By: Sarthak Sethi
Introduction
Financial regulation is at an inflection point; the exponential pace of the development of technology continues to disrupt incumbent financial institutions, and the larger systems these institutions form constituting elements of. The deployment of big-data analytics, API Software, and improved credit-risk assessment hold potential to not only make financial services cheaper, more efficient, and more malleable to dynamic market forces, but to extend the transformative reach of global financial systems to previously untouched, marginalised populations. The examples listed are only a fractional illustration of the diverse changes financial service markets are currently experiencing; future tectonic shifts cannot be perceived by forward-looking regulators.
India’s financial regulation system is relatively nascent, and its fintech regulation system is effectively non-existent, other than a scattered, incohesive acknowledgement of the changing attributes of financial markets. While subsequent sections of this paper attempt to identify the elements of an ideal regulatory framework, and consider whether the cohesion of a fragmented regulatory network is necessary, or possible, it is essential to state that to create an economic environment that fosters fintech innovation, it will be essential for Indian regulators to adopt a proactive approach. Financial service providers are severely burdened with high regulatory compliance costs. The elimination of bureaucratic uncertainty or inconsistent policy can result in compounded, long-term benefits for fintech institutions, as has been demonstrated by the United Kingdom, which was an early-mover in this process.It implemented legal systems that not only acknowledgedfinancial technology, but created fertile ground for their viable proliferation.
This paper, placed in an Indian context, attempts to navigate the challenges of fintech regulation, and how such regulation can be optimised to foster innovation. It must be primarily recognised however that this paper makes a pragmatic case for the implementation of viable regulation, by recognising the bounds of regulation itself. A regulatory system that gives primacy only to the ideal of promoting innovation is inherently problematic. If the higher-order priority is development of financial technology, then the more economically efficient model would be a complete absence of regulation. The enforcement of regulation inherently implies a focus on the promotion of competition in markets, protecting consumers against exploitative practice, and most significantly, maintaining financial stability. Effective regulation must give primacy to the policy objectives inherent to the concept of regulation itself. Understanding this condition, this paper constructs a regulatory framework that promotes innovation while assuredly maintaining financial stability, and protecting consumer rights. The intrinsic purpose of regulation is the first bound on regulation. The second bound on regulation is a pragmatic acknowledgement of the perennial limitations of regulation, irrespective of jurisdiction or subject-matter. These include limited availability of technical, monetary and human resources. This paper, in cognizance of the de facto external limitations of Indian regulators, does not attempt to create an idealistic check-list of regulatory mechanisms. Rather, by identifying the relative importance and cost-efficiency of specific mechanisms, it advocates for pragmatic fintech scholarship that maximises regulatory interests.
Foundational Principles
To identify the appropriate regulatory tools to create a balanced legal framework for fin-tech, and to assign relative importance to different mechanisms, an identification of the guiding principles of the regulation as a whole is crucial. The overarching objectives of the regulators must lend to the selection of specific provisions, creating synergy between regulatory goals, and the regulation itself. This paper recognises the “first-principles” of fintech regulation, and uses them to derive the specific form of the framework.
A. Flexibility
The first, and arguably most important principle is flexibility. Technological innovation, and scientific research, operate on the principle of compounded knowledge – Incremental advances result in increasing rates of gain, such that each additional improvement or development adds geometrically, not linearly, to overall development. A manifestation of this phenomenon is computing; as costs of computing simultaneously fall non-linearly, our computing prowess is compounding at an exponential rate. This phenomenon itself compounds at a greater scale – higher computing power at lower costs enables the development of technology that was previously unviable. Financial services, and financial markets are inherently dynamic. The combined effect of dynamic markets with the rapid-evolution of technological systems creates a highly complex, inter-connected environment that constantly extends to greater degrees of complexity and interconnectedness. With such inherent systematic uncertainty, regulators designing forward-looking legal frameworks are setting themselves up for regulatory failure. This failure arises because regulators construct forward-looking regulation by attempting to model future development through the lens of the current technological reality. However, by virtue of compounded, exponential change, regulators cannot perceive the way fintech will evolve. How do you regulate effectively, when you cannot accurately forecast what it is that requires regulation? Recognising the pragmatic limitations of regulation in unpredictable environments ultimately leads to the development of more viable legal frameworks in the long run. Therefore, one guiding principle for fintech regulation is structural flexibility– regulation cannot be prescriptive. Prescriptive provisions are anchored to the regulator’s belief in a speculated future reality. Financial markets, and scientific progress, are the products of random change. Prescriptive regulation accounts for detailed nuances, which is beneficial in a technological vacuum, but highly fragile to the fast-moving winds of scientific change [1]. Therefore, an ideal regulatory framework for fintech must be flexible, granting regulatory bodies with the legal mandate and autonomy to robustly adapt regulation to dramatically changing market conditions. However, it is important to be cognizant that absolute flexibility can result in non-cohesive, ad hoc regulation. Therefore, this paper roots the abstract idea of flexibility in more structured, tangible principles.
