A Sandbox for the U.S. Financial System

Toddlers play in sandboxes and, increasingly, so do big banks. Around the world, regulators allow banks to experiment with new technology by deploying what are known as “regulatory sandboxes.”

A regulatory sandbox is a controlled “safe space” where companies can test and develop innovative products and business models free from many major regulatory barriers, but under regulators’ watchful eyes. Firms explore in this space for a limited period of time pursuant to strict guidance from the relevant agency.

For U.S. regulators, however, the task of creating a regulatory sandbox for the financial system is more complex than mere child’s play.

Regulators can create sandboxes in any regulated market, but financial institutions are particularly suitable candidates for this trendy model because technology has become a necessary survival tool. Banks, insurance companies, financial advisors, and other providers of financial services now rely on advanced technology—such as artificial intelligence—to compete with fintech firms that are increasingly transitioning traditional markets toward new digital financial services.

Because of this reliance on new technology, observers wonder why the United States has not yet established a regulatory sandbox for financial firms. After all, industry experts have long called for greater innovation by financial regulatory agencies across the United States—both at the federal and state levels.

Other countries have applied the sandbox concept to their financial industries. For example, in 2015, the United Kingdom’s Financial Conduct Authority (FCA) created the first fintech regulatory sandbox to “promote competition by supporting disruptive innovation” in its financial markets. In its first cohort, the FCA’s regulatory sandbox accepted 24 applicants that ranged from innovation firms to well-established financial institutions such as HSBC and Lloyds Banking Group. Over the years, the FCA has established seven cohorts in total.

Britain’s fintech regulatory sandbox has been an inspiring success for other countries. The World Bank has reported the existence of 73 fintech regulatory sandboxes in 57 jurisdictions across the globe, as of November 2020.

But to establish an effective regulatory sandbox in the United States, regulators must confront a fundamental structural feature of the American financial industry: a complex, fragmented regulatory system. Federal and state agencies possess overlapping authorities and sometimes competing interests or priorities.

The U.S. financial regulatory framework comprises a variety of agencies at the federal and state levels. As such, a single agency or jurisdiction in the United States cannot, by itself, create an effective regulatory sandbox that would permit innovation and disruption in financial services.

This fragmented framework is different from the structure of the United Kingdom and that of other jurisdictions that have adopted sandbox models. Thus, U.S. regulators will face unique challenges when building upon the lessons learned elsewhere.

The major challenge in the United States stems from a lack of coordination between agencies in federal and state levels. Each agency has its own authority and powers to operate within its jurisdiction. More often than not, fintechs, banks, and other financial players in the industry are subject to supervision by multiple federal and state agencies.

Any player trying to develop an innovative business—whether fintechs or banks—must map out and comply with all the rules by all the agencies or they will face severe consequences.

As a result, a regulatory sandbox designed by only one agency cannot give disruptive models enough comfort to move forward with tests of new technologies and business practices. Doing so would risk breaking the rules by other agencies. Moreover, even if a business could take advantage of sandboxes in several jurisdictions, each would likely come with different rules and conditions.

In light of these complexities, members of the U.S. Congress have proposed legislation to promote uniformity. In 2016, U.S. Representative Patrick McHenry (R-N.C.) introduced the Financial Services Innovation Act to create a framework for a federal regulatory sandbox.

The bill proposes a joint effort of 12 federal agencies involved in financial regulation, including the Board of Governors of the Federal Reserve System, the Consumer Financial Protection Bureau, the Commodity Futures Trading Commission, the U.S. Department of Treasury, the Federal Deposit Insurance Corporation, and the U.S. Securities and Exchange Commission. Although this legislation is a starting point, it would be limited to federal agencies and, of course, it has not yet been passed.

Some states have initiated their own regulatory sandboxes for fintech, but geographical barriers blur in the digital world. Few, if any, technological products can be confined to a single state’s geographical boundaries. Consequently, any state-based initiative will also be limited on its own.

State-based regulatory relief for fintech businesses will also necessarily be limited to just one state and its agency’s regulations. One state’s sandbox does not prevent another state or federal agency from initiating an enforcement action against a sandbox candidate, producing a level of uncertainty that collides with the goals of safe experimentation.

Furthermore, no existing U.S. agency seems to have the authority to impose a uniform state-federal sandbox framework—not even the Federal Reserve or the Securities and Exchange Commission.

In a 2018 report, the Treasury Department expressed its support for regulatory sandboxes, but it also pointed out the need for joint action by federal and state agencies to implement an effective regulatory sandbox for the U.S. financial system. The Treasury Department suggested that, if a joint initiative fails, Congress could preempt state laws instead. This approach, however, could cut off access to sandboxes for state-licensed financial entities.

At this point, the only foreseeable way to create an effective regulatory sandbox in the United States would be through congressional action joining federal and state agencies through a cooperative framework. One viable option would be an overarching statute with the same intent of the proposed Financial Innovation Act of 2016 without being limited to federal agencies or simply preempting state law.

Regulatory burdens on the financial markets result in costs and complexity that can inhibit innovation. Sandboxes attract and foster business models that disrupt highly regulated markets, and banks can take advantage of the controlled space without increasing risk.

Congress has a Herculean task ahead. With both big banks and fintech startups eager to play with new advanced technologies, Congress may have to get in the game and lay down new rules for both sandboxes and financial innovation.