Regulators can do more to encourage fintech innovation

The United States’ fintech firms may be leading the way with new, cutting-edge innovations in financial technology, products and services, but the country’s financial regulators and policymakers are sadly lagging behind their international counterparts in creating “fintech regulatory sandboxes” as a means of testing ideas and products and promoting responsible financial innovation.

The United States needs to up its game soon if it doesn’t want to be eclipsed by European and Asian regulators, many of which formed the Global Financial Innovation Network and issued a consultation paper this summer on how best to foster financial innovation and regulatory collaboration. GFIN deserves credit for trying to flesh out the global regulatory sandbox concept within the world’s vastly different and complex regulatory structures, mandates and jurisdictional boundaries. This regulatory diversity is of particular concern to fintechs and financial services innovators, many of which have designed cross-border technologies, products or services. GFIN’s task is particularly challenging in a world where nations may be increasingly skeptical of international economic cooperation.

Still, U.S. regulators and policymakers are starting to act. In July, the Treasury Department endorsed the regulatory sandbox concept and called for greater coordination among the host of federal, state and international regulatory agencies having jurisdiction over fintechs, financial services innovators and/or the markets in which they operate. It also endorsed the Office of the Comptroller of the Currency’s special-purpose national bank charter for fintechs, which was part of the OCC’s 2016 “Responsible Innovation Framework.” Although not everyone agrees with all of Treasury’s recommendations, the report has started a much-needed conversation on how best to move forward.

A lot of work has been done in this area by the Consumer Financial Protection Bureau’s Office of Innovation and Project Catalyst, its predecessor, and by states like Arizona, which became the first state in the United States to adopt a regulatory sandbox statute.

Yet these efforts, while welcome, fall short because they are largely focused on each agency’s policies and procedures and participant eligibility. Fintechs need more than process-oriented frameworks. To be successful, regulatory sandboxes require clearly articulated safeguards, terms of use and expectations on transparency. These matters are too important to be left to one-off negotiations.

Regulatory sandboxes sound like a great idea, but what actually is a regulatory sandbox? In order for regulatory sandboxes to succeed, stakeholders need to have a common understanding — and acceptance — of the basic concept. First, regulatory sandboxes need a better name. Terms like “clinical trial,” “experiment” and “lab” may better convey what is really needed. Informal dialogue with regulators at the idea or initial concept and early design stages and controlled experiments with real-time regulatory input and feedback at the development and testing stages benefit everyone — just like the Food and Drug Administration’s clinical trials. Transparency is essential. The research and findings from any such experiment need to be readily available to other regulators, fintechs, financial services innovators and the public.

Borrowing from the medical profession’s Hippocratic oath, the goal should be do no harm, particularly if consumer harm or risks to financial stability may be implicated by an innovative technology, product, or service. This is of the utmost importance in the case of consumer-facing technologies, products, or services. A well-designed clinical trial or experiment should involve the smallest statistically valid number of consumers, be time limited, and be designed with appropriate controls, disclosures, and a funded escrow or commitment to make restitution in order to mitigate any possible financial harm to members of the control group. Regulators also need to have a kill switch to terminate any clinical trial or experiment, if deemed necessary.

In turn, there must be regulatory buy-in. That is, regulators must overcome cultural inhibitions and freely provide constructive feedback and informal advice and need to agree at the outset not to impose civil money penalties or other enforcement actions as long as the experiment is properly conducted within lawful bounds. Additionally, regulators across a number of agencies must show a willingness to collaborate and share their experience and expertise both among agencies and with innovators. Agencies should start small and build on their successes. The OCC, with its new special purpose national bank charter for fintechs, can design appropriate trials in the payments area with the Federal Reserve and the CFPB. Similarly, OCC-chartered fintechs could test consumer credit applications and products with just CFPB and OCC oversight.

A perhaps unfair perception exists that fintechs want a get-out-of-jail-free card. That is a bad idea that, if adopted, could ultimately engender a consumer, regulatory, and/or legislative backlash against fintechs. Applicable prudential and consumer financial laws should not be waived unless there is clear legal authority to do so. The clearly better approach is to engage with applicable regulatory agencies sooner rather than later. A baked-in legal or regulatory flaw will be harder to correct and may have significant financial and regulatory costs if left to a later date to correct.