Photo: iStock
Photo: iStock

Opinion | Regulatory sandbox: A roadmap and use-cases

Financial ecosystems need a mechanism to strike the right balance between innovation and regulation

The collapse of Lehman Brothers in 2008 heralded a new era in the regulation of the financial industry not only in the US but also in India. Today, the industry is known for its innovations that are changing the way financial institutions lend and insure. Yet another area that is growing fast within the financial industry is fintech. From established banks and non-banking financial companies (NBFCs) to lean start-ups, almost all players are betting on innovations in technology that increase the efficiency of financial products. The pace of innovation in the financial sector, however, has been slow, in part, as an unintended consequence of the maze of regulations governing the sector. While many of these regulations were expected in the aftermath of 2008, the second order effects of these regulations have inhibited the speed of financial, and more so fintech, innovation. Ultimately, this affects the rate at which India brings its hitherto excluded masses into the formal financial system.

Financial ecosystems need a mechanism to strike the right balance between innovation and regulation. Regulatory sandboxes have emerged as the mechanism that can intermediate the tensions caused by the gaps between innovation and regulatory cycles. The Financial Conduct Authority (FCA) in the UK has been among the first movers in constituting a sandbox and defines it as a “safe space" for businesses to test innovative products, services and business models under relaxed regulatory requirements. Businesses are given a “no-action letter" from the regulator concerned, ensuring regulatory relaxations for the period of testing. These products are then released to a limited number of customers, giving regulators and innovators a chance to assess its performance in a controlled environment. Such an environment ensures that businesses operate without fear of enforcement from the regulators. Conversely, regulators can learn how new products work in a relatively risk-free environment and design regulations as needed.

Globally, regulators have been quick to follow the FCA’s template, with Australia, Hong Kong, Malaysia and Singapore setting up their own sandboxes. A CGAP (a global partnership for financial inclusion) white paper on the issue informs us that more than 20 countries from Abu Dhabi to Sierra Leone have adopted the concept.

India’s central bank, too, has realised the potential of a sandbox. In the November 2017 report of the working group on fintech and digital banking it recommended that the sandbox be hosted at the Institute for Development and Research in Banking Technology. The objectives and mandate of each sandbox vary widely. For instance, Australia follows a licence-exemption model, whereas Hong Kong is open only to established incumbents. India, for its part, must seek to sandbox fintech start-ups for they are the risk takers who invest capital and intellectual labour in a business idea to solve financial inclusion problems. These start-ups face low chances of success and the presence of incumbents and hard-coded legal rules and procedures don’t make their task easier. Thus, creating institutional frameworks that enable them to test their socially beneficial business cases is imperative.

Through its three-year journey, Catalyst has worked with businesses pursuing mass digitization use-cases. From digital payments to digital credit, these solutions look to digitize the entire gamut of financial services for hitherto undigitized and excluded customers. The road to digitization has been arduous, with consumer attitudes towards cash, internet access and smartphone penetration acting as obstacles. Regulatory forbearance has also played its part in impeding the scaleup of these solutions.

Consider the use-case of customized wealth solutions for informal sector consumers. Typically, consumers who have been excluded from the benefits offered by the formal financial system are under/uninsured, and face volatile cash flows. Yet, customized portfolio management services for these consumers are foreclosed by the Securities and Exchange Board of India portfolio managers regulations, which require investors to have a minimum investible corpus of 25 lakh.

The challenge that the Indian payments ecosystem faces is the requirement for every transaction, regardless of ticket size, is to undergo a two-factor authentication. A 2FA (multi-factor authentication ) mandate increases the risk of consumer drop-off in either receiving or entering the second factor (usually a one-time password sent via SMS) and generally increases checkout friction. There is a case for relaxing the 2FA mandate till a specified threshold ticket size to facilitate ease of use for digital payments. In this regard, the Ratan Watal Committee Report had also noted that the authentication framework should be designed subject to the value of transaction.

Then there is the new model of lending on a non-recourse basis; a peer-to-peer (P2P) platform that matches a borrower to a group of lenders discovering the coupon on the loan by bidding on the platform. At present, this use-case has been restricted by the Reserve Bank of India (RBI), capping both the lender-side and borrower-side exposure. Such P2P lending models offer great promise in terms of plugging the credit demand-supply gap for formal channels of credit, which currently stands at 17.64 trillion.

There is a case for relaxing these caps and experimenting with the efficacy of these platforms with micro and small business credit. Additionally, scenarios where institutional capital invests in these businesses and not merely natural persons may also be tested. These platforms can facilitate the deepening of secondary markets for loans on balance sheets of conventional originators, effectively diversifying secondary market participants from not only banks and ARCs but also to these new-age lending platforms.

A sandbox holds great promise for testing out all the aforementioned use-cases and for giving a fillip to innovation and reaping the benefits of successfully integrating India’s masses into the formal financial system. It is, however, important to note that these benefits shall accrue only when private and public stakeholders work seamlessly to ensure that the most socially beneficial use-cases are experimentalized, and later scaled up.

Mandar Kagade and Raghav Katyal are, respectively, a payments/fintech policy consultant, and a student at Ashoka University.

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