How Regulatory Sandboxes are Shaping Fintech in Asia

Welcome to Pacific Exchanges, a podcast from the Federal Reserve Bank of San Francisco. I’m Nick Borst.

And I’m Sean Creehan. We’re analysts in the country analysis unit, and our job is to monitor financial and economic developments in Asia. Today’s episode is part of our continuing series on financial technology in Asia. We sat down with Kate Lauer, a lawyer and senior policy advisor to The Consultative Group to Assist the Poor (CGAP), a global partnership based out of the World Bank, which is focused on financial inclusion.

One of the things we’ve heard from firms is that the most beneficial part of operating in a sandbox is that that dialog with the regulator has helped the firms to shape their business model.

Kate is an expert in microfinance, financial inclusion and global financial regulation. She has extensively studied the regulatory and policy barriers to financial inclusion around the world, and she recently completed research into the rise of regulatory sandboxes to promote fintech. Kate comes at these issues from a global perspective as someone that’s engaged with regulators and policymakers in a variety of developing countries.

Yeah, I was struck in the conversation about, we often think about what are the market and technological barriers that prevent people from accessing the financial system, but Kate’s thinking about how regulation and policy can also serve as a barrier. I think one of her interesting takeaways here is this idea of the sandbox as a two-way learning environment. It’s not just about allowing startups to understand the laws and regulations that they should be following, but allowing regulators and policy makers to learn about these emerging technologies.

Okay, let’s hear our conversation with Kate.

Thanks for joining us, Kate.

Yeah, nice to be here, Sean, Nick.

Could you tell us a little bit about your work for The Consultative Group to Assist the Poor (CGAP)? Why are you guys interested in fintech, and just tell us a little bit more about what you’re doing.

Sure. The Consultative Group to Assist the Poor, or as it’s known, CGAP, is a global partnership of 34 organizations, countries bilateral organizations, multilateral organizations and foundations. That partnership is oriented specifically towards financial inclusion, which is improving the poor’s access to financial services. It will help to improve their lives. We provide technical assistance to providers. We work with regulators and policy makers, and I specifically work on the regulatory and policy issues relevant to financial inclusion.

Fintech, it depends on how one might define fintech, but we recognize that this term is used today in a way that actually incorporates things that have been influencing financial inclusion over the past 10 years. Specifically, I’m sure most people have heard of M-Pesa in Kenya. M-Pesa is a mobile phone-based service. It was quite innovative in 2006, 2007 when it launched. It provided people who had mobile phone lines with the opportunity to load money onto their phones and then use it to make payments and to transfer money to family and friends. This is now something, I think, many people are familiar with, but at the time 10 years ago it was way out there, way ahead of what was going on in the United States and in most markets. We consider that fintech, and that was actually a huge leap forward conceptually in how poor people might be served.

When we have seen, not just M-Pesa, but all different kinds of use of mobile phone technology and other technology to provide the poor with the access to financial services that they otherwise wouldn’t have access to, either because they’re located in remote and rural areas, or because banks are not interested in opening up their doors to serve poor people. A whole range of ways that poor people otherwise couldn’t access financial services can now do so through technology, we see that as fintech. CGAP has, over the past 10 years, delved into how providers can use technology to reach poor people, and then how regulators and policy makers can create a more enabling environment for that to happen, while also ensuring that customers are protected and that the financial system remains safe for the providers and customers.

Kate, I think there’s a pretty widespread acknowledgement of the benefits of using financial technology amongst regulators and policy makers. It also raises some new challenges in terms of in some cases you have existing financial institutions outsourcing various functions to startups. In other situations you have startups directly offering services to customers, and add on top of all this you have a lot of new customers coming in to the financial system who may not be familiar and have lower levels of financial literacy. How do you think about all these different, new challenges that financial technology presents in terms of financial inclusion?

Of course, regulators are going to be primarily concerned with, probably, three or four issues. One is the stability of the financial system, in general. The second is consumer protection issues, the third is integrity, so the absence of crime, money laundering, terrorist financing. Those are standard risks.

We see in many countries that an example of fintech would be mobile money. If you are a customer who all of your financial services are accessed by your phone, including signing up for an account. You sign up, you read all the disclosure, you read all the terms of a loan, for example, on your phone. Your phone, it’s a pretty small face, so the question is what do you put on there?

It could be a flip phone for some people, right?

