Last month, a bill was introduced in the North Carolina General Assembly that would make North Carolina the fourth state – after Arizona, Wyoming and Utah – to offer a regulatory sandbox for innovative financial services firms. Broadly defined, a regulatory sandbox is a ‘safe space’ in which businesses can test innovative products or services without immediately incurring all the normal regulatory consequences of engaging in the activity in question.[1]
North Carolina has long been a leader in financial services[2] – the state ranks third in total bank assets – and the industry is a main driver of economic growth, accounting for 18% of the state’s real GDP in 2017 (second only to manufacturing at 19%). Given this reliance on financial services, it is understandable why state legislators seek to provide a welcoming environment for fintech innovators. However, the current draft of the sandbox bill unnecessarily promotes innovation at the expense of consumer protection.
This post highlights my concerns with the current text of the sandbox bill and offers several recommendations for capturing the benefits of a regulatory sandbox while maintaining appropriate consumer safeguards.
Sandboxes Should be Pro-Consumer, not Pro-Industry
In 2015, 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 a dozen jurisdictions around the globe. The UK’s banking industry has historically been highly concentrated. Thus, the FCA’s sandbox was designed to promote: “effective competition in the interests of consumers.” According to the FCA, their sandbox achieves this result by:
- reducing the time and, potentially, the cost of getting innovative ideas to market
- enabling greater access to finance for innovators
- enabling more products to be tested and, thus, potentially introduced to the market, and
- allowing the FCA to work with innovators to ensure that appropriate consumer protection safeguards are built into their new products and services.
The consumer lies at the heart of the FCA’s sandbox, and firms applying to get into the sandbox must demonstrate that the product they seek to test offers an identifiable benefit to consumers. North Carolina’s sandbox bill barely mentions consumers; focusing instead on the need to promote state competitiveness and economic growth. The draft statute begins by noting that: “Financial and insurance services are major economic drivers in North Carolina, and financial and insurance technology is undergoing a transformational period.” The bill goes on state that a regulatory sandbox “will encourage further development of the Fintech and Insurtech industries.”
There is nothing inherently wrong with a state promoting specific industries in furtherance of economic growth – indeed, many voters encourage such actions. The problem with this approach, when it has historically been applied to financial services, is that it can lead to consumer abuses and potentially, more widespread economic harm – just think about the relaxation of mortgage lending regulations in the run-up to the financial crisis.
The current sandbox bill clearly places ‘innovation’ and the interests of the financial industry, ahead of the interests of consumers. This is seen most clearly in the proposed administration of the sandbox. North Carolina’s sandbox would be administered by a newly established “North Carolina Financial and Insurance Innovation Commission” (Innovation Commission) which would sit within the Office of the Commissioner of Banks, whose stated mission is to: “promote and maintain the strength and fairness of the North Carolina financial services marketplace through the supervision and regulation of financial service providers in that marketplace.” This mission appears to be at odds with the mission of the Innovation Commission, which is to: “develop a regulatory environment that encourages and supports innovation, investment, and job creation in the financial and insurance industries among new and existing companies in this State.”
The proposed membership of the Innovation Commission is particularly worrisome. In addition to the uncontroversial appointments of the Commissioner of Banks, the Commissioner of Insurance, and the Secretary of State (or their designee), the Innovation Commission would also include three “public members” who have a background in either financial services, insurance services, or technology. These public members would be appointed to six-year terms by the Governor, the President Pro Tempore of the Senate, and the Speaker of the House. This means that three out of seven seats on the Innovation Commission would be held by private citizens.[3]
Based upon my interpretation of the text, and given the political makeup of the North Carolina General Assembly (Republicans hold majorities in both houses while the Governor is a Democrat), it is safe to assume that these ‘public members’ will come from private industry – specifically, the financial services and insurance industries. As members of the Innovation Commission, these private citizens will determine which firms are admitted into the sandbox and the conditions imposed on the products or services to be tested within the sandbox. Given that it’s possible for currently regulated firms to apply for the sandbox[4], or have a financial stake in sandbox firms, the structure of the Innovation Commission effectively grants regulated financial services and insurance firms a say in how they are regulated.
Sandbox Benefits are not Clear
Compared to national supervisors, like the FCA, states are more limited in the kinds of benefits they can offer sandbox participants. The three state sandboxes currently in place generally provide the following benefits: a provisional license to operate in the state, or the ability to test a new product on a limited basis without a license; waivers from specific statutes or rules that would otherwise apply to the firm and product being tested; and personalized guidance from applicable state agencies.
The exact nature of these benefits will vary from state to state. Wyoming, for instance, allows the state banking commissioner or secretary of state to “specify the statutory or rule requirements, or portions thereof, for which a waiver is granted”, while Utah’s sandbox participants are “not subject to state laws that regulate financial products or services”, except under limited circumstances.
Based upon the current bill, the benefits for North Carolina’s sandbox participants are less clear. The bill requires firms to indicate in their application which laws will be superseded if they are permitted to test their product within the sandbox, but the bill does not say whether the Innovation Commission has the discretion to reject or modify this assertion, other than to say the Innovation Commission “may impose conditions on a Regulatory Sandbox registrant’s test.”
The bill is also silent on whether sandbox admittance comes with the necessary license, or an exemption from licensing. Arizona’s sandbox bill makes it clear that sandbox participants can test their “products or services on a limited basis without otherwise being licensed or authorized to act under the laws of this state.” Utah’s statute contains near-identical language.
Presumably, an applicant to North Carolina’s sandbox would indicate in their application that they are seeking an exemption to the licensing regime applicable to their product, and the Innovation Commission would grant such an exemption provided the application is approved. However, for the sake of clarity, the General Assembly should amend the bill’s text to make it clear that the product or service being tested is exempt from licensing.
The final benefit that accrues to sandbox firms, individualized guidance, is more informal and typically not codified in statute. Nonetheless, its importance should not be understated. Most firms operating within sandbox regimes are recent startups, with little to no experience in the complexities of regulatory compliance. While the laws and regulations governing various financial activities are typically in place for good reason, they still act as a barrier to entry for young fintech firms with limited funding and experience – this is one reason for creating a sandbox in the first place.
Not only are sandbox firms allowed to test their products on real consumers – within limits[5] – but they are also afforded an opportunity to interact with regulators in order to better understand how their product fits, or doesn’t, within the current regulatory infrastructure. This interaction also benefits regulators by allowing them to learn more about innovative technologies and the impact they have on consumers.
One unusual aspect of North Carolina’s proposed sandbox is that it appears to outsource this informal dialogue to nongovernmental organizations (NGOs):
“Certain nongovernmental partner organizations can help companies through the Regulatory Sandbox process, provide guidance as to how each product or service would fit within the given regulatory framework, and provide technical assistance to support design and implementation of tests of product and services.”
Endorsing the use of NGOs in this context is problematic for several reasons. First, it denies one of the essential sandbox benefits to both fintech firms and regulators. As mentioned previously, regulators and fintech firms benefit from the two-way information exchange that a sandbox facilitates. Second, only the government can truly tell a firm how their product or service fits “within the given regulatory framework.” While NGOs can provide their best advice, they cannot guarantee that regulators will view things the same way. Finally, the draft text amounts to the state government endorsing the use of NGOs by sandbox applicants for legal advice. Few, if any, NGOs possess the requisite knowledge and expertise to perform this function, and should the language in question be deleted, fintech firms can still consult with NGOs if they wish.
Recommendations
North Carolina’s sandbox bill has been referred to the Banking, Insurance, and Finance committees in the State House of Representatives. I recommend the committees make the following changes:
- Membership on the Innovation Commission should be restricted to the Commissioner of Banks, the Commissioner of Insurance, and the Secretary of State.[6] The current structure, if preserved, would provide the finance and insurance industries too much influence in the regulatory process.
- Sandbox applicants must demonstrate that their product or service provides an identifiable benefit to consumers (either directly or via heightened competition). This should be the primary requirement for admittance.
- A disclosure regime should be added that requires sandbox participants to disclose to consumers that: the product or service being tested is authorized pursuant to the regulatory sandbox, the sandbox participant does not have a license or other authorization to provide products or services outside the sandbox (if applicable), and the product or service may expose the customer to financial risk. A disclosure regime is included in the other state sandboxes.
- Sandbox extensions or renewals should be limited to a period of no more than one year. Sandboxes provide the participants with a competitive advantage[7] and this advantage should not be permanent. The current text suggests that sandbox participants will be allowed to renew their registration every two years indefinitely.
- Language should be added to make it clear that sandbox participants can test their product or service without a license while in the sandbox.
- The language around consulting with nongovernmental organizations should be deleted. In order to codify one of the main benefits of a sandbox, legislators may want to consider adding language that references information sharing between sandbox participants and the Innovation Commission.
Conclusion
As the Mercatus Center’s Brian Knight notes, critics of regulatory sandboxes “worry that any relaxation in regulatory standards will increase the odds that consumers are harmed.” While North Carolina follows the lead of Wyoming, Utah, and Arizona in requiring sandbox participants to compensate consumers for any harm done to them during the testing period, it is not enough.
North Carolina’s long history of leading in financial services has been accompanied by strong consumer safeguards.[8] By making the simple changes I recommend above, the General Assembly will help the state remain a leader in financial services AND consumer protection.
[1] This definition comes from the UK’s Financial Conduct Authority. See Regulatory Sandbox. Financial Conduct Authority, Nov. 2015, https://www.fca.org.uk/publication/research/regulatory-sandbox.pdf
[2] For a better understanding of the historical factors that made North Carolina a banking hub, see Broome, Lissa L., The First One Hundred Years of Banking in North Carolina. North Carolina Banking Institute (NCBI), Vol. 9, pp. 103-131, 2005.
[3] Technically, the appointee could be a state government employee, but this is unlikely to happen in practice. It is clear from reading the statute that the intention is to have these ‘public members’ come from the private sector.
[4] For example, a state-chartered bank could develop a brand new product and apply to the sandbox so that they can test this product on a limited number of consumers.
[5] In North Carolina, the test shall not be conducted on more than 25,000 consumers and shall not affect transactions or policies exceeding $50,000 per consumer.
[6] North Carolina would be unique amongst sandbox states in setting up a new commission to administer the sandbox. Arizona’s sandbox is administered by the Attorney General’s office while Utah’s is administered by the Department of Commerce. Wyoming’s sandbox is administered by the state banking commissioner or the secretary of state, depending on the product or service being tested. I support a revised commission structure as it would force multiple state agencies to work together and better understand how technology is influencing all aspects of finance and insurance.
[7] Some might say an unfair competitive advantage.
[8] For instance, in 1999 North Carolina became the first state to pass an anti-predatory lending law.
