NEW YORK (Thomson Reuters Regulatory Intelligence) - Financial regulators across the globe face an enormous challenge keeping pace with the rapid evolution of technology affecting finance, financial products, and markets. Equally challenging is the need to apply rules, laws, and compliance and oversight associated with the financial industry at a time of rapid technological change.
Evidence of this is the rapid evolution and acceptance of bitcoin and blockchain. The U.S. Commodities Futures Trading Commission (CFTC) has been at the forefront of U.S. financial regulators in the engagement with financial technology -- ‘fintech’ -- companies that are seeking to alter the landscape.
As the CBOE Futures Exchange and the CME Group launch trading of bitcoin futures contracts, the CFTC, in allowing trading to begin, sent a message that the regulator is not going to stand in the way of technological change and innovation. However, the derivatives regulator also said it was not explicitly endorsing the bitcoin, and retained authority to intervene and set new requirements.
Regulators in the U.S. are taking a different approach to this technology innovation challenge than their international counterparts. The UK and several other international regulators have taken what is commonly known as a “sandbox” approach where technology innovators can collaborate and communicate in a “safe space” to test and eventually enter the financial services market with some degree of regulatory oversight and support.
In the United States regulators have not gone as far as to create formal sandboxes. However, some have encouraged fintech innovation through other initiatives. One of these is the CFTC’s fintech initiative known as “LabCFTC.”
Unlike the sandboxes, LabCFTC does not offer a regulatory structure for innovation. What it does provide is a forum for fintech firms to discuss their efforts with CFTC specialists, and for the agency to start educating market participants on fintech developments.
Below is a review of LabCFTC and its differences from international sandboxes. Included is a discussion by the LabCFTC director in a recent Georgetown University Law Center paper on the agency’s blueprint regarding regulatory engagement with fintech innovation.
SANDBOX VERSUS LAB
The CFTC announced in May(here) the creation of LabCFTC, an initiative aimed at helping to "bridge the gap" in promoting responsible fintech innovation to improve the quality, resiliency, and competitiveness of the markets the CFTC oversees. LabCFTC is also tasked with accelerating CFTC's engagement with fintech and regulatory technology "regtech" solutions that may help the CFTC to carry out its responsibilities more effectively.
The “sandbox” concept was taken from the world of software development, in which a sandbox is a tool that allows developers to test a proof of concept prior to a full-scale public release. This allows a firm to amend and improve a product based on feedback and before it has invested significant costs in the project.
The sandbox regulatory approach allows fintech startups to launch products on a limited scale to actual customers without incurring the large regulatory burdens and cost that they would otherwise face.
This controlled environment makes it easier for innovators and startups to navigate the often cumbersome regulatory process. Additionally, successful testing and cooperation with the regulator of new products helps later efforts to raise capital for a larger scale launch of the product.
Most importantly, sandboxes involve the regulators from the onset. The UK’s regulatory sandbox started in May 2016 and regulators across the globe have followed with similar frameworks. There are now regulatory sandboxes in Abu Dhabi, Australia, Canada, Hong Kong, Lithuania, Singapore, Switzerland and Thailand. The European Union recently set out proposals for a possible EU-wide regulatory sandbox as well.
THE UNITED STATES IS DIFFERENT
There are two significant differences between the United States and the rest of the world which perhaps are the key obstacles in creating fintech sandboxes. First, in the United States there are multiple financial industry regulatory bodies, such as the CFTC, the Securities and Exchange Commission, the Financial Industry Regulatory Authority, and a host of banking agencies and state regulators. In the UK, in contrast, there is one central regulator, the Financial Conduct Authority (FCA).
Second, there is no certainty that if a U.S. sandbox were in place that participants would be shielded from consumer class-action litigation. There is, therefore, “an absence of trust, which has become an impediment to promote new ideas and innovation in the U.S. financial sector,” according to Subas Roy, President of the International RegTech Association (IRTA).
Roy asserts in a white paper(here) titled "RegTech in the USA: the state we are in," that financial regulators including the CFTC need to clarify their intent with innovation in regtech.
“They will be expected to take the initial role of creating an innovation zone, asking the banks and regtech innovators to come together and work collaboratively for joint purposes including, financial inclusion, digital identity, smart reporting, automated and real-time compliance,” Roy says.
Regulatory sandboxes are not only of interest to startup firms. They have potential benefits for established firms that are looking to launch innovative new products that do not fit easily within existing financial services regulation. Sandboxes are also considered beneficial to the regulators in that they help the regulator keep pace with innovation as it is occurring rather than playing catch up.
In the United States the CFTC with its LabCFTC launch has taken a step toward a regulatory framework for innovation, but stopped short of a sandbox. Similarly, the Office of the Comptroller of the Currency (OCC) has proposed a system designed to promote innovation while protecting the public. In March 2017, the OCC introduced a draft supplement fintech licensing manual(here), for companies seeking to conduct banking activities that meet bank charter standards. The OCC is seeking to provide a structure to allow for these companies to continue to provide those services while receiving oversight to protect consumers, businesses and other participants.
LABCFTC DIRECTOR OFFERS BLUEPRINT
A recent article by the LabCFTC Director Daniel Gorfine(here) detailed the fintech landscape and provided a comprehensive overview of LabCFTC's model for regulatory engagement with fintech innovation. Gorfine also outlined the core components of LabCFTC and detailed some current and pending projects where the agency seeks "to build a modern 21st century financial regulator."
The first component is what the CFTC calls its “Guide Point.” This is a dedicated point of contact for fintech innovators to engage with the CFTC, learn about the CFTC’s regulatory system and receive feedback. “Guide Point is also the conduit for innovators to identify potential friction or uncertainty in existing rules that may, if appropriate, be addressed by working with our colleagues across our divisions to leverage proper regulatory tools, including no-action relief, guidance, or rulemakings,” Gorfine said in the report.
“CFTC 2.0” is the second component, aimed at helping the CFTC learn about and test new technology with the potential to help the CFTC itself keep pace and be a more effective and efficient regulator. “While U.S. regulators do not currently appear to have the same ability or authority to engage in certain sandbox or proof of concept trials as do our counterparts in other parts of the world, we will continue to explore all avenues and regulatory tools that permit us to ‘kick the tires’ and truly understand emerging technologies and systems,” the report said.
“DigitalReg” will help the CFTC identify and develop regulatory tools, approaches, and culture that promote market enhancing innovation and satisfy key regulatory objectives. It will also serve as an internal resource to help educate CFTC staff on fintech-related developments.
LabCFTC has already began engagement efforts with technology firms and innovators. It has held more than 100 such meetings and has plans to hold more in 2018. There will also be prize competitions held in 2018 which “may involve, for example, novel ways to use or share data, make our rules machine readable (i.e. develop a “robo rulebook”), or build a more dynamic, digital, and “smart” notice-and-comment platform.
Through LabCFTC the agency has also conducted investor education and information projects such as a primer on virtual currencies(here). More such efforts are planned for the future.
Fintech innovation covers a broad spectrum of financial services and markets ranging from capital markets, trading and market infrastructure to retail banking and wealth management. Although one would assume Gorfine’s and the CFTC’s emphasis would primarily focus on the trading and market infrastructure it regulates, the overarching objective of LabCFTC is broader.
CFTC Chair Christopher Giancarlo placed LabCFTC within the general counsel’s office so that it could “manage the interface between technological engagement and innovation, regulatory modernization, and existing rules and regulations,” the report said. Gorfine said the initiative is intended to make the CFTC more accessible to fintech innovators and to inform the CFTC’s understanding of emerging technologies.
In a "CFTC Talks" podcast (here) interview last month Gorfine asserted that LabCFTC, as with sandboxes, allows for the development of innovation and will drive rapid adoption. He also cites the CFTC's efforts to engage with innovators through outreach efforts, programs to solicit feedback, and other guidance related initiatives.
Allowing of bitcoin futures to commence trading, along with the CFTC’s creation of LabCFTC and outreach efforts in the areas of fintech and regtech send a message of openness to technological change and are steps in the right direction to engage the U.S. regulatory agencies with technology innovators.
Although U.S. regulators may be seen by some in the industry as lagging international sandbox efforts, the steps it has taken move in the direction of promoting fintech innovation.
(Todd Ehret is a Senior Regulatory Intelligence Expert for Thomson Reuters Regulatory Intelligence based in New York.)