It could be a flip phone, exactly. So, how do you read those terms, and how do you absorb those terms? Do people just say, “Yes, yes, yes,” because they say yes to all the terms and conditions because either they just want that loan, or they don’t understand that there might be alternatives. How do they also meaningfully absorb what’s in the terms and conditions, and how do they, for example, compare terms and conditions one loan against another if it’s all on a flip phone or a smart phone? The question of how, then, do you craft consumer protection regulations that ensure that the customer in that particular situation, which is a situation many people we work with in countries with developing economies, those people actually face those issues, so it’s a real issue. Crafting regulation and ensuring that the regulator understands the consumer protection risk is something that’s really critical, I would say, to the healthy future of fintech for poor people.

That’s an issue here in the United States, too. You can sign a loan document for a home mortgage that’s like 50 pages long-

Exactly.

… with a hundred pages of disclosures on your mobile phone now. People may be kind of in the midst of a process and out and about and not really be looking at it very carefully because the technology makes it so easy.

This is one of the issues, actually. For countries where there is the financial services for certain populations are primarily accessed through mobile phone. Where do those countries look to as models or for guidelines in developing appropriate consumer protection rules? There’s a lot of work that’s been done by FinCoNet, CGAP has worked a lot on trying to identify what should be in regulations, how regulators can best supervise institutions and the whole complaint mechanism, et cetera, and what should be in disclosure rules. I think we’re at the very beginning of this. In fact, in general with fintech, even though someone fintech like as I was saying before, payment cards have been around for 50, 60 years.

Mobile money has been around for 10 years. 10 years is a pretty short time, so I think we’re still seeing in almost every area of regulation and supervision we’re seeing a lot of this dynamic of crafting the regulation, seeing how good a job it does, and then revising. We’re seeing this in many different countries that range from countries that are really large, like India, to countries that are very small, or relatively small, like Sierra Leon or Rwanda. How do we have consistency that also takes into consideration variation in context in how the financial sector is composed? What are the institutions that exist in the sector? How many regulators are involved in the financial sector? Is there just one overarching regulator? In some countries you have regulators responsible for banks, and then separate regulators responsible for payment service providers and another regulator responsible for financial cooperatives. Those kinds of institutions may all be using similar technologies or different. They may be serving similar customers, and so trying to figure out how to do things in a way that’s effective as well as proportionate is a real challenge, especially when trying to reach poorer customers.

You’ve alluded to this idea of a sandbox, and you were just talking about some of the challenges of regulating by type of activity versus type of legal charter. Could you define a little bit more what do we mean when we say a sandbox, and why is this considered, maybe a good approach for emerging technologies in the fintech space?

A regulatory sandbox, we have both regulatory sandboxes and industry sandboxes today. A regulatory sandbox is set up by a regulator. The first regulatory sandbox that was set up was in 2015, so really recently, and it was the UK’s Financial Conduct Authority. Since the UK set up its sandbox, which was oriented towards encouraging technological innovation that would ultimately benefit consumers, since they set that sandbox up there have been about a dozen countries that have expressed interest in setting up their own sandboxes. Probably of that dozen there may be fewer than 10 who have actually passed guidelines or set up a structure and have begun to let fintech companies into the sandbox. Those entities that are accepted into a sandbox in a country are generally referred to sandbox entities.

What is the purpose of doing this? I would say most of the countries that have set up sandboxes are looking at fostering innovation, both to have a thriving financial sector that is competitive on a global scale, and have innovation that advances and benefits the interest of consumers, and also has the potential to improve the efficacy of the financial system. We at CGAP are interested in sandboxes because we have spoken with some regulators that are working with financial firms that are trying to innovate for financial inclusion. Our angle is always financial inclusion.

For CGAP the question is, is a sandbox something that would be useful to a regulator that’s interested in innovation for financial inclusion? I would say it’s an interesting question. The sandbox presents the regulator with the opportunity of working in a very close way with innovators, whether they’re startup fintech companies or incumbents, to test the use of technology, either in the design of specific new products, or in processes that will make the delivery of financial services and products more efficient. The regulator has to decide, “What are we interested in? Are we interested in developments across from incumbents and from fintech startups, or are we just interested in supporting small startups that otherwise wouldn’t have the resources to be able to do the testing?”

The second question is why is a sandbox necessary? Why can’t these firms just innovate on their own? In some cases the problem is that the regulations set up barriers to certain products and services or to certain firms entering into the space. In some cases the regulations, and this is the case in many countries where I work, the regulations are silent, so the regulator doesn’t really know, “Should we permit this non-bank financial institution to ‘issue’ electronic money? If we permit this entity to issue electronic money,” which is the stored value. An example is M-Pesa.

