Enabling new digital financial services models requires an open-minded approach to innovation, with sufficient certainty over the legal framework.
Innovations in financial technology (fintech) include mobile phones, digital platforms, biometrics, online peer-to-peer lending, crowdfunding, and blockchains. For small businesses and households, these innovations all hold much promise as tools for helping meet modern financial needs. They can also assist institutions scale up operations efficiently, as well as making transactions faster and safer. In short, fintech could become the lynchpin for financial inclusion.
However, fintech innovations are not risk-free, and their transformative implications are being scrutinized by regulators, including the Financial Stability Board. Regulators are exploring ways to apply innovation responsibly – ways to manage systemic risks that may arise from technological change.
A few developed market regulators—the UK’s Financial Conduct Authority, the Monetary Authority of Singapore and the Australian Securities and Investments Commission—recently allowed the private sector to experiment within certain bounds to learn how to regulate and supervise this emerging industry, using a “sandbox” approach.
Although publicized as novel, the “sandbox” is not a new concept; it is just a new expression. Quite sometime back in many developing countries, regulators adopted a flexible “test and learn” approach to foster innovation. By letting regulation follow change, the central banks of the Philippines and Tanzania created space for innovating with digital financial services (DFS) to glean a better understanding of the business, its operational risks and mitigating factors. Both countries authorized reputable early implementers to try new products and business models under close monitoring and frequent contact, rather than imposing a predetermined regulatory framework upfront.
At the time, supervisors saw this as somewhat outside their mandate. They argued that there was a conflict of interest between regulatory and developmental roles. Given this backdrop, the recent decisions of the UK, Singaporean and Australian market regulators to go with a ‘regulatory sandbox’ vindicates the old “test and learn” approach.
The sandbox gives limited authorization for fintech startups to test new products and models with a small number of actual users in a simulated environment. This gives them more time to build and test business ideas, instead of spending time navigating complex financial services regulations. Focusing on regulatory compliance eats up seed capital before anyone knows whether an idea could work and be scaled up. Participants are nonetheless required to follow rules on marketing, privacy, anti-money laundering, disclosure, and management of conflicts of interest.
Establishing fintech offices that bring together business innovators with regulators is another related development. Some governments also allocate funds for setting up innovation labs, and supporting infrastructure.
Piloting a product or business model in the sandbox will help companies manage their regulatory risk during testing. Restricting transaction size will limit any large adverse consequence of product or model failure. And this approach also allows regulators to test new financial products and services for risk and compliance, along with creating preconditions for ensuring competition and successful uptake. It will also improve access to sustainable equity financing.
Only when the risks of applying new technology become material would companies be required to obtain full regulatory approval. Once a business grows and reaches a certain critical mass, it could pose significant potential impact on financial stability through possible operational disruption of core financial institutions or infrastructure, or badly affect a large number of consumers.
A unique aspect is the agreement to cooperate between regulatory bodies in the UK, Singapore and Australia to share information and implement a referral process. Thus, fintech firms from these jurisdictions are not likely to face regulatory barriers when entering each other’s markets.
Developing country experience shows that traditional financial players, when restricted by regulations, do not meet end-user needs. Enabling new DFS models requires an open-minded approach to innovation, with sufficient certainty over a legal framework that protects users and clearly assigns liabilities. If regulators understand the product and their risks, they can tailor the regulatory regime to specific risk characteristics.
Governments in Asia and the Pacific should actively promote investment in developing digital financial infrastructure. And regulators must also encourage piloting innovative fintech applications to build better synergies with the real sector to boost productivity, competitiveness, and resilience.