The increasing use of technology in finance (FinTech) in recent years has added complexities and posed challenges for regulators and supervisors in a sector that is complex, inherently risky and highly regulated. A recent study requested by the European Parliament’s ECON Committee aimed to provide an overview of the level of dissemination and the key features of innovation facilitators, mainly looking at the models adopted in the EU and the EFTA countries. The study examined the setting up of regulatory sandboxes and innovation hubs done by various jurisdictions in response to FinTech developments. It also aimed to identify certain key elements of design and operational parameters of innovation facilitators, which impact on the potential benefits and risks linked to their operation.
While certain technologies fall into the traditionally regulated financial sector space (such as digital banking or payment services, platform-based financing etc.), others are applicable across sectors. Applying technologies in the financial sector provides new products, practices and processes that bring new risks (such as automation of decision-making) in addition to those risks that are inherent to the financial sector (such as systemic risk, operational risk, market integrity and principal-agent risk).
Across the globe, jurisdictions have reacted differently to FinTech developments; while countries such as China considered any crypto-related activity to be illegal, Malta was the first jurisdiction to adopt a regulatory framework on DLT/Blockchain and Innovative Technology, legally embracing technological development. Other countries such as Japan, introduced licences for exchanging crypto-assets.
In order to further understand and identify risks for financial stability, supervisors need to understand, isolate and target the limitations and vulnerabilities of various complex technologies. This would allow a significant build-up of supervisory knowledge and capacity, something that has become more institutionalised in the forms of innovation hubs and regulatory sandboxes.
Generally, innovation hubs provide a specific scheme via which firms can engage with the supervisory authority to raise questions and seek clarifications or non-binding guidance about FinTech related issues. On the other hand, regulatory sandboxes go a step further and provide a special scheme where companies can test innovative financial products, services or business models with actual customers in a controlled environment (a ‘sandbox’) pursuant to a specific testing plan agreed with the supervisor and subject to the application of distinct safeguards. The MFSA has recently issued a FinTech Regulatory Sandbox allowing FinTech Service Providers and FinTech Suppliers, including start-ups, technology firms and established financial service providers providing technologically-enabled innovation in their business models, applications or products to test their innovations within a regulatory environment for a specified period of time and under certain prescribed conditions
The main difference between these two models lies in the nature of the facilitation, because while innovation hubs provide a platform to exchange knowledge and informal guidance, a regulatory sandbox usually implies some lenience or supervisory discretion about the way in which the regulatory framework applies to innovative products or services. Moreover, within an innovation hub, the supervisor does not monitor the actual development of a FinTech product as closely as in the case of regulatory sandboxes. Innovation hubs are also easier to establish, because they do not require any protracted legislative or regulatory charge and can be set up under existing supervisory mandates.
The main expected benefits from the operation of innovation facilitators include the enhancing of supervisory understanding of emerging technologies, which can inform an adequate policy response to FinTech. Facilitator schemes also help new entrants to develop a much better understanding of supervisory expectations. As for innovators, they can help reduce regulatory uncertainties and provide clarification on regulatory and supervisory expectations. Innovation facilitators can enhance visibility of broader technology-related developments, helping supervisors to bridge information gaps that emerge at the edge of the regulatory perimeter.
There are however potential risks, the most common one being the potential for regulator arbitrage, because there can be some regulators that opt for a ‘race-to-the-bottom’ in a bid to attract start-ups and investors. In the long run this could lead to compromises on consumer protection and financial stability. Other risks are specific to innovation facilitators, such as competition and level-playing field concerns related to preferential treatment granted to entities within an innovation facilitator. In the context of the EU Single Market, innovation facilitators bear a risk of market fragmentation. Moreover, certain choices made in the design and operational parameters of an innovation facilitator may emphasise certain risks and would require specific safeguards to mitigate potential negative impacts.
The scope and parameters for access to the innovation facilitators are also of relevance in the context of ensuring cross-sectoral consistency of supervisory practices and a level-playing field. Where a joint operation by all sectoral regulators is not possible, enhanced mechanisms for supervisory knowledge-sharing across the different financial sectors are necessary.
Adequate knowledge sharing to the broader FinTech community is vital to bridge the knowledge gaps emerging between entities within the facilitators and those outside. Proper channels for internal supervisory knowledge are necessary in order to ensure a coherent supervisory approach. A multidisciplinary supervisory cooperation and knowledge-sharing on issues such as competition, fraud, anti-money laundering, cybersecurity, consumer and data protection may be highly relevant in the FinTech space. Although the establishment of an EU level regulatory sandbox may seem far-fetched as of now, the possibility of a successful testing, which enables market access across the EU, would make EU Member States, collectively, a more attractive destination for FinTech innovation.
Article written by Dr Cherise Abela Grech and Legal Trainee Mr Steve Vella.
This article is not intended to impart legal advice and readers are asked to seek verification of statements made, from an advocate or law firm, before acting on them.