Fintech Startups and Incumbent Players Series – Designing a Regulatory Sandbox

In the Fourth Oxford Business Law Blog Annual Conference on ‘Financial Start-ups and Incumbents Players: Policy Challenges and Opportunities’, different ways to foster innovation were discussed including the use of a sandbox tool, which allows companies to test products in an altered regulatory environment.

The sandbox concept spread around the world shortly after it was first announced in the UK in 2015. Such a wide and swift implementation of a local regulatory concept in foreign jurisdictions is not a usual phenomenon by itself, and, although it could be explained as some kind of a regulatory fad, it seems that it at least reflects a real need of financial regulators around the world for regulatory tools to enable them to better understand and regulate innovation. The case of the Israeli regulatory sandbox can be used to highlight some of the practical challenges in regulating innovation and to sketch out some policy considerations in designing a sandbox.

Regulating Innovation

Different approaches to regulating innovation are provided in the literature. In general, two extreme approaches can be described as the ‘do nothing’ approach and the ‘regulate too fast’ approach. The ‘do nothing’ approach was described by Zetzsche et al as a potentially restrictive or permissive approach, depending on the context. The opposite approach, regulate ‘too fast’ can happen when a regulator intends to take a more formal approach and introduces reforms or new regulations, before fully realizing the potential risks or implications of the new technology, its features, or potential benefits (whether intentionally or not). Such regulation is prone to be non-efficient or non-technology neutral. In the middle there are various more flexible or collaborative approaches.

In reality, though, the line between those two extremes is rather blurry and often a matter of hindsight. When regulators are studying an innovation and its potential risks, they might easily find themselves at one of the extremes: if understanding the risks or features of technology takes time and they are ‘too slow’, they might be ‘doing nothing’. However, if an expedited process occurs, and regulation is put in place before exhausting the regulatory research, they would easily be accused of acting ‘too fast’.

One can find an example for each of those two approaches in Israel’s attempt to deal with innovation. An example of a non-intentional do-nothing-approach is Israel’s experience with regulating virtual assets. While Israeli regulators have been studying the implications and risks of blockchain technology for almost five years now, with an intent to allow the industry to develop (and even after a dedicated intergovernmental team was established to that end), the regulators are still not close to clarifying the legal situation. In fact, in a recent court case [C/A 51757-08-18 Arev vs. mercantile Bank (2019)], the Attorney General referred in its submitted opinion to two contradicting viewpoints, one from the Bank of Israel and one from other financial regulators and the Ministry of Justice with regard to the legality of dealing in bitcoin and of transferring returns to an Israeli bank account. The court has yet to decide on this case, but, naturally, shedding light on the regulatory controversy does not help legal clarity.

An example of the opposite regulate-too-fast approach can be found in the Access to Account regulation in Israel, which was drafted and approved almost overnight. This expedite process resulted in an incomplete, non-technology-neutral regulation, which would also be hard to apply. So much so that the Israeli government has subsequently decided to revoke this regulation and to replace it with a new one (which has not been published yet). 

Those are just a few examples to demonstrate the difficulties regulators face when dealing with innovation, especially where changes are rapid and constantly developing. Those challenges, coupled with the fear to act ‘too fast’, emphasize the importance of more flexible approaches (such as case by case decisions, restricted licensing, no actions, etc) as well as experimental tools.

Sandbox Design—Policy Considerations

The sandbox has emerged as one of the main experimental tools regulators can use. The main advantage of a sandbox from a regulatory point of view is that it enables regulators to make permissive or restrictive decisions with confined results, while carefully observing their impact. In a sense, it allows making regulatory decisions ‘on time’, without the fear of being ‘too late’ or ‘too early’, thereby lowering the error cost.