Adaptability is linked to the second principle, which is multi-sectoral regulatory coordination. The creation of a singular entity vested with complete authority for the governance of fintech has lower information-costs, and has the advantage of being a singular point of contact. While such a centralisation of regulatory authority sounds ideal and cost-efficient, it is inherently flawed. Financial regulation is compartmentalised on the basis of institutional function – The Reserve Bank of India is the banking sector regulator, the Securities and Exchange Board of India regulates the securities and commodity market, and the Insurance Regulatory and Development Authority regulates insurance in India. The statutory creation of a singular body for fintech regulation operates on two flawed assumptions. Firstly, it presumes that the legislature can identify and adopt a valid definition of fintech activity. However, as identified in the previous paragraph, the volatile growth of financial technology implies that any definition will be restrictive, and prescriptive, violating the first principle. Moreover, the second assumption in the creation of a singular regulatory body is that fintech activities can be separated from conventional financial activity, or incumbent financial institutions, which a range of regulators are already statutorily mandated to govern. Assuming that it is viable to construct a distinctly separate body for fintech regulation ignores the reality of our financial markets– Incumbent institutions are rapidly adopting financial technology, and technological innovation is integrating into, and simultaneously re-orienting, financial services. Constructing a distinctly original regulatory authority for fintech would require the creation of a legal mandate that directly clashes with the regulatory jurisdiction of incumbent regulators. The alternative is the creation of multi-sectoral, activity-based regulatory coordination. Financial Conglomerates are increasingly offering bundled-financial services, covering a range of financial activity. The need to engage in coordinated financial governance has already been recognised in an Indian context, with the Financial Stability Development Council accepting a proposal to create the Inter Regulatory Forum. Moreover, financial technology frequently breaches conventionally accepted sectoral boundaries, creating a requirement for cohesive legal intervention. The phrase “activity-based” regulation is emphasised here. An emerging trend is that incumbent financial institutions, such as banking organizations, which tend to be heavily regulated and are subject to credit-controls and liquidity requirements, are at an economic disadvantage. Smaller entrants categorised as non-banking organisations, while offering specific banking-related services, such as deposits, are at a regulatory advantage. This phenomenon is known as regulatory asymmetry. Encouraging innovation in the market requires regulatory consistency. Larger financial institutions are capital-heavy, with highly-penetrative distribution systems and strong consumer goodwill. A disproportionate regulatory burden on such incumbent organisations is a disincentive from innovation. This disincentive however, arises because our current regulation is charter – based. This means that companies are regulated based on their legal form. Not only does charter based regulation selectively place a greater compliance burden on some firms, but results in other firms escaping scrutiny by virtue of their size or structure. Clearly, a shift is required where specific categories of activities are regulated, and categories are assigned to regulators based on their mandate, with the larger spirit of coordination.
It has been interestingly articulated by Hillary J. Allen that the presumption of all innovation being good innovation is a dangerous idea. Extending this argument is the idea that such a presumption, of all innovation being inherently desirable, is a short-termist approach that actually damages innovation and growth in the long run. Unregulated innovation that results in limited contestability and competition, or severely infringes data security of systems, is likely to result in reactionary regulation that is disproportionately stringent, diminishing long-run innovation through restrictive compliance requirements. A more sustainable short-term approach, and one that still proactively encourages innovation in the long-run, is of reconciliation. Reconciling fintech with other domains of law, such as cybersecurity, data protection, or antitrust requirements can be the foundation for encouraging healthy engagement between fintech companies and regulators. This is necessarily a short-term principle. As has been emphasised before, it is inflexible and inefficient to ascertain the long-term interactions between financial technology and other domains of law. In the short term however, we are validly aware of the potential negative effects fintech can have on cybersecurity, or competition law. For example, there is increasing vulnerability to cyberattacks. The RBI, in its report of the Working Group on Fintech and Digital Banking, also suggested that a stand-alone privacy or data security law will be increasingly important as fintech market share increases. This parallels the larger point about intersecting fintech with diverse legal domains to create a sustainable trajectory of innovation and growth. Another illustration of this effect is the sphere of competition law – there is hope that growing financial technology diminishes barriers to entry, debundles services and challenges incumbent institutions, all of which would promote competition. Simultaneously, the introduction of BigTech, and increasing complexity in technology could result in rapid concentration of market power by high-capital institutions that create artificial barriers to entry. It is outside the ambit of this paper to argue the degree of probability of either of these directions. Rather, this paper argues that irrespective of the effect fintech has on market structure and contestability, it will be prudent to reconcile legal systems for fintech with larger antitrust principles and ideas.
The second-half of this paper lays heavy emphasis on the specific, economically efficient tools that must be adopted by coordinated Indian regulators to rapidly foster innovation, and create systemic change for financial inclusion in India. However, it is prudent to recognise that proactive steps to boost innovation can result in regulatory capture. While this should not deter any proactive steps, regulators can benefit through active cognizance of the regulatory capture phenomenon. Frequently, limited capacity, and a shortage of high-skilled human resources results in regulators becoming heavily reliant on the financial industry for technical knowledge, and information. As the source of information on which analysis and policy is based is the industry itself, regulatory perception of market conditions can become biased towards the industry, adopting the worldview of industry participants. This is regulatory ‘capture’– unintentionally, policymaking is no longer from a neutral, third-party perspective. This analysis can be extended even further when linked to the idea of the regulatory sine curve, which graphically indicates the regulatory response to financial crises. Regulatory scrutiny and public pressure peaks after a financial crisis, and then diminishes. The reduction in regulatory scrutiny, and a stabilisation in rules, ultimately paves the way for a new financial crisis that regulators did not perceive at all. Promoting innovation leads to rapid development of new, cheaper financial services that are more inclusive, making regulators feel as though there exists a diminished need for regulatory stringency and scrutiny. This period of regulatory optimism is precisely where regulatory capture is highest, and the seeds of future financial crisis are sown. Therefore, this paper advocates that when innovative improvements are at their peak, and financial optimism is highest, is exactly when regulators need to introspect for the possible regulatory capture, emphasising the dangers of the regulatory sine curve. Overall therefore, regulators must proactively promote innovation. However, to do so sustainably, flexibility and coordination is needed, allowing for regulators to constantly re-evaluate the effects of policy, such that they prevent potential financial crises that are induced by regulatory complacency. Affirming the foundational principles of healthy regulation, subsequent sections will now focus on the idea of innovation, and how specific tools can help transform financial technology.
The process of promoting innovation is not accidental. Conventionally, financial services require dense regulation. If such regulation can be formulated to consciously create an environment that boosts innovation, while balancing other regulatory demands, such as systemic stability, then economies can strongly benefit from creating more nuanced technology. A number of regulatory tools are considered below, including sandboxes, innovation hubs, ‘SupTech’, capacity building, as well as a comparative study of jurisdictions that have been most efficient in encouraging fintech development.
A regulatory sandbox is a narrowly defined market, on geographical or activity based terms, which partly or wholly suspends regulatory systems for specific business organisations, within the defined market. This allows for approved companies to test products, obtain feedback for developing technology, and scale projects without high compliance costs, or incompatible regulatory rules. ‘Regulatory sandboxes’ have effectively become a signalling tool for regulators – The presence of a regulatory sandbox is deemed to reflect a pro-innovation regulatory standpoint to firms and investors, irrespective of the efficiency of the sandbox within itself. Firstly therefore, it must be acknowledged that in the status quo, regulatory sandboxes have potential as a useful signal to startups in India, or looking to invest in India. In fact, regulators have recognised this, with the RBI, SEBI and the IRDAI having already instituted sandboxes. Sandboxes have a cross-effect, as when smaller companies have access to markets without having to obtain licenses, and operational requirements, they are able to affordably gain market feedback, as well as create presence in the market. For the regulator, they are a compressed, yet dense source of information about market fluctuations. It is inevitable for regulatory sandboxes to proliferate and increase in frequency; they are the most commonly recognised symbol of financial technology regulation. It must be recognised however, that they are high-cost mechanisms to implement. It is pragmatic to acknowledge that Indian regulators are bounded by monetary limits, and therefore a system that wishes to promote innovation beyond just a prima facie level must acknowledge the cost-efficiency of regulatory sandboxes. Regulatory sandboxes are most useful when there already exists a flourishing startup ecosystem, and the sandbox is a point of leverage that existing businesses can harness to reach a point of market-delivery. India has pioneered several fintech technologies, particularly in the context of payment systems. Holistically however, our fintech ecosystem is nascent relative to economies like the United Kingdom or Hong Kong, reducing the likely effectiveness of regulatory sandboxes. By acknowledging the limited upside of regulatory sandboxes in the Indian economy, regulators can employ other tools, such as Innovation Hubs and SupTech in a more cost-efficient manner, ultimately creating a pro-innovation ecosystem tailored to India.
An innovation hub is a system or platform through which companies can gain access to regulatory authorities and supervisors, seeking advisory opinions, explaining innovations and questioning the integration of future technology with current regulatory provisions. This is inherently less resource intensive than regulatory sandboxes, which require the construction of an artificially restricted market or region, within which regulation is to be suspended. Moreover, the direct suspension of regulation, even if it is for a restricted period of time, in a vacuum, can result in startups developing products based on the regulatory vacuum, which will not exist outside of the sandbox. An innovation hub, by virtue of primarily being a communication channel, can simultaneously serve a very large number of fintech firms, especially those that are very small, have limited funding, and have not yet reached product-market fit. Statistics from Australia mirror this observation. The Australian innovation hub engaged in communication with 380 organisations, while its regulatory sandbox could only sustain 6 organisations. Other than cost-efficiency, this variation arises because regulatory sandboxes have higher entry-standards by design, as real consumers are tangibly affected. Historically, sandboxes have developed out of innovation hubs, with the FCA Sandbox in the United Kingdom being preceded by an innovation hub. Similarly, the Australian securities regulator (ASIC) derived a sandbox programme from its innovation hub, indicative of the idea that innovation hubs have been intuitive channels set up by regulators, across jurisdictions. It can be derived therefore that sandboxes are particularly useful in communicating the message of proactive regulatory openness. In terms of distributing advice, directly collaborating with fintech companies, boosting competition, and learning for regulators themselves, innovation hubs are more effective. In the pragmatic reality of regulatory limitations that this paper propagates, innovation hubs are more cost-efficient as well. With the same budgetary allocation therefore, innovation hubs can access a wider range of fintech innovation and organisations, improving a regulators probability of drafting better policy, and identifying financial stress-points by virtue of access to better data, quantitatively and qualitatively. Ultimately, the most efficient use of regulatory resources is to create a regulatory sandbox to signal ease-of-business to the market, while giving primacy to the development of innovation hubs.
An entirely alternative mechanism in the paradigm of fintech regulation proposes a methodology that promotes innovation through direct emphasis on regulatory goals themselves. This methodology is classified as ‘SupTech’, where supervisors themselves actively experiment with technological systems and processes to innovate in a manner that regulatory goals are solidified. This methodology is nascent; while the Financial Stability Institute identifies that over twenty jurisdictions have already initiated SupTech, the degree of capital investment, monetary and human, is largely fragmented, with heavy variance. Currently, most SupTech innovation is currently linked to regulatory experimentation with data, in attempts to detect fraud, or enhance reporting requirements. The Indian regulatory landscape can take advantage of this, and establish an early-mover advantage in SupTech policy, similar to the United Kingdom’s early experiments with regulatory sandboxes. Irrespective of the benefits to India’s financial regulatory image, SupTech within itself can transform our ability to balance innovation with larger demands of financial stability. An interesting observation was made in the Journal of Law and Innovation– if regulatory processes are business-driven, such as regulatory sandboxes, then it is likely that the innovation process primarily benefits the innovator, which is markedly different from creating benefits for consumers, or markets as a whole. Business-driven experimentation programmes can allow for exploitation of underequipped consumers, under the facade of “improved financial inclusion”. SupTech scholarship goes on to argue that experimentation models like a regulatory sandbox, by centering business organisations, create a dangerous moral hazard problem. Sandboxes do not necessarily orient fintech companies to future regulation, as is assumed. They foster environments of deregulation, suspending protective policy and market stability, which has potential to induce tangible harm to consumers. The idea that sandboxes are tangibly dangerous to consumers is misplaced, as they are designed to be geographically, or demographically, strictly restricted and monitored. However, there is validity to the idea that they foster deregulatory thinking in fintech companies, making future cooperation and compliance more unlikely by lowering their expectations about the degree of scrutiny they will be subject to. This narrative indicates that the drawbacks to a sandbox-experimentation approach are unacknowledged, and regulators may benefit from the adoption of alternative mechanisms.
The most powerful alternative is SupTech. Innovator-based models facilitate the process of reconciling industry and regulatory demands, but are largely deficient in aiding regulators in the furtherance of specific regulatory goals, such as financial stability, or consumer protection. SupTech is the development of financial technology by regulators, in pursuance of improved market conditions, and the fulfillment of their regulatory mandate. Machine learning, big data and artificial intelligence aid regulators on two counts of regulation. Firstly, in-house experimentation is not attached to the risk of profit-driven innovation, while still allowing regulators to comprehensively understand the specific processes involved in fintech development. Secondly, in-house experimentation allows regulators to directly harness scientific development into creating products that enhance consumer rights. India has already demonstrated the capacity to engage in such product development; the Unified Payments Interface was created by the RBI and the National Payments Corporation of India, and has been tremendously successful.
Applying Nicholas Taleb’s principle of randomness [2], this paper identifies that financial technology experimentation by the regulator itself can create unforeseen efficiency through application of such in-house technologies on prudential regulatory operation. It is inherently difficult to predict the specific direction that compounded knowledge will take in improving conventional regulatory functions. We already see glimpses of this phenomenon however, with regulators using machine learning in market stress-testing, allowing for more sophisticated computational power to be combined with human experience. Central banks are increasingly integrating tailored artificial intelligence into their core functions, redefining the accuracy and reliability of forecasting and risk-determination models. SupTech remains bounded by the regulatory limitations identified in the introduction of this paper, the most pertinent of which is limited monetary resources. Despite SupTech being resource-intensive, it provides regulatory autonomy in the innovation process, and has a higher ceiling for long-term returns. This argument does not oppose industry innovation at all, but argues that when regulators make active expenditure, SupTech must be assigned higher weightage than regulatory sandboxes.
Underlying all proposed suggestions for Indian regulation in this document however, is a challenging presumption. For effective enforcement of a well-coordinated, flexible, activity-based legislation, with optimum resource allocation between innovation hubs, SupTech and sandboxes, is the core idea of capacity-building. Globally, financial watchdogs have recognised an urgent threat. As technology becomes increasingly complex, and highly-specialised human capital is needed to understand the development of these complex digital ecosystems, regulators find themselves facing the risk of incompetency. Irrespective of the ultimate approach adopted by regulators, effective policy can only be conceptualised, and implemented, by trained, experienced individuals that understand the intersection of finance and technology. India is relatively slower in the adoption of complex technological ecosystems, especially in finance, giving our regulators a brief window of time where capacity building can be prioritised. A lack of well-adapted, yet experienced personnel is both a cause and effect of the perennial regulatory limitations identified in the first section; a vicious cycle that breeds regulatory incompetence. Ultimately, if the Indian economy wishes to capitalise on a potentially transformative wave of financial technology to create credit growth and improve financial access, it will have to specifically prioritise capacity building. This will require resource allocation, and the development of indigenous programs investing in talent-development. While capacity building is a tedious process, attracting little public or commercial appreciation, it is the foundation of a healthy, and sustainable regulatory framework, and a central recommendation.
The challenge for financial regulators is not to promote innovation, but to do so sustainably, while maintaining larger systemic stability, preventing concentration of market power, and furthering consumer interests. To successfully formulate fintech regulation, it becomes essential to recognise the limitations of regulation itself. Only upon acknowledging the limited resource capacity regulators possess to supervise uncertain and dynamic market conditions, can we reasonably work towards conceptualising a cohesive policy framework. This paper advocates a top-down approach, where central principles trickle down in the selection and implementation of specific mechanisms. These core principles require fintech regulation to be flexible, well-coordinated and inter-sectional, fulfilling the idea that long-term innovation is sustainably achieved when balanced with systemic stability. Embodying these principles, and the realistic bounds of regulation, regulators must first converge around the idea of capacity-building, using it as a foundational springboard for the creation of innovation hubs, and SupTech research. Regulatory sandboxes must be recognised for their utility as a market-signaling tool, and can be combined with grants and no-action letters to aid live-experimentation. The pro-active merger of private innovation and governmental caution will allow India to develop a global fintech hub, extending forward the liberating hand of financial services to more individuals than ever before.
[1] Nassim Nicholas Taleb, Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets, (2001, Random House) 81
[2]Supra, Note 11.
(Sarthak is currently a law undergraduate at West Bengal National University of Juridical Sciences. The author may be contacted via mail at sarthak219092@nujs.edu)
Cite as: Sarthak Sethi, ‘Financial Regulation in Fintech: A Bounded Regulatory Approach to Promoting Innovation in the Indian Ecosystem’ (The RMLNLU Law Review Blog, 10 May 2021) <https://rmlnlulawreview.com/financial-regulation-in-fintech-a-bounded-regulatory-approach-to-promoting-innovation-in-the-indian-ecosystem/> date of access
The RMLNLU Law Review Blog 