about new technologies as they emerge and ensure that appropriate consumer protections are built into new products and services before they are widely deployed.

Fortunately, Congress does not have to start from scratch. In 2016, Congressman Patrick McHenry (R-NC) introduced Act on innovation of financial services. Although the bill never uses the word “sandbox,” it would require each financial regulatory agency to establish a financial services innovation office (FSIO) that would facilitate the development of financial innovations and work with fintech companies to help them understand and comply with the relevant regulatory requirements . The director of each agency’s FSIO office will also serve on the FSIO Liaison Committee, which will help ensure a level of interagency coordination unlikely to occur otherwise.

The bill would allow any fintech company to petition one or more federal financial regulators for a waiver or amendment of an existing agency rule or regulation provided their innovation meets four criteria. It must serve the public interest, improve access to financial products or services, promote consumer protection and must not pose a systemic risk to the financial system. If those conditions are met, the company will enter into an agreement that will prevent a federal or state agency from initiating an enforcement action against the company “with respect to the economic innovation that is the subject of the enforceable compliance agreement.”

The bill also addresses the complaint that sandboxes allow the government to pick winners and losers by placing the onus on federal regulators to provide credible reasons why a waiver or amendment should not be granted and to make that information public.

Now that he chairs the Financial Services Committee, Congressman McHenry is in a much better position to advance sandbox legislation, and his 2016 bill is a natural starting point for bipartisan negotiations. Both parties claim to support innovation, but it is difficult to know which innovations are “responsible” until they are in the hands of consumers. A sandbox gives consumers, regulators and innovators the opportunity to work together toward a responsible future where the United States remains a leader in financial services.