However, designing a sandbox requires careful tailoring. The presence of multiple financial regulators, for instance, provides unique challenges: how can a broad but coherent and coordinated approach be maintained? No less important, how can this be done while preserving the independence of each regulator? While some countries preferred to establish separate sandbox programmes under each financial regulator, Israel took a different approach and suggested a programme run by a joint roundtable with representation of all financial regulators. In order to maintain the independence of each regulator, the regulator that supervises the relevant activity is considered the lead regulator and is granted a veto right; thus, companies under its regulatory perimeter may not participate in the programme without its consent. The advantage of such an approach is threefold: first, it ensures a more collaborative and nuanced approach, especially with regard to activities that are relevant to more than one financial regulator. Second, it fosters knowledge and expertise sharing. Third, applications to the programme are examined by representatives of all financial regulators, in a way that would support the lead regulator in its decisions and encourage braver decision-making processes after joint consultation and exchange of ideas. There is also a clear advantage for participating companies, especially those with activities which concern more than one financial regulator (whether because of the nature of such activities or because they are involved in innovative partnerships with other entities).

Another concern is consumer protection, especially when there is no designated compensation scheme in place which could be extended to the sandbox programme. Establishing such a scheme solely for the purpose of a sandbox programme is usually not feasible. The solution adopted in Israel was to restrict regulators’ ability to alleviate the regulatory burden that resulted from consumer protection laws as well as enforcing proper disclosure. This is, of course, a partial solution, as it does not ensure that consumers are compensated for damages caused by participating companies. However, it does increase the chances that consumers are aware of potential risks. It was therefore preferred since it conforms to the general regulatory framework of consumer protection. At the same time, underlying this solution is the understanding that failures of companies can happen and are part of the programme.

An additional challenge is expanding the regulatory perimeter. Different countries established innovation hubs or mentoring schemes to that end. In Israel it was suggested to establish a designated mentoring scheme within the sandbox programme. The mentoring scheme is designed mainly for fintech startups, whether as part of an innovative collaboration with incumbent players or not. The underlying idea is to utilize the joint regulatory roundtable to address difficulties that fintechs face, particularly to the extent that such difficulties are the result of the current regulatory framework that applies to incumbents (for instance, regulatory requirements with regard to opening a bank account). Such difficulties were highlighted in Israel as a major barrier to entry. In addition, the mentoring scheme would be useful for innovative partnerships of new players and incumbents that could benefit from expedited and more collaborative communication with the regulator, even where no formal exemption or regulatory change is necessarily required.

The mentoring scheme would support different goals. First, it would enable incumbents to receive some guidance from regulators which is goes beyond the alleviation of regulatory requirements. Such dialogue between the industry and the regulator not only improves collaboration but also supports the expansion of regulatory knowledge. Second, in combination with the sandbox option the scheme would enable better cooperation of fintechs and incumbents (including banks), which is a major issue everywhere. Third, it would allow for an expansion of the regulatory perimeter, enabling it to learn more about the characteristics of both such collaborations and the new players involved. Fourth, the mentoring scheme might help addressing challenges for the non-regulated players and assist in removing barriers to entry, thus fostering competition.

Although the programme (which was crafted by an intergovernmental team consisting of all financial regulators) has been endorsed by the government, it is not yet in operation. This is due to the required legislative process which was put on hold as a result of the political situation in Israel. Subsequently, it will take some time before the benefits and shortcomings of this approach can actually be assessed. Otherwise, if the legislative process is not completed soon, the sandbox might become yet another example of the non-intentional ‘do nothing’ approach.

Going forward, it is still too early to assess the success of the regulatory sandbox and other experimental tools which are being used to regulate innovation. Currently, those tools are being developed primarily within the context of the financial industry. However, this only serves as a test case, an experiment to examine the benefits of these regulatory tools. If successful, we might see their quick adoption and implementation in other industries and jurisdictions. Establishing them in the standard regulatory toolkit would be a great success.

Zlil Levin was the coordinator of an intergovernmental team established to design a regulatory sandbox in Israel.

The views and opinions expressed in this article are those of the author only and do not necessarily reflect the official policy or position of the Ministry of Justice or any other authority.