Financial Technology and Economic Equity: The Promises and Perils of Regulatory Sandboxes

By Scott Astrada, Non-Resident Fellow, Digital Civil Society Lab

Technology has a shadow. An unstated consideration proceeding every increasingly rapid technological innovation, especially when it comes to financial services and consumer lending—how can we harness the potential of new technology such as big data, machine learning and artificial intelligence to remedy current economic inequities? This is particularly complex given that many of these inequities are in large part caused by a legacy of racial discrimination and exclusion from the housing and financial services marketplace. As a result, two related, yet distinct, dialogues emerge when it comes to technological innovation–one on remediation and another on access. These dialogues are not preclusive, but must be reckoned with by two distinct considerations. This article takes up the latter, access, while leaving the former to be addressed in a subsequent writing.

In response, to the initial query –“how can we harness innovation for social progress?”—we find an increasingly popular answer from many stakeholders in the Regulatory Sandbox. Sandboxes can take many forms, and can be created at either the state or federal level, but, in general, a sandbox is an agreement between a regulator and an individual company that allows for certain qualified exclusions from oversight requirements. These exclusions take many forms, such as No Action letters, disclosure waivers, or reduction of legal liability from certain oversight (a short video can be found here to provide broader context). These agreements are individualized, but generally are entered into on the premise that they are needed to spark the innovation that drives financial inclusion and credit access across the broader marketplace.

Are Sandboxes Needed?

As a starting point, the initial question is “are sandboxes necessary?” Many proponents hold that without a monitored space for innovation, free from the fear of legal liability or regulatory penalty, we are missing a unique and crucial opportunity to harness technology and big data to drive financial inclusion and solve long standing economic and credit inequalities. As this brief (~12 min) docushort summarizes, there are a variety of perspectives on the promises and perils of sandboxes, as discussed in further detail below. Ultimately, one of the key objective determinants of the utility of sandboxes is how can effectively they capture and leverage innovation in an equitable and responsible manner, and identify regulatory gaps and points of uncertainty. Within this broader context, the search for the balance between appropriate levels of regulation and effective flexibility to support innovation, is often framed as the tension between a rules-based and principles approach to regulation. This tensions pits systems based on highly specific rules designed to address all possible considerations relating to products or services, against systems based on principles that provide guidance to be applied in a variety of circumstances (for further info, see Regulating a Revolution). The sandbox, at its most disruptive, surpasses this binary in a way that provokes new ways to consider responsive regulation.

Broad Consumer Protection Concerns

At the center of consumer protection concerns is the thematic prioritization of preserving the regulatory and legislative progress thus far accomplished in regards to racial and gender economic equity. There is an insistence on ensuring fintech lending evolves in cadence with existing and developing consumer protection laws, and furthermore, innovation must be assessed by how effectively it drives credit access for vulnerable consumers and communities of color (see NCLC). From this standpoint, sandboxes warrant the highest scrutiny because they are subject to being hijacked by ulterior aims such as anti-competitive behavior and carve outs from common-sense consumer protection oversight. In addition, many consumer advocates have expressed grave concerns that these sandboxes evade the Administrative Procedure Act, are based on questionable legal authority, and compromise the integrity of long-standing civil rights protections and fair lending laws (see, NCLC). This cuts against the contention held by many proponents that without a space for innovation free from the fear of legal liability or regulatory gridlock, we are missing a historical opportunity to harness technology and big data to solve long standing economic inequity trends, precisely because financial services regulation needs to be ‘updated’ to address technological innovations that simply weren’t present ten years ago, let alone decades ago (see, Fintech needs more regulatory ‘sandboxes’)

Marketplace Questions

Many businesses are wary of the how sandboxes would be implemented, and many policy experts have expressed concerns about how sandboxes would impact the broader competitive landscape (see The Sandbox Paradox).

Competitive advantage. Does access to the sandbox provide a competitive advantage for participants? The potential for companies to gain a competitive advantage to develop their platforms and technology over firms that do not gain admittance, implicates questions of fairness in the broader marketplace.
Gateway function of regulators. Are regulators put into the position of determining who will be successful and who will not (by virtue of not being in the sandbox)?
Federalism. Do multiple layers of liability in state and federal regulators preclude actual spaces for innovation when companies can face liability immediately after exiting the sandbox from various regulators not involved in the company’s specific sandbox?
Ownership or availability of data. Who owns, and who can access, the data generated?

Sandbox Iterations

It is admittedly quite difficult to speak of sandboxes in the abstract, because they have a very diverse spectrum of specifics when it comes to implementation. Below is a non-comprehensive list of different sandbox initiatives.

OCC Innovation Pilot Program: The program is designed to provide eligible entities with regulatory input early in the development of proposed innovative activities. The program focuses on new or unique activities where uncertainty is perceived to be a barrier to development and implementation.
CFPB No Action Letters. No Action Letters provide increased regulatory certainty through a statement that the Bureau will not bring a supervisory or enforcement action against a company for providing a product or service under certain facts and circumstances.
SEC No Action Letter: An individual or entity who is not certain whether a particular product, service, or action would constitute a violation of the federal securities law may request a “no-action” letter from the SEC staff. If the staff grants the request for no action, concludes that the SEC staff would not recommend that the Commission take enforcement action against the requester based on the facts and representations described in the entity’s request.
UK Sandbox: The regulatory sandbox allows businesses to test innovative propositions in the market, with real consumers.
New England Regulatory FinTech Sandbox a multistate initiative meant to coordinate regulatory strategy across multiple jurisdictions.

Expert Perspectives

Richard Rodriguez, Consumer Protection Trial Attorney. The question is not whether or not Sandboxes are good. The question should be: how can Sandboxes make innovators and regulators true partners in developing products and services that bring innovation without inadvertently harming consumers? Not all innovations are necessarily good; The primary goal of these Sandbox live-tests should be correcting unknown externalities and consumer harm; and Consumers should not be harmed while you work out the kinks on a particular product– if there’s a safe harbor for innovators, then maybe there should be a safe harbor for consumers.
Dan Quan, Adjunct Scholar, Center for Monetary and Financial Alternatives, Cato Institute. A regulatory sandbox is an interesting regulatory innovation of its own. If used smartly, it can benefit consumers and the economy. Unfortunately, too often sandboxes are misunderstood, misused, or mismanaged. Regulatory agencies should use sandboxes to keep up to date with fast-paced innovation and promote market competition without sacrificing consumer protection. Real innovation-minded regulatory agencies see sandboxes as means, not ends. Real innovation-minded regulatory agencies shun the glitz of sandboxes; rather they take the insights gained from sandboxes to improve rulemaking, supervision, and enforcement policies so that the entire market can benefit.
Naeha Prakash, Senior Vice President, Associate General Counsel, Bank Policy Institute. Given that financial services firms—banks or non-banks—in the U.S. operate in a multi-agency system, with both federal banking agencies and state regulators, any approach to regulatory sandboxes inherently requires regulatory consistency and coordination in order to further foster innovation. Of course, one of the benefits of a regulatory sandbox is that it has the potential to provide clear rules of the road for market participants, particularly where new technologies or new products and services pose challenging questions with respect to regulatory requirements and ensuring consumer protection.

The Future

Questions abound: Is there a sandbox that can be safe for consumers? Can this be done right, from an equity perspective? Why are sandboxes preferable to what is possible without them, especially considering The Administrative Procedure Act, and even the Equal Credit Opportunity Act as it pertains to disparate impact liability. What is clear is that without regulatory federal and state coordination there are significant challenges to scale sandbox participation—worthy of note is the recent initiative from September 2019 tackles this obstacle; the American Consumer Financial Innovation Network (ACFIN), The Bureau invited all state regulators to join ACFIN, and the initial members of ACFIN are the Attorneys General of: Alabama, Arizona, Georgia, Indiana, South Carolina, Tennessee, and Utah. The various stakeholder priorities converging around the operation of a sandbox, present more questions than answers at this point, yet many states, and federal regulators, are pushing forward with sandbox, or sandbox type, policy initiatives. What is almost universally unequivocal, is that no one is satisfied with the present reality when it comes to financial inclusion, we need more tools and better solutions, especially for LMI borrowers and communities of color. The question remains: are sandboxes part of the solution?