Keeping up with Innovation: Designing a European Sandbox for Fintech

In the aftermath of the 2008 financial crisis, Western financial markets saw the introduction of comprehensive regulatory reforms, most of them with an increased focus on financial stability. At the same time, a new breed of digital financial services have emerged, fuelled by advancements in computational technology and also Big Data. Among them, “robo advisors”, automated investment advisers, are one of the most promising and fastest growing players. In our recent output, including the policy paper “Keeping up with Innovation: Designing a European Sandbox for Fintech” and the academic article “A Regulatory Sandbox for Robo Advice”, we analyse how the provision of automated, digital financial advice clashes with the current EU regulatory framework and propose a “Guided Regulatory Sandbox” to cope with those problems.

 

Robo advice has grown at a rapid pace since the beginning of this decade and during the recent years attracted attention of several regulators such as the SEC and EBA). While they bring a welcome addition to the choices available for many investors, their merits warrant close scrutiny. As the advice process takes place in a wholly internet-based setting, (private) investors are prone to make hasty, unverified investment decisions. Also, the questionnaire, on which the advice is based, may fail to take into account the individual preferences, situations, and specific needs of the investor. On a more general scale, where automated services recommend certain asset classes to investors on a similar pattern, this bears the risk of large-scale parallel behaviour, the development of bubbles, and ultimately the emergence of systemic risks. Moreover, advances in artificial intelligence bear the potential to significantly improve the service of robo advisors, but also inherit new idiosyncratic risks, such as “black box” decisions and may exacerbate existing systemic risks.

 

According to their mandate, regulators should promote financial innovation, while mitigating risks for consumer and financial stability. In our paper, we analyse the current regulatory situation of robo advisors and argue that in large parts regulation falls short of these goals. Apart from the sheer magnitude of regulatory obligations, rules seem partly ill-suited for the digital nature of robo advice. Moreover, rules are applied differently among EU Member States, partly as a result of diverging implementation, partly due to different interpretation of (similar) rules. The consequence is a prevailing regulatory uncertainty, ultimately resulting in market barriers for robo advisors on the one hand and risks for consumers and in the long-run for financial stability on the other.

 

Against this backdrop, we explore the innovative concept of a “regulatory sandbox” to address these particular challenges. Regulatory sandboxing in the financial sector refers to a controlled space in which businesses can test and validate innovative products, services and business models with the support of the authority. Regulatory requirements are relaxed to allow innovative players easy experimentation and growth. At the same time risks consumers are limited through specific safeguards. While the first regulatory sandbox was introduced in 2015 by the British Financial Conduct Authority, there are now 17 sandboxes running worldwide (March 2018). After outlining the common parameters of existing regulatory sandboxes, we show that a regulatory sandbox is able to address the majority of problems that the current regulatory framework implies for robo advisors. First, a regulatory sandbox would significantly facilitate market entrance for robo advisors. Engaging with the market authority on regulatory issues would reduce regulatory uncertainty for robo advisors and make them better equipped for a (full) market licence. Secondly, this engagement not only benefits robo advisors: it is the regulators who yet lack sufficient data and knowledge about the phenomenon. Testing all different kinds of robo advisors in a safe space could facilitate a dynamic information exchange process and thereby significantly increase expertise of regulators. Regulators would further be able to test different market scenarios to assess stability risks and thus promote financial stability. The information obtained would then put the regulator in a position to make sound long-term regulatory decisions and could – when forwarded to the legislature - form the basis for eventual adjustments of the legislative framework. Hence, the dialogue would not only promote innovation by reducing regulatory uncertainty, but also improve regulators’ understanding of new technologies. Ultimately, we believe that this mutual learning process constitutes the key benefit of a regulatory sandbox for robo advice.

 

In the particular EU legal framework with various layers of legal instruments, installing a sandbox is not straightforward. In this paper, we propose a “guided sandbox”, which should be guided by an interplay between the federal (EU) and national levels. More specifically, it would be the Member States who operate the sandbox in practice, but with endorsement, support, and monitoring by EU institutions. This would leave room for testing innovative sandbox approaches, while simultaneously facilitating a common information flow that enables Member States to learn more about both robo advice and regulatory sandboxing. In a way, this approach applies the underlying principle of a regulatory sandbox to its very own implementation on the EU level.

We further endorse to complement this “guided sandbox” with a follow-up regulatory “trajectory” that proceeds in line with the size and risk-level of respective robo advisors. This trajectory should aim towards maintaining the established mutual learning process while ensuring an adequate and proportionate regulation at every stage of a robo advisor’s development.

 

Certainly, a regulatory sandbox is no panacea: it is highly resource intensive and the capacity in regard of participants is strongly dependent on the resources invested in it. Moreover, it bares the risk of regulatory capture. A challenge that as well needs to be addressed is whether to allow incumbents to enter the sandbox, raising level-playing field and competition questions.

 

Even though there are still open questions, we believe that a “guided sandbox” for robo advice is a good and necessary first step towards a better regulatory environment in Europe. This innovative approach would be somewhat unchartered territory for the EU, and thereby also contribute more generally to the future development of EU financial market governance.

 

 

Wolf-Georg Ringe, University of Hamburg and University of Oxford.

Christopher Ruof, University of Hamburg.

 

 

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