If there’s no regulatory space for an e-money issuer, then how would a country know what to do with that entity? How would they know how to protect customer funds that were loaded, for example, onto a mobile phone? Would that regulator, then, want to create a sandbox where something like electronic money could be experimented with? That’s a question for the regulator, whether they need to create a regulation first, or do they want to open up a space where they can observe and work with firms in a controlled environment for a limited time period and see whether a product, or a process, can take off, whether it can serve to provide customers with better service or with new service, with new products in a more efficient way.

Sandboxes create that, have the potential to create an environment where you have entities coming in. After the end of a specified period, usually it’s six to 12 months, of working together with the regulator and the regulator observing and monitoring the actions and the provider understanding better through this process whether the regulations would be manageable and maybe working towards a situation where the regulator is willing to revise regulations, that whole process is the way that a sandbox optimally would work.

There are drawbacks of sandboxes, and I think one of the biggest drawbacks of a sandbox is that when you set up a sandbox and you decide who can enter, whether it will be, broadly, any financial institution and non-financial fintech, or do you want to create a sandbox only for banks. Do you want to create a sandbox that provides timely exemptions from certain requirements, and what kind of exemptions would those be? When you set up that kind of sandbox and you let firms into the sandbox, by definition you’re, in some way, giving those firms a benefit that firms not in the sandbox don’t have.

It’s like picking winners.

Picking winners, yeah. There are people who have said, “This is really unfair. You’re kind of skewing with or playing with competition, and you’re giving some people leads, and why would you do that?” Some regulators have said, “Well, we’re only going to give leads to small startups.” Others have said, “Well, we’re going to open it up to the whole field because what we’re really interested in is innovation, regardless of how it comes in.”

It sounds like it’s a combination of benefits. No matter how you approach it, though, it’s hopefully promoting innovation, but also allowing the regulator to learn.

Yes. I think it is a two-way benefit. I think one of the things we’ve heard, both from regulators and from firms, is how each has learned a tremendous amount through the ongoing dialog and intensive dialog between the two, between the firm and the regulator. The regulator also gets this opportunity to have almost a microscope into what the firm is doing, which helps, especially regulators whom we work with who might have real challenges with capacity and understanding of certain technologies. I think many regulators are, actually, challenged today when they’re faced with really sophisticated coders who are creating products, whether it’s machine learning or other things. It’s really hard for the regulator to catch up. This intensive monitoring can be really helpful to regulators.

But, one of the things we’ve heard from firms is that the most beneficial part of operating in a sandbox is that that dialog with the regulator has helped the firms to shape their business model. Partially to shape their business model because of a better understanding of the regulations and the way the regulations impact their business because, remember, a lot of these fintechs are not financial institutions. You have a bank that’s been in a relationship with the supervisor forever and understands the reporting requirements and the ratios that need to be complied with and why. For these fintech startups they don’t know very much at all about these issues. This introduction is both helpful from the understanding the what and the why about a supervisor, but also what I said before, just that whole dialog has helped the providers in shaping their models.

For some providers it’s really valuable. We have heard as well from some supervisors that when they are vetting applicants into the sandbox, they are, essentially, providing what used to be expensive legal advice that providers would be told, “You want to know whether you have to comply with certain regulations, go get a lawyer.” But if you’re a small startup and you don’t have the funds, then, you might just say, “We can’t afford to do that,” so back away from the project. In the cases where there are sandboxes and the firms go in and say, “We’d like to do X,” we hear about the regulators saying, “Well, you can do that, and there’s no regulation that prevents you,” or, “You’re not even falling under our jurisdiction,” or, “Yeah, there’s this and this regulation. This is what you have to be aware of.”

You mentioned that the first sandbox was in the UK, but it seems like a lot of the new activity is actually in the Asia-Pacific.

Mm-hmm (affirmative).

Could you give us an overview of what sandboxes in the Asia-Pacific look like? Are there any key differences amongst them, amongst the sandboxes themselves or compared to the UK?

There are probably six or seven Asian countries, looking broadly at Asia, that have talked about and are interested in sandboxes. There are four that have set up sandboxes, and as far as I know only three of them are really operational, meaning they have taken applications and are working with sandbox entities. Those three countries where they’re operational, those three jurisdictions, are Hong Kong, Singapore and Malaysia. Thailand has set up a sandbox, but as far as I’m aware there aren’t any sandbox entities operating in that sandbox. The three that I mentioned, Hong Kong, Singapore and Malaysia, have set up their sandboxes in very different ways.

I think, perhaps, the most important feature or difference is that in Hong Kong sandbox entities, it’s only authorized institutions or banks that are permitted to enter the sandbox. If you’re a fintech startup and you have an idea, you have to get a bank to agree to partner with you to go into the sandbox. You can’t go in on your own, you can’t apply. That’s actually caused a lot of, there’s been people questioning whether this is the right approach, both small startups and large startups. Some of the big fintech companies in China, for example, have objected to not being able to go into that sandbox, like, “Why is that sandbox in Hong Kong set up that way?”

They feel like they’re big enough. They don’t need a partner bank to do this.

Yes. At the same time you could say, “Why do they, then, need a sandbox?” That is a legitimate question. If you’re a really big company why do you need a sandbox? It could be that you’re just not permitted to do something under current regulation. It’s not that you need the sandbox to fund you. You just need the sandbox to create an open space to operate so that the regulator can consider whether regulations need to be amended to permit a certain activity by a non-bank.

In contrast to Hong Kong, in Singapore the regulator permits financial institutions and fintech companies. In Malaysia, the regulator permits banks and fintech companies that are partnering with banks and other incumbents, as well as fintech companies that would be money remitters and I think that’s it. Separately from the sandbox in Malaysia they’ve set up regulations for crowd funding, for P2P lending. They’ve carved that out of the fintech sandbox in Malaysia.

That difference of approach of who’s allowed in the sandbox makes them look very different. What is the outcome? Will you see much more activity in Malaysia and Singapore because they have a broader potential pool of applicants? We don’t know, but I think most people think that the answer is yes, that the framework in Hong Kong is really going to hinder small startups from being able to introduce innovations.

Kate, in your opinion how big a role should regulators play in terms of creating competition within the fintech space for financial inclusion? Should a regulator take an active role in terms of ensuring interoperability amongst different mobile payment services? Is there something to be said for not allowing too many entrants in so that players who are already in the financial system operating these services can actually have a sustainable business? What’s your opinion on what role regulators should play in terms of creating a healthy marketplace for financial inclusion?

Okay. This is a very tricky issue. Of course, competition depends on market participants being interested in serving a market, which is always a challenge when you’re talking about serving poor people. Let’s just talk first about interoperability, and maybe even specifically interoperability that involves mobile network operators because this is really something quite new. Just historically, payment systems were set up. They were private arrangements between banks. Then non-banks started entering into these private arrangements. Increasingly over the past 20 years we’ve seen countries adopting payment systems laws, and under those laws regulations, and then starting to oversee retail payment systems and saying, in some cases, regulating, basically, fees to ensure that retail payment systems that are powerful in terms of their ability to capture the markets. You might have major banks who set up a payment system and keep everybody else out. They enable payments between the participants, but they don’t permit others to enter, or they charge very high fees.

You see in some countries that regulators have said, “That’s not fair. Your fees are too high,” or, “Your criteria for participating in the payment system are too onerous, and you’re doing that, and it’s anti-competitive. You need to revise your rules to broaden that.” That’s an example of a regulator stepping in to say, “You’re hindering competition and you have to do certain things to increase interoperability.” Then the question is, what should happen? Should the regulator do that same thing when you have an even broader circle of providers such a MNO’s? We’ve seen-

Mobile Network Operators.

Mobile Network Operators. We’ve seen regulators try to do that and pass rules saying, “You must interoperate,” and nobody does anything because there’s not a business case for doing that, either because the technologies are quite different, so there isn’t actually technical compatibility between the systems. You have MNO, mobile network operators, that they don’t have their own accounts with the central bank, so they can’t actually settle, but they clear between themselves. To bring those mobile network operators into a system that includes banks can require both the banks and the mobile network operators to change their technology system, so it’s costly.

Should the regulator do that? If the regulator sees that the banks are keeping the mobile network operators out of a part of the business that, for an example, serves the poor? I think the answer depends on where you are in the development of a certain market. Again, do you have dominate players who are keeping others out, creating a market that does not serve a segment of the population? If the answer is yes, I think there’s a good argument for saying the regulator should step in. Again, what teeth does the regulator have? Should the regulator be specifying what the fees are, what the technology is? It’s really quite challenging, and there aren’t good examples of regulators doing that effectively.

What we have seen is collaboration between the private sector and regulators to come up with solutions. For example, in Tanzania there are four mobile network operators. They are all now interoperable between themselves, but not with the banks. They talk to each other, but, actually, they have an arrangement which is, basically, bi-lateral agreements between the four. There are a total of six agreements.

That was done voluntarily?

It was done voluntarily with the encouragement and the participation of the central bank. The mobile network operators saw the benefit to them of having an expanded market if they were to work together because their customers wanted to be able to make payments and transfers to customers of each other. They wanted interoperable services, so the central bank helped and facilitated certain discussions. Actually, the arrangement is good for now, but it’s a little bit limited because the way that it works, in order to effectively clear payments is that each mobile network operator has to have an account with each other mobile network operator. That account holds funds that ensure the payments made between the two mobile network operator’s customers can clear. As the volume of payments, the total amount of payments goes up, that solution, that technical solution probably won’t work over time as there’s too many transactions and too much money flowing because they’ll always have to top-up those balances, and, ultimately, will not be willing. For the moment, for the markets that they’re serving, that is a beneficial arrangement, and that was something that was done in collaboration.

Kate, before we let you go maybe we can ask you to speculate a bit or forecast into the future. Where do you see the most potential for fintech in Asia over the next decade?

The first thing is that when you look at the people who generally don’t have access to financial services, whether it’s an account or savings or credit or insurance, over 50% of the two billion excluded reside in Asia. Asia’s a really important market for just changing the global picture on financial inclusion. Then if you look at Asia, about 20 countries, and you look at the variety of situations today in Asia. You have the very large fintech providers in China. They are providing, primarily, payments, but also access to credit. Then you look at what’s happening in India where you have the “India Stack” with the use of the unique ID and biometrics. You see the government very involved in trying to build an entire infrastructure where excluded people have access, not just to accounts, but the range of financial services.

I see incredible potential in both countries, but for different reasons. I guess in China, they’ve recently adopted regulations to address certain crises that they’ve had related to fintech. The peer-to-peer lending platforms and the fraud that was involved. Then they adopted regulations quite recently, but I think that most of the innovations in China are around these payments and credits. It’s less the technological innovations like what you see in Silicon Valley than business models using certain technology but really fine-tuning the customer end of to.

What do I see in the future? I would hope to see, first, in India a real take off from the India Stack, bringing in people mostly by mobile phone. If that were to change, as I said, the global picture, that would really be significant just because of the numbers of people living in India. We also see in many countries in Asia that the uptake of fintech products is low today. You can see regulators working really hard, for instance in the Philippines, which is one of the places where that had one of the first e-money issuer. The use of e-money in the Philippines is still quite low.

Even if people create these services, they’re not necessarily being used right away.

Right. In the Philippines, for example, where it’s a country of islands, you would think that fintech would offer great opportunity for rural populations who can’t get to banks and they can’t get to the brick-and-mortar. Then the question is, “Why isn’t this taking off?” Actually, when you see much more in the Philippines is the use of the microfinance banks and other banking, like small banking options as opposed to the fintech. I don’t know if there’s an answer right now as to why those things aren’t taking off, how much of it is just a cultural issue. Over the next 10 years, we’ll see people who get much more comfortable using technology instead of having face-to-face interactions to deal with their financial transactions. I think that many of the countries in Asia, it’s just a big question mark right now, how quickly there will take-up.

But it’s also incredibly complex, right? There’s convenience to mobile money and digital transactions, but there’s also in countries where people maybe don’t normally pay taxes on their income or they avoid sales taxes sometimes. If you’re being tracked electronically using these fintech services, then maybe it’s not convenient.

That’s right. I think we see in some countries where they know that they’re getting pulled into the formal system anyway. Whether it’s because of the unique ID, maybe that. The fear of taxes is definitely what keeps people in the informal system, and we see that in every country. Yeah, it will interesting to see whether people, once they have the light shown on them, whether they’ll be then more inclined to use formal services.

Great. Thank you so much.

Thank you.

Thanks for joining us.

Thank you. It was a pleasure.

We hope you enjoyed today’s conversation with Kate. For more episodes like this you can find us on iTunes, Google Play and Stitcher. For even more content look up our Pacific Exchange blog, available at FRBSF.org. Thanks for joining us.