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

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Last March, President Biden signed an executive order on digital assets that identified six policy objectives, including "support technological advances that promote responsible development and use of digital assets." While 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 the regulators, who hold substantial power to prevent new entrants from coming to market and restrict regulated entities from offering new products and services in the interest of preserving "safety and soundness." But regulators are incentivized to not 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 incumbents see their protective moats grow wider.

To their credit, some regulatory agencies have tried to be more receptive to new technologies by opening financial technology or innovation "hubs," which are designed to be initial points of entry for nascent firms wanting to learn more about applicable 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 nondepository fintech firms in 2018, and more recently, establishing an Office of Financial Technology. But even these modest efforts have been met with resistance by incumbent firms and state regulators, who are leery of losing any of their authority, even if it means consumers benefit from more choices.

The United States' fragmented financial regulatory framework prevents a comprehensive and coordinated response to emerging financial technologies. In short, we have too many cooks in the kitchen. Congress must act, and they can look across the pond for an example of what to do.

In 2016, the United Kingdom'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 globe. The FCA defines their sandbox as "a 'safe space' in which businesses can test innovative products, services, business models and delivery mechanisms without immediately incurring all the normal regulatory consequences of engaging in the activity in question." The FCA's sandbox was designed to promote competition in what has historically been a highly concentrated retail financial services market, and it has received over 550 applications from firms utilizing a variety 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 getting innovative ideas to market and facilitated greater access to capital for admitted firms.

In the U.S., several state legislatures have attempted to emulate the U.K.'s success by creating their own state-level sandbox, but these efforts have borne little fruit. Compared to national supervisors, like the FCA, states are more limited in the kinds of benefits they can offer sandbox participants. The main benefit is the ability to test a novel product or service without having to obtain a full license, but there are only so many willing consumers in each state, and most states restrict how many consumers a sandbox participant can engage with. For instance, Arizona's sandbox companies can test their products for up to two years and serve as many as 10,000 customers before needing to apply for a formal license. But most fintech firms are online only; they want the ability to operate nationwide under one rulebook.

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The rapid ascent of artificial intelligence highlights the need for a federal regulatory sandbox that allows innovative firms to deploy their products and services on a limited basis across the country. A federal sandbox can 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 are emerging and ensure appropriate consumer protection safeguards are built into new products and services before they are widely deployed.

Thankfully, Congress needn't start from scratch. In 2016, Congressman Patrick McHenry (R-NC) introduced the Financial Services Innovation Act. While the Bill never uses the word "sandbox," it would require each financial regulatory agency to establish a financial services innovation office (FSIO) that will 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 that is unlikely to occur otherwise.

The bill would allow any fintech company to petition one or more federal financial regulators for a waiver or modification to 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 present a systemic risk to the financial system. If these conditions are met, the company would enter into an agreement that would prevent any federal or state agency from bringing an enforcement action against the company "with respect to the financial 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 come up with credible reasons for why a waiver or modification should not be granted and to make this 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 hard to know which innovations are "responsible" until they are in the hands of consumers. A sandbox allows consumers, regulators and innovators an opportunity to work together toward a responsible future where the U.S. remains a leader in financial services.