By Richard Rodriguez, Consumer Protection Trial Attorney
In September 2019, the recently formed American Consumer Financial Innovation Network (ACFIN), a joint creation with the CFPB and several State Regulators, urged other state regulators to join the newly created network. ACFIN, among other things, is intended to coordinate Regulatory sandboxes (Sandboxes) and reduce “overlapping State and Federal laws” which sparked new conversations on Sandboxes in the FinTech space.[i]
Like every new development in the markets, Sandboxes have already been analyzed for their pros and cons by experts. Industry-experts have been largely in favor of Sandboxes with consumer-advocate experts largely skeptical if not outright opposed to them. But Sandboxes are ostensibly just a framework that allow companies to “live-test” FinTech innovations in controlled environments. These controlled environments may take different forms of special exemptions—such as limited consumer bases, limited geographical area, or limited time. It really boils down to providing FinTech companies a safe harbor or exemption from certain laws or regulations to operate and test new products without fear of agency enforcement or litigation.
The term itself, coined in 2015 by the U.K. Financial Conduct Authority, was first implemented by the CFPB’s Project Catalyst.[ii] Project Catalyst sought to partner regulators with innovators to (1) exchange information on new fintech products and services; (2) establish policies and programs to further consumer-friendly innovation; (3) develop policies to enable innovators to conduct controlled disclosure testing in furtherance of a more informed consumer; and (4) use no-action letters to reduce regulatory uncertainty.
Currently, Sandboxes generally rest on the key principle that financial innovation is always a positive. Financial innovations such as Crowdfunding, peer-to-peer payment apps such as Venmo, or Credit Karma have been absolute boons for consumers. Some of the most high-impact financial innovations in recent years—from retail level products like NINJA mortgages[iii] and payment protection insurance to the more exotic innovations like Credit Default Swaps, synthetic Collateralized Debt Obligations, and CDOs-squared—have harmed consumers in ways that were not previously imagined. Indeed, the latter exotic innovations were deemed “financial weapons of mass destruction” after the 2008 financial crisis. But, more importantly, these financial innovations were rolled out in what amounted to earlier, crude versions of sandboxes.[iv]
The concept of a Sandbox is not really new. Congress has already experimented with creating crude versions of Sandboxes. In 1998, the Commodity Futures and Trading Commission (CFTC) issued a ‘concept release’ requesting comments on whether regulations for the OTC derivatives markets were appropriate.[v] In response, SEC Chairman Arthur Levitt, Federal Reserve Chairman Alan Greenspan, and Treasury Secretary Robert Rubin testified to Congress that even discussing the regulation of credit default swaps and other OTC derivative instruments would (1) increase legal uncertainty, (2) reduce the value of these instruments, and (3) stifle innovation—all things regulatory sandboxes attempt to address.[vi] Shortly thereafter, Congress passed a bill that placed a moratorium on the CFTC’s rulemaking authority with respect to swaps and hybrid instruments—effectively deregulating swaps and derivatives to create, what could be argued, one of the nation’s first crude but largescale FinTech Sandboxes.[vii] Ten years later, that largescale derivatives sandbox would play an integral role in causing the 2008 global financial crisis—after which Greenspan and Levitt would both publicly confess that they erred in their judgment and the regulation of derivatives was, in fact, needed.[viii]
There is certainly a need for financial innovation, but even good innovations have to be adjusted and changed depending on market performance. Crowdsourcing has proven to be one of the most powerful FinTech products developed in recent years, but with little regulation have also been sources for fraud.[ix] Other FinTech loan products with weaker compliance programs have also been used for fraud by bad actors. And often, the problem was not that the FinTech companies were acting with bad intentions; instead, it was that products or services were offered with good intentions but without benefiting from input from the wisdom that regulators and consumer protection advocates have.
Indeed, Sandboxes’ can create an information-sharing mechanism between innovators and regulators that could serve to ferret out these issues early on. But Sandboxes would do better if they did not rest on the primary principle that innovation is always good. Sandboxes would work best with (a) an active and engaged regulator, (b) true dedicated information sharing between the innovators and the regulator, (c) and commitment by the innovators and regulators to catch possible consumer and regulatory issues, while illuminating whether the particular innovation will be viable or useful in the consumer market.
I’ll leave you with one final thought on a Fintech innovation that both draws my optimistic interest while simultaneously setting off my consumer protection spidey sense. Algorithms and sophisticated software are being touted as the new way to analyze the credit risk of individuals based on their language use and writing, including whether capitalization and punctuation is used.[x] Without question, using algorithms to study language for credit risk is innovative and a more holistic way of doing credit analysis. For example, recent college graduates who may not have extensive credit histories but show a strong command of language and a penchant for eventually becoming a lawyer (hint! This is me!) would do well in this holistic FinTech innovation. But, what about my mom? My mother is Costa Rican and immigrated to this country at 21 and never mastered the English language as well as her children. Similarly, my dad, left school before finishing high school. Would this innovative system deem my parents less credit worthy than me—even though my parents were able to manage credit, manage to always find savings (that I still marvel at!), and purchased a home on salaries that jointly were a fraction of my current salary—just because they don’t understand English as well as I do? This innovative new software has the risk of discriminating against immigrants and violating anti-discrimination laws when it comes to lending—simply because English was not their first language.
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? There may not be a simple answer to that, but my consumer protection spidey sense suggests that at the very least there are three pillars upon which Sandboxes should rest: (1) not all innovations are necessarily good; (2) the primary goal of these Sandbox live-tests should be correcting unknown externalities and consumer harm; and (3) 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.
Views expressed here mine and mine alone and do not reflect the views of my employer
[i] CFPB and State Regulators Launch American Consumer Financial Innovation Network, CFPB (September 10, 2019), available at https://www.consumerfinance.gov/about-us/newsroom/bureau-state-regulators-launch-american-consumer-financial-innovation-network/
[ii] Regulatory Sandboxes and Financial Inclusion, Working Paper – CGAP, October 2017, available at https://www.cgap.org/sites/default/files/Working-Paper-Regulatory-Sandboxes-Oct-2017.pdf; Project Catalyst report: Promoting consumer friendly innovation, CFPB, October 2016, available at https://www.carltonfields.com/files/Uploads/Documents/Articles/CFPB-Project-Catalyst-Report.pdf; see also CFPB Launches Project Catalyst to Spur Consumer-Friendly Innovation, CFPB press release, November 14, 2012, available at https://www.consumerfinance.gov/about-us/newsroom/consumer-financial-protection-bureau-launches-project-catalyst-to-spur-consumer-friendly-innovation/
[iii] NINJA mortgages typically stand for “no income, no job, no assets” mortgages that require little documentation.
[iv] Dirk A. Zetzsche et al., Regulating a Revolution: From Regulatory Sandboxes to Smart Regulation, 23 FORDHAM J. CORP. & FIN. L. 31, 37 fn. 11 (2017), available at https://ir.lawnet.fordham.edu/cgi/viewcontent.cgi?article=1450&context=jcfl
[v] Over-the-Counter Derivatives, 63 Fed. Reg. 26,114 (May 12, 1998).
[vi] Financial reform warrior Brooksley Born warns of more crises to come, Roosevelt Institute, (2009), available at https://rooseveltinstitute.org/financial-reform-warrior-brooksley-born-warns-more-crises-come/
[vii] The text of that act read: “…the Commission may not propose or issue any rule or regulation, or issue any interpretation or policy statement, that restricts or regulates activity in a qualifying hybrid instrument or swap agreement”. Agriculture, Rural Development, Food and Drug Administration, and Related Agencies Appropriations Act, 1999, § 760, as enacted in Omnibus Consolidated and Emergency Supplemental Appropriations Act, 1999, Pub. L. No. 105-277, 112 Stat. 2681, 2681–35 (1998), available at https://www.govinfo.gov/content/pkg/PLAW-105publ277/html/PLAW-105publ277.htm.
[viii] Supra note 5; see also PBS “Frontline” Documentary (October 2009), available at https://www.pbs.org/wgbh/pages/frontline/warning/interviews/levitt.html.
[ix] Rodriguez & Morris, New Technology, But Just the Same Old Traditional Fraud, National Attorneys General Training & research Institute, (April 2019), available at http://naagms.informz.net/naagms/data/images/Article%20of%20the%20Month%20April%202019.pdf
[x] Steve Lohr, Banking Start-Ups Adopt New Tools for Lending, The New York Times (January 18, 2015), available at https://www.nytimes.com/2015/01/19/technology/banking-start-ups-adopt-new-tools-for-lending.html?_r=0