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Sandbox Regulations Framework of SEBI – Beta Testing before Releasing to the Public?

SEBI

In India, technological innovation has extended across all industries, as it is the need of the hour. In recent times we have seen a spike in innovation within the finance sector in India. Technology is creating new opportunities to deliver financial services in unique ways and lots of start-ups are leveraging on this. We now have innovative ways to make payments, access to credit, budget our finances, and many other services because of the rise in FinTech companies. Financial technology is abbreviated as ‘FinTech‘. FinTech includes a variety of products, services, technologies, and business modules that enable us to make cashless transactions. The most common examples of FinTech companies would be Paytm and GooglePay. These FinTech companies are all about experimenting and creating innovative solutions to make the financial market more accessible to people.

Regulatory Sandbox

RBI had set up an Inter-regulatory Working Group (WG) in the year 2016 and the primary function of this working group was to look into and report on the aspects of FinTech implications. This working group had to come up with recommendations, on how to respond to the dynamics of the rapidly evolving FinTech scenario. The working group made several key recommendations, one of which was to establish an acceptable regulatory sandbox structure. On their recommendations, RBI became the first institution in India to introduce a regulatory sandbox. In the following years, the Securities Exchange Board of India (SEBI) and Insurance Regulatory and Development Authority (IRDAI) introduced the regulatory sandbox through SEBI (Regulatory Sandbox) Regulations, 2020 and IRDAI (Regulatory Sandbox) Regulations, 2019 respectively.

A Regulatory Sandbox refers to the live test of new products and services. It means that if a new product or service is introduced by a company, the regulatory sandbox enables such a company to test what are the pros and cons of such products or services. This testing takes place in a regulatory environment, where the regulators (i.e., RBI, SEBI, and IRDA), innovators, financial service providers, and customers can conduct field tests which allows them to collect evidence on both the benefits as well as risks associated with the new product or services.

How it works is that the regulator specifies the criteria for eligibility for FinTech’s who will be granted access or admitted to participating in the sandbox. The regulatory sandbox would have time and scope restrictions and focus mainly on newer innovations. These tests are carried out in a confined environment under the supervision of the regulator to ensure that the tests are conducted safely.

Regulatory Sandbox in SEBI

Digital Payments

The Securities Exchange Board of India (SEBI) proposed an innovation sandbox that will test the environment where the financial market participants and intermediaries, FinTech firms, etc that are regulated by SEBI can test their proposed products, services, or business models in a controlled market and on real customers for a limited period with the benefit of temporary relaxations on certain rules and regulations. This planned innovation sandbox is being implemented in the securities market to test new technologies in a live market and create innovations to encourage customers to invest in the capital market. Advantages of the Regulatory Sandbox:

  • Live Testing Product – It provides an opportunity for live testing the product before actually launching it.
  • Limit the negative consequences – Any product error discovered during testing can be simply corrected, and any risk can be avoided.
  • Enables more innovation – It encourages more innovation by providing a stable testing environment. The testing environment provides insight into how the product or service can be enhanced, costs decreased, and so on.
  • Accessibility to retail investors – The SEBI Regulatory Sandbox also aims to ease the accessibility of retail investors resulting in greater convenience, reduced operational costs, lower fees, and transaction charges. 
  • Lower Risk – Effective supervision decreases risk while also improving efficiency and transparency.
  • Help in policymaking – Sandbox allows SEBI to observe FinTech near gain a better understanding of their technologies and business models which enables them to draft better regulations on areas that were previously unclear or not familiar with. 
  • Obtaining Information – The companies get a one-on-one oversight from the regulators and an understanding of what regulatory regimes apply to their products or services. It indicates that the company is getting some real-time data and insights from the regulatory authority which they would have never been able to access in a normal scenario. 
  • Raising Capital – Companies can raise capital during their testing period

Eligibility Criteria for SEBI Regulatory Sandbox

SEBI on July 2021 bought in some more revised eligibility norms for the regulatory sandbox. It specified that all the registered entities who are a part of the regulatory sandbox have to go through two stages.

 1st Stage – The applicant will be able to use a limited number of customers and fulfill some basic eligibility criteria to be a part of the innovation sandbox such as genuineness of Innovation, test genuine need, direct benefits to users, no risks to the financial system, testing readiness of the solution and deployment post-testing.

2nd Stage – The number of customers will increase in the second stage and the eligibility criteria to enter this stage is that the applicant should demonstrate appropriate progress, offer user input, and demonstrate the goal and ability to scale up the solution. A minimum of 90 days should be completed in the regulatory sandbox testing for the applicant to be eligible. The end of this stage will lead to the expiration of the exemption of regulatory requirements provided by SEBI. 

A maximum of 12 months is the duration of the sandbox testing stage (both stage 1 and stage 2) and can be extended upon the discretion