Why “Regulatory Sandboxes” May Hold the Key to Responsible Digital Financial Inclusion

In the second article of our partnership with Meridian International Center’s series on The Digital Finance Future, Amanda Sperber investigates an important theme: regulation of financial technology.

Digital financial technology is growing fast — and with it financial empowerment for millions of “unbanked” people around the world. But for governments — with their mandate to safeguard the stability of their economies and safety of consumers, innovations in digital finance create a whole slew of challenges. “Regulatory sandboxes” offer one way to balance innovation and regulation — and their history is surprising.

With millions of unbanked people worldwide now equipped with mobile phones, a slew of innovations have been created to get a once-disconnected population on the fiscal grid. For the global south in particular, digital finance offers huge possibilities. But with new ways for money to flow come new challenges for regulating these flows for governments.

In most poor and remote areas around the world, setting up a bank account, getting a credit card or accessing cash via an ATM is not a viable option. This means millions upon millions of “unbanked” are unable to establish credit, get loans that might better their businesses, upgrade their homes, send their children to school, or otherwise put themselves on the financial map.

A new virtual value proposition — putting money on people’s phones and setting up bank accounts with telecom companies — has created new players, like Tigo Money, which spans South America and Africa, or Pakistan’s mobile service Easypaisa. These entrants in turn pose a new challenge for governments, specifically in regulating the financial space.

A 2015 Deloitte report advises banks to take note of these changes, which have the potential to “take over the customer relationship.” “Cash and (quite possibly) credit cards are giving way to digital alternatives that will cost financial institutions at least some influence over the transaction experience.” The report further advises traditional financial institutions to view the newcomers’ entrance into the financial services marketplace as an opportunity.

Asia and Africa are leading the way in mobile money adoption. The flagship example of this, of course, comes from Kenya. More than half of the East African country’s population has an M-Pesa mobile money account. M-Pesa is the brainchild of Kenyan telecom giant Safaricom, a Vodacom subsidiary. M-Pesa has placed Safaricom squarely into the everyday payment process: in 2015 more than 80 percent of the country’s GDP — 63 billion dollars — flowed through the service.

In a number of countries in Africa — Somalia, Cote d’Ivoire, Tanzania, Uganda and Zimbabwe, for example — more adults have a mobile money account than a bank account. These, then, are the markets to watch when it comes to seeing how regulators will — or won’t — adjust to the new territory.

A Regulatory Tightrope

As regulators grapple with the rapidly growing financial technology landscape, we see the key stakeholders — banks, telecom companies and fintech companies — advocate for their respective priorities. Regulators have the responsibility to protect consumers and guard against monopoly. New fintech companies want freedom to experiment and scale up and scale out. Banks want to remain relevant players in the space.

Balancing these priorities is critical both for the future of financial inclusion and for protecting consumers and economies. Eduardo Tugendhat, Director of Thought Leadership at the Palladium Group, an international development, strategy execution and impact investment firm in DC, advises regulators to ensure that the procedures they enact allow for creativity to flourish. Only then can the potential of digital finance be fully leveraged. As he told Innovations in an interview, “Areas such as digital finance can evolve with innovative applications that are completely unforeseen. Most of these innovations are for good, [but] some may actually be ways of getting around current regulations.”

Tugendhat suggests that rather than creating detailed regulations a priori, regulators should stick to key policy principles that provide protections, while keeping these guidelines flexible enough to allow for “competition, flexibility and innovation.” Regulators can respond to problematic developments as they arise, as opposed to being overly cautious in advance.

A World Economic Forum report underscores this point. It says that collaboration and communication between regulators, incumbents and new entrants is vital in order to manage the competing demands of the new landscape.

In most cases there are four central elements of a digital financial service product: banking, telecommunications, the payment service business, and the agent network. Regulations must come to terms with each of these parts, individually and collectively. This requires communication, coordination and compromise.

The Regulatory Sandbox

Enter “regulatory sandboxes”. The regulatory sandbox is a sort of safe space which allows innovators to test their products in a live environment, in which impact can be felt immediately without following pre-set industry restrictions. These sandboxes could open up space for paradigm-changing innovation.

There have been public launches of official regulatory sandboxes, including an endorsement by the Financial Conduct Authority in the United Kingdom, and the April 20 R2A (Regtech for Regulators Accelerator) opening in Indonesia.

However, implementing these sandboxes is challenging and requires multi-stakeholder convening and communication. The question remains as to whether they are viable for all markets.

The Origin of the Regulatory Sandbox

Arup Kumar Chatterjee from the Asian Development Bank points out that regulatory sandboxes aren’t a new concept, just a new expression of an already existent practice. The Philippines has been deploying such “test and learn” approaches for more than a decade, he explains in a blog post. Rather than issuing predetermined regulations, the country empowered prominent businesses to pilot products and models under close monitoring. The success of this approach provided proof of the concept that multi-stakeholder communication and convening allows regulation to coincide with innovation.

The original regulatory sandbox, says John Owens, a senior advisor on digital financial services, was created in 2004 when Philippines telecom company Globe approached Bangko Sentral ng Pilipinas (BSP), the country’s central bank, with a proposal to create money independently. Globe was inspired by Smart Communications, which created the first mobile money in the Philippines, in conjunction with BSP. The bank allowed them to move ahead under the test and learn approach.

This step was internationally unprecedented: no telecom had issued money without any banking affiliation. Most considered it too risky, especially with concern about money laundering. East Africa, however, quickly followed the Philippines’ example, as did China.

Thanks to companies such as Alibaba’s AliPay and Tencent’s WeChat Pay in China, Owens explained in a phone interview, “mobile payments offered have grown dramatically from less than RMB 1 trillion (US$81 billion) in 2012 to an estimated RMB 20 trillion (US$2.9 trillion) in 2016.” Owens believes the growth of mobile payment services in China has “largely been due to a supportive regulatory enabling environment which, like the early test and learn approaches in the Philippines, has taken a similar wait-and-see approach that allows innovation with regulatory responses that closely follow these developments but do not hinder them.”

The market-led approach that has helped the Philippines lead the way in financial services innovation is in large part due to its history with microfinance regulation, according to a 2015 paper by Gilberto M. Llanto. Microfinance as a legitimate form of banking was introduced to Filipino legislators, representatives of government financial institutions, and government officials on a 1999 trip to Latin American microfinance institutions in Guatemala, Peru and Bolivia. This engagement influenced subsequent legislation and informed the flexible regulatory stance that underpins fiscal governing today.

Debating the Merits of Flexible Regulatory Approaches

In a 2016 conference on financial inclusion in the digital economy convened by the Asian Development Bank, Patrick Joseph Sadornas, the Head Core IT Specialist at the Central Bank of the Philippines, said the bank encourages financial technology companies to come in and meet with the regulator to discuss new products and services.

“We were in constant communication with the BSP all throughout the last 3 years we have been doing our business, meaning they were well aware of us and our business models,” recalled Miguel Cuenta, the Chief Community Officer and co-Founder of Satoshi Citadel Industries in an interview. The blockchain company didn’t have an official “sandbox,” but was allowed to operate anyway.

Cuenta believes the flexible regulatory environment in the Philippines contributes to innovation. The country was actually the first in the world to legalize Uber, and the central bank was one of the first to issue a framework around Bitcoin and blockchain technology. “It allows us to approach our industry with confidence and legitimacy,” Cuenta said.

Lenddo, a company that uses non-traditional data to provide credit scoring, was founded in the Philippines in 2011, and now operates in more than 20 countries around the world. Lenddo allows unbanked people to build credit and get loans.

Florentin Lenoir, a Marketing and Business Development Director at Lenddo, said the company was one of the first to leverage non-traditional data for online lending. At the time, few regulations were in place, and the lack of data infrastructure in the Philippines made it easier to launch. “The Philippines is very unique,” Lenoir said, “because there isn’t a lot of information available to begin with — there is no national ID system, no credit bureau.” Practically speaking, there are fewer offices with which the company had to contend than in countries like Thailand, to which Lenddo is currently in talks to expand operations.

Markus Gnirck, the Co-Founder and Managing Director at tryB Capital, an investment firm in Singapore, sees the Philippines a bit differently. “I can see regulators in the Philippines not being active in regulations,” he said in an interview. “But not being involved doesn’t mean you’re forward looking…I would argue [that] as a regulator your job is to find a stable and consistent regulatory framework, and to regulate. The way to be progressive is to have an interest.”

Gnirck, who regularly visits the country, said he was surprised to hear it was the Philippines that had inspired other regulatory models. He doesn’t chalk up the lax approach to intention: “It doesn’t mean [you’re] a progressive regulator if you just don’t care. I have a feeling they are just too busy doing other things.”

The 2008 global financial crisis quickly comes to mind, Gnirck commented, when envisioning the potential pitfalls that come from loose rules.

Data Protection: A Downside to Less Restrictive Regulation?

Financial data is of course a sensitive subject. Around the world, there’s generally a direct, negative correlation between GDP and regulation: the poorer the country, the less restive the regulatory environment. With less regulation, opportunity for companies to abuse the system is a potential problem. On the flip side, government access to financial data could pose serious problems in repressive or simply poorly managed regimes.

Florentin Lenoir says he is not concerned that Lenddo is taking advantage of poor countries because the company complies with American and European standards when it comes to data protection. The company treats data from the Philippines just like data in the United States. The reason for this, Lenoir explained is that Lenddo expects data regulations to only become more restrictive (as the east catches up with the west, presumably), so the company wants to be ahead of this evolution. “We believe that there will not be such thing as less restrictions in the future, so we want to make sure, by complying to the most strict regulations, that we will be able to deploy anywhere, and find long term solutions for our partners,” he explained.

Lenddo, itself, however, would advocate for a more cautiously flexible approach when it comes to regulations, advising governments and banks to not be so restrictive that the potential of these new innovations can’t fully spread its wings.

“We are only discovering what could be done with this data,” said Lenoir. “Part of the process behind the regulators is to prevent anyone from misusing information. At Lenddo we’re not against regulators, but we want to make sure users are owners of their own data. If I am a user, I should have the right to decide what to do with my data.”

Lenoir’s thoughts reflect Tugendhat’s: while consumer protection is vital, both think that regulators have to take a leap into the unknown in order to realize the full potential of these innovations.

Given that a number of sandboxes have been launched in the last year, 2017 will be a time to judge their effectiveness. “I have seen a number of startups going to the sandbox in part to work closely with the regulator,” said Gnirck. “London and the Bank of England already had lots of companies going to sandbox. We have yet to see valuations. Let’s see this year how the companies adjust or how regulators adjust and give licenses out.”

Others take a big picture approach: For his part, Ignacio Mas, the executive director and co-founder at the Digital Frontiers Institute, a company that trains professionals in digital finance, finds the glorifying of technologizing money to be over the top. He advises relative thinking instead.

“All finance businesses have been technologically enabled going back to the Babylonian times (cuneiform writing was invented initially for this purpose),” Mas said in an email. “So why we are treating the current batch of startups as qualitatively different to all the ones that came before is a little beyond me.”

This article is part of our partnership with Meridian International Center’s series on The Digital Finance Future, made possible with funding from the Bill & Melinda Gates Foundation.