Safe in sandbox: India provides cocoon to fintech start-ups

-Kanakprabha Jethani

kanak@vinodkothari.com, finserv@vinodkothari.com

Published on April 22, 2019 | Updated as on April 22, 2020

Background

April 2019 marks the introduction of a structured proposal[1] on regulatory sandboxes (“Proposal”). ‘Sandboxes’ is a new term and has created a hustle in the market. What are these? What is the hustle all about? The following article gives a brief introduction to this new concept. With the rapidly evolving entities based on financial technology (Fintech) having innovative and complex technical model, the regulators have also been preparing themselves to respond and adapt with changing times. To harness such innovative business concepts, several developed countries and emerging economies have recognised the concept of ‘regulatory sandboxes’. Regulatory sandboxes or RS is a framework which allows an innovative startup involved in financial technologies to undergo live testing in a controlled environment where the regulator may or may not permit certain regulatory relaxations for the purpose of testing. The objective of proposing RS is to allow new and innovative projects to conduct live testing and enable learning by doing approach. The objective behind the framework is to facilitate development of potentially beneficial but risky innovations while ensuring the safety of end users and stability of the marketplace at large. Symbolically, RSs’ are a cocoon in which the startups stay for some time undergoing testing and growing simultaneously, and where it is determined whether they should be launched in the market. In furtherance to the recommendation of an inter-regulatory Working Group (WG) vide its Report on FinTech and Digital Banking1 , the Reserve Bank of India has released the draft ‘Enabling Framework for Regulatory Sandbox’ on April 18, 20192 . The final guidelines shall be released based on the comments of the stakeholders on the aforesaid draft.

Benefits and Limitations

Benefits:

• Regulator can obtain a first-hand view of benefits and risks involved in the project and make future policies accordingly.
• Product can be tested without an expensive launch and any shortcoming thereto can be rectified at initial stages.
• Improvement in pace of innovation, financial inclusion and reach.
• Firms working closely with RS’s garner a greater degree of legitimacy with investors and customers alike.

Limitations:

• Applicant may tend to lose flexibility and time while undergoing testing.
• Even after a successful testing, the applicant will require all the statutory approvals before its launch in the market.
• They require time and skill of the regulator for assessing the complex innovation, which the regulator might not possess.
• It demands additional manpower and resources on part of regulator so as to define RS plans and conduct proper assessment.

Emergence of concept of RS

The concept of RS emerged soon after the Global Financial Crisis (GFC) in 2007-08. It steadily gained prominence and in 2012, Project Catalyst introduced by US Consumer Financial Protection Bureau (CFPB) finally gave rise to the sandbox concept. In 2015, UK Government Office for Science exhibited the benefits of “close collaboration between regulator, institutions and FinTech companies from clinical environment or real people” through its FinTech Future report. In 2016, UK Financial Conduct Authority launched its regulatory sandbox. Emergence of RS in India In February 2018, RBI launched report of working group on FinTech and digital banking. It recommended Institute for Development and Research in Banking Technology (IDRBT) as the entity whose expertise could run RS in India in cooperation with RBI. After immense deliberations and research, RBI announced its detailed proposal on RS in April 2019. Some of the provisions of the proposal are described hereunder.

Who can apply?

A FinTech firm which fulfills criteria of a startup prescribed by the government can apply for an entry to RS. Few cohorts are to be run whereby there will be a limited number of entities in each cohort testing their products during a stipulated period. The RS must be based on thematic cohorts focusing on financial inclusion, payments and lending, digital KYC etc. Generally , 10-12 companies form part of each cohort which are selected by RBI through a selection process detailed in “Fit and Proper Criteria for Selection of Participants in RS”. Once approval is granted by RBI, the applicant becomes entity responsible for operating in RS. Focus of RBI while selecting the applicants for RS will be on following products/services or technologies:

Innovative Products/Services

• Retail payments
• Money transfer services
• Marketplace lending
• Digital KYC
• Financial advisory services
• Wealth management services
• Digital identification services
• Smart contracts
• Financial inclusion products
• Cyber security products Innovative Technology
• Mobile technology applications (payments, digital identity, etc.)
• Data Analytics
• Application Program Interface (APIs) services
• Applications under block chain technologies
• Artificial Intelligence and Machine Learning applications

Who cannot apply?

Following product/services/technology shall not be considered for entry in RS:

• Credit registry
• Credit information
• Crypto currency/Crypto assets services
• Trading/investing/settling in crypto assets
• Initial Coin Offerings, etc.
• Chain marketing services
• Any product/services which have been banned by the regulators/Government of India

For how long does a company stay in the cocoon?

A cohort generally operates for a period of 6 months. However, the period can be extended on application of the entity. Also, RBI may, at its discretion discontinue testing of certain entities which fails to achieve its intended purpose. RS operates in following stages:

An alternative to RS

An alternative approach used in developing countries is known as the “test and learn” approach. It is a custom-made solution created by negotiations and dialogue between regulator and innovator for testing the innovation. M-PESA in Kenya emerged after the ‘test-and-learn’ approach was applied in 2005. The basic difference between RS and test-and-learn approach is that a RS is more transparent, standardized and published process. Also, various private, proprietary or industry led sandboxes are being operated in various countries on a commercial or non-commercial basis. They conduct testing and experimentation off the market and without involvement of any regulator. Asean Financial Innovation Network (AFIN) is an example of industry led sandbox.

Globalization in RS

A noteworthy RS in the Global context has been the UK’s Financial Conduct Authority (FCA) which has accepted 89 firms since its launch in 2016. It was one of the early propagators to lead the efforts for GFIN and a global regulatory sandbox. Global Financial Innovation Network (GFIN) is a network of 11 financial regulators mostly of developed countries and related organizations. The objective of GFIN is to establish a network of regulators, to frame joint policy and enable regulator collaboration as well as facilitate cross border testing for projects with an international market in view.

Final framework for RS

RBI introduced final framework[2] for the RS on August 13, 2019 which is almost on the same lines as the Proposal as mentioned above. However the RBI has relaxed the minimum capital requirement to Rs 25 lakhs in place of Rs. 50 lakhs as required under the draft framework with a view to expand the scope of eligible entities.

SEBI’s framework for RS

In May 2019, SEBI also came up with a discussion paper on RS for entities registered with SEBI under section 12 of SEBI Act. The framework was later on finalised in a board meeting of SEBI held in 2020. In line with the finalised framework, various SEBI regulations have also been amended to include a new chapter, allowing case-to-case based exemptions to entities operating in RS.

The SEBI framework is slightly different from the one prescribed by the RBI. SEBI has kept an open window for accepting applications under the RS framework, while the RBI will accept applications under theme-based cohorts. Further, RBI allows entities registered with it as well as other start-ups to apply for entry into RS. However, for the time being, SEBI has allowed only the entities registered under section 12 of SEBI Act to apply. Intermediaries that are registered under section 12 of SEBI Act are as follows:

• stock broker
• sub-broker
• share transfer agent
• banker to an issue
• trustee of trust deed
• registrar to an issue
• merchant banker
• underwriter
• portfolio manager
• investment adviser
• depository
• depository participant
• custodian of securities
• credit rating agencies
• any other intermediary associated with the securities market

In the due course of time, SEBI may allow applications by other entities not registered with it.

Conclusion

Regulatory sandboxes were introduced with a motive to enhance the outreach and quality of FinTech services in the market and promote evolution of FinTech sector. Despite certain limitations, which can be overcome by using transparent procedures, developing well-defined principles and prescribing clear entry and exit criteria, the proposal is a promising one. It strives to strike a balance between financial stability and consumer protection along with beneficial innovation. It Is also likely to develop a market which supports a regulated environment for learning by doing in the scenario of emerging technologies.

[1] https://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=46843

[2] https://www.rbi.org.in/scripts/PublicationReportDetails.aspx?ID=938