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25 July, 2019
The technological innovation has led to revolutionary changes in business operations across industry verticals. The financial sector has also been a part of this technological revolution. In fact, technological innovation is considered to be one of the most influential developments affecting the global financial sector in the near future. The changes in financial services industry due to technological innovation has led to evolution of fintechs.
Fintechs, being considered as a fusion of finance and technology, have seen a rapid growth in the recent years across the globe. According to the Financial Stability Board of the Bank for International Settlements, fintech is considered as a technologically enabled financial innovation that could result in new business models having a material effect on financial markets and institutions and the provision of financial services2.
In view of the growing significance of fintech innovations in India, the Reserve Bank of India (“RBI”) has recently taken several initiatives for re-orienting the regulatory framework to respond to the dynamics of rapidly evolving fintech industry. As innovation can create new risks for financial institutions, consumers of financial services as well as the financial system as a whole, it is important that the technology and innovation is used in the financial service sector with checks and balances.
The RBI had set up an inter-regulatory working group to examine the granular aspects of fintech. The report of the working group was issued in February 2018 (“WG Report”) with one of the key recommendations to introduce an appropriate framework for 'regulatory sandbox' which would be an experiment space for the pilot testing of newly developed technologies. Regulatory sandbox is a commonly used term in the fintech industry now. Several countries such as United Kingdom, Australia, United States of America, Netherlands and Singapore have already introduced framework for regulatory sandbox. Further, in order to promote innovation in the securities market, the Securities and Exchange Board of India (“SEBI”) has also proposed an 'innovation sandbox' to provide a testing environment to fintechs for offline testing of their proposed solutions in isolation from the live market subject to fulfillment of eligibility criteria3.
Pursuant to the WG Report, the RBI has issued the draft framework for 'regulatory sandbox' on April 18, 2019 (“Framework”)4. This article focusses on the concept of regulatory sandbox, its pros and cons and its prospects in India if the proposed Framework is adopted as it is.
What is a regulatory sandbox?
As provided in the Framework, a 'regulatory sandbox' refers to live or virtual testing of new products or services in a controlled / test regulatory environment for which regulators may permit certain regulatory relaxations for the limited purpose of testing. The regulatory sandbox is a formal regulatory programme for market participants to test new products, services or business models with customers in a live environment.
The proposed financial service to be launched under the regulatory sandbox should include new or emerging technology, or use of existing technology in an innovative way and should address a problem or bring benefit to the consumers. The RBI may provide the appropriate regulatory support by relaxing specific legal and regulatory requirements on a case-to-case basis (with the exception to customer privacy and data protection, secure storage and access to payment data of stakeholders, security of transactions and statutory restrictions) for the duration of the sandbox which the sandbox entity will otherwise be required to comply.
Functioning of regulatory sandbox
The entire process for a regulatory sandbox including launch, theme of the sandbox, entry and exit conditions would be communicated by the RBI through its website.
The regulatory sandbox would conduct end-to-end processes with a limited number of participants having common interest in each sandbox for testing their products in a time bound manner. The entire process would be overseen by the fintech unit of the RBI. Further, the boundary conditions such as limit on number of customers, transaction ceilings and cap on customer losses would be clearly specified for a sandbox.
The sandbox participants would have to ensure that the test customers are informed, and their consent is obtained, regarding the potential risks and available compensation during the testing process. Further, before exiting or discontinuing the sandbox, the participants should ensure that the existing obligations to the customers under experimentation are fulfilled or addressed.
Eligible participants and criteria for using regulatory sandbox
The products / services / technology which could be considered for testing under regulatory sandbox include block chain technology, mobile technology applications, retail payments, money transfer services, smart contracts and artificial intelligence. However, products / services / technology such as crypto currency, credit registry, initial coin offerings and credit information would not be accepted for testing under regulatory sandbox.
The Framework provides for the following key conditions to be satisfied in order to participate in a regulatory sandbox:
(a) The entity should be a company incorporated and registered in India and should meet the eligibility conditions prescribed for 'start-ups' by the Government of India5. It may be noted that an entity formed by splitting up or reconstruction of an existing business would not be considered as a start-up. An entity would be considered as a start- up:
(i) up to a period of seven (7) years from the date of its incorporation / registration;
(ii) if turnover of the entity for any of the financial years since incorporation / registration has not exceeded INR 250 million, and
iii) if it is working towards innovation, development or improvement of products or processes or services, or if it is a scalable business model with a high potential of employment generation or wealth creation
(b) The entity should have a minimum net worth of INR 5 million as per its latest audited balance sheet;
(c) The entity should demonstrate that their products / services are technologically ready for deployment in the broader market;
(d) The entity should have necessary arrangements to ensure compliance with the existing laws on consumer data protection and privacy and should have a robust IT infrastructure;
(e) The proposed fintech solution should highlight an existing gap in the financial ecosystem and the proposal should specify how it would address the problem or bring benefit to the consumer; and
(f) The entity should show that there is a relevant regulatory barrier that prevents deployment of the product / service at scale or a genuinely innovative product or service is proposed for which relevant regulation is necessary and is not there in the existing regime.
Pros and cons of regulatory sandbox
As mentioned in the Framework, one of the key benefits of regulatory sandbox for fintechs is that they will get an opportunity to test the product's viability before rolling out their product / services in the market to public at large.
Further, the advantage for regulator is that it will obtain evidence on the benefits and risks of emerging technologies enabling it to take a considered view on the requirement of regulatory changes or making new regulations required to support new innovation.
On the flipside, fintechs may still require RBI approval for launching the product / service in the market post sandbox testing. One of the key downsides for the regulator is that it may face legal issues such as claims from competitors who are outside the regulatory sandbox especially whose applications have been / may be rejected.
Our views
The proposed Framework is a step in the right direction to evolve technology innovation in the financial services sector, however, in our view, there may be following challenges if the proposed Framework is adopted as it is:
a) Entry restrictions: The Framework only permits companies meeting the criteria of start-ups (discussed above) to participate in the regulatory sandbox. The Framework restricts types of entities which can participate in the process. In fact, the Framework has not contemplated all types of entities which are considered as start-ups (which include limited liability partnership and partnership firm if they meet the prescribed criteria) and incorporating limited liability partnership or partnership firm is a preferred legal structure by start-ups.
B) RBI's intervention and dispute resolution:
The Framework provides that the RBI shall bear no liability arising from the regulatory sandbox process and any liability arising from the experiment will be borne by the applicant. Further, the Framework does not provide for any dispute resolution framework between the consumers and the participating entities. In the absence of dispute resolution framework and intervention of RBI and considering that the testing would be in relation to financial services, it has to be seen that whether consumers would like to participate in such processes. RBI's intervention in resolving disputes between the entities and the consumer may give confidence to consumers in participating in such processes. For instance, the regulatory framework of Australia governing regulatory sandbox provides for external dispute resolution mechanism which requires engagement of the regulator.
(c) Requirement of group of entities: The Framework provides that a regulatory sandbox would require a group of entities having similar interest for conducting tests. In the event there is only one entity with a kind of product / service to be tested, will it be permitted to use the regulatory sandbox? Clarity in this regard should be provided by the RBI.
(d) Fit and proper test: The directors / promoters of the participating entity would need to clear 'fit and proper' test of the RBI which would require documents such as CIBIL score, bank account details including loan accounts and declaration relating to, amongst others, pending proceedings. As the fit and proper test lays down lot of requirements to be complied with, it may act as a barrier for the entities considering participation in the sandbox.
In order to have an effective utilization of the regulatory sandbox, the above aspects should be taken into account by the RBI while finalizing the Framework.
For further information, please contact:
Gaurav Wahie , Partner, Clasis Law
gaurav.wahie@clasislaw.com
1 https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/WGFR68
AA1890D7334D8F8F72CC2399A27F4A.PDF. 2Ibid.
3 https://www.sebi.gov.in/legal/circulars/may-2019/framework-for-innovation-sandbox_43027.html
4 The Framework can be accessed at https://rbi.org.in/scripts/PublicationReportDetails.aspx?UrlPage=&ID=920.
5 The eligibility conditions prescribed for start-ups can be accessed at: https://dipp.gov.in/sites/default/files/Startup_Notification11April2018_0.pdf.
