Sandbox approach for innovation in financial inclusion

Creating space for financial services

A regulatory ‘sandbox’ that creates a safe space for fintech innovation is an idea whose time has come

Varad Pande, Nirat Bhatnagar, Raahil Rai

It is widely acknowledged that financial inclusion, and financial services more broadly, are at an inflection point in India. The so-called JAM trinity (Jan Dhan-Aadhaar-Mobile) and recent regulatory innovations (like the introduction of differentiated banking licences) have set the stage for a transformation. The Unified Payments Interface (UPI) will make digital transactions smoother, and the India Stack—a set of digital public goods that can dramatically reduce the cost of financial transactions such as lending—is ready for use.

As Nandan Nilekani eloquently put it, India has reached its “WhatsApp moment” in financial services.

This transformation has important regulatory implications. A lot of fintech innovation requires regulatory permissions or modifications, but given the (often unknown) risks involved (e.g., fraud, customer security and even financial stability), regulators understandably take a conservative approach. Notably, there is a chicken-and-egg problem of innovation. Regulators desire to fully understand the potential risks of new technologies and approaches before making a decision.

The fintech sector, and financial service providers more broadly, look for clear, certain regulations before investing large amounts in new technology-driven services. With uncertainty on future regulation, innovators invest less in new technologies on aggregate than what might be socially desirable. And without the innovations being developed, it is difficult for regulators to understand their effects fully and regulate them appropriately.

So, how does one overcome this chicken-and-egg problem? One big idea that is taking shape is that of a “regulatory sandbox”. A sandbox is a mechanism through which the regulator permits realistic simulations and limited-scale experiments of financial innovations in controlled environments (often ‘relaxing’ some regulatory norms). It studies the results of these experiments, and then makes final regulatory decisions. The sandbox functions as a safe space to try out innovations, and understand their associated risks, before allowing full-scale roll-out.

Take an example. One promising area in the financial services space is that of digital peer-to-peer (P2P) lending. The idea is that by directly connecting potential individual lenders and borrowers, P2P platforms can unlock the market for small-ticket loans, thereby driving greater inclusion. Doing it digitally can dramatically reduce the cost of intermediation, making this a viable and scalable market. Over the past few years, more than 30 digital P2P lending platforms have been set up in India. But they have been working in regulatory grey areas or working with severe regulatory constraints (e.g., not being able to hold funds in centralized accounts, not having access to CIBIL credit scores or centralized know your customer (KYC) databases, etc.) thereby limiting their ability to provide value to users.

The Reserve Bank of India, as the regulator, has been cautious because it has some legitimate concerns around the unintended consequences of P2P lending (it has recently announced draft regulations for this space). Here’s where a sandbox approach could help—by permitting an experiment where P2P lending platforms can be given some regulatory leeway such as being allowed to access centralized credit score and KYC databases, and hold funds in centralized accounts. Such an experiment could be run as a pilot with a limited set of customers—for instance, 1,000 customers in one city, for three months. If the regulator is satisfied that there were no major regulatory issues, the regulatory leeway could be formalized into the regulations.

There are several such use cases where the sandbox approach could help bring much-needed evidence to bear on regulatory decisions, and thereby spur financial innovation. Blockchain, which provides an open public ledger approach to documenting and verifying financial transactions, is another innovation that could benefit from such a sandbox. Regulators around the world are in the early stages of studying and regulating blockchain. Complex questions remain to be answered, such as what exactly should be regulated, who is responsible for compliance, could it lead to money laundering and will it compromise consumer protection. Blockchain simulations and field trials, under the sandbox approach, could help provide some answers.

The idea of such a regulatory sandbox to spur responsible fintech innovation has gained traction across the world. UK’s Financial Conduct Authority (FCA) moved first to set up a sandbox late last year. Singapore, Australia and Abu Dhabi are following suit. We believe that the time is ripe for India to set up its own regulatory sandbox. In fact, India could go a step further and create a ‘sandbox plus’, i.e., not just limiting itself to giving permission for experimentation, but actively leading and co-creating such experimentation end-to-end. For instance, in the P2P lending example, the sandbox team could lead the pilot design, including geography selection and recruitment of trial customers, manage the experiment, and gather data for itself. More broadly, the sandbox could also take the lead in spurring fintech innovation through open innovation challenges, hackathons and by curating innovation from leading global fintech centres. It could come up with new experimentation ideas related to the next generation of fintech innovation, such as testing blockchain or digital fiat currency.

By actively curating such tests, the sandbox could help bring down the cost of experimentation and hasten the regulatory learning curve.

We believe that by creating such a sandbox, India can set a global benchmark for a pro-innovation, yet safe, regulatory and policy environment for fintech and financial inclusion. India’s financial services regulators, notably the RBI and the Securities and Exchange Board of India, have been pioneers in enabling innovation over the past few years. With a sandbox in place, they could help India take its next big leap.

Varad Pande, Nirat Bhatnagar and Raahil Rai are, respectively, partner, associate partner and consultant at Dalberg.