Building Fintech Ecosystems: Why Regulatory Sandboxes Tend to Get the Plaudits and Innovation Hubs Do the Work of Promoting Development, Innovation and Competition in Financial Services

By | October 8, 2019

Courtesy of Ross Buckley, Douglas Arner, Robin Veidt, and Dirk Zetzsche

Regulatory sandboxes are the flavor of the month. Over 50 countries have now established or announced a “financial regulatory sandbox” since the UK Financial Conduct Authority established the first one in 2016.

Sandboxes are safe spaces in which FinTech start-ups and other innovative enterprises can develop and test their innovations without being subject to the full extent of financial regulation.

Innovation hubs, in contrast, are portals, a means by which industry can readily access regulators: to discuss their proposed FinTech innovation, gain some guidance on navigating regulatory requirements, and potentially seek dispensations or adjustments in the specific regulations to which they will be subject.

Regulators often seem to love sandboxes and be less keen on innovation hubs. They typically seek to use a sandbox to bring greater competition into their financial services sector through more diverse and affordable product offerings for consumers.

The real question though, is how best to support the development of innovation and FinTech ecosystems in markets around the world?

In a new paper, we argue that while sandboxes garner most of the attention, innovation hubs tend to be more effective at promoting innovation and competition in a financial system.

The FCA’s regulatory sandbox has, with fewer than 120 sandboxed firms since inception, reached but a tiny portion of the total number of UK financial services firms—significantly fewer than have been assisted through its innovation hub. In other places, such as Australia, a sandbox has proven relatively unattractive for innovative firms while the hub has assisted hundreds of firms. Important financial systems, including most regulatory agencies in the United States, Germany and Luxembourg, have refrained from introducing regulatory sandboxes.

A sandbox is one of many approaches to promote and support a FinTech ecosystem. Such approaches can include a range of efforts, focusing on research and development; human capital development; marketing; establishment of regulatory contact points; various forms of investment promotion, including the establishment of investment funds and matching schemes; creation of incubators and accelerators; and legal and regulatory reform. Together, these elements make up the central components of a supportive FinTech ecosystem.

We suggest that while sandboxes tend to attract the headlines and attention, innovation hubs are generally more effective at the real work of promoting and facilitating innovation in financial services.

Of course, regulatory resources are always tightly constrained, especially so in most emerging and developing countries seeking to bolster innovation. We argue that it is the promise of facilitating real innovation in financial services without imposing real demands on these resources which accounts for the remarkable popularity with regulators, globally, of sandboxes. This is entirely understandable. However, regulators who wish to genuinely promote innovation need to make available the staff to interact with industry, and where necessary, issue bespoke waivers or other forms of dispensation of some regulatory requirements, and assist with advice and guidance to FinTech start-ups seeking to navigate the regulatory maze.

The problem, however, is that most jurisdictions lack the innovation ecosystems that  produce FinTechs and other innovative firms which could take advantage of the opportunities presented by a sandbox. Thus, in the vast majority of countries around the world, the objective is to support the development of such firms, and innovation hubs are much more effective at promoting the emergence of firms than sandboxes.

Even in the relatively small number of markets which produce more than a tiny number of FinTechs and other innovative startups, the reason the numbers of entities in sandboxes are typically limited is because if the access regime is sufficiently broad to enable the participation of a wide array of participants, the likely result will be lax consumer protection. For this reason, sandbox entry conditions tend to be tight. Genuinely innovative regulation can only, it seems in most cases, occur on a case-by-case basis (as most sophisticated financial regulators around the world have done for decades with no-action letters, tailored dispensations and other such measures).

This is not to say regulatory sandboxes serve no purpose. For the relatively small number of entities that qualify, sandboxes do assist. And more importantly, because it is sandboxes that have been attracting the attention, having a sandbox sends a clear message to industry that a regulator is flexible and open to innovation in a way that having an innovation hub does not—in part because hubs are called different things in different places. Hubs simply lack the catchy descriptor that sandboxes carry. In our view, the most important function of any sandbox for a regulator is the strong message having it sends to the market.

At the same time, an increasing number of jurisdictions are taking a more holistic approach and combining innovation hubs to support startups and innovation with sandboxes which can be used for regulatory testing and learning so as to establish more broad based legal and regulatory approaches to emerging technologies and businesses. South Africa provides a good example of such an approach.

The FCA sandbox grew out of its innovation hub, termed Project Innovate. Likewise in Australia, the Australian Securities and Investments Commission’s sandbox grew out of its innovation hub, which well preceded the sandbox. However, many other countries, attracted by the lower regulatory resources needed to operate a sandbox, have implemented a sandbox without a broader hub. We argue that what is needed instead is a more holistic approach, focusing on the realities of the ecosystem in a given jurisdiction, which will mean that in most cases the best approach will be to focus on the development of an innovation hub to support the emergence of FinTech and innovation firms while providing the regulator an opportunity to learn in order to develop appropriate approaches. In cases where FinTech and innovation firms are emerging and presenting challenges to the existing regulatory regime’s approaches, a sandbox may be a useful additional element of the FinTech and innovation ecosystem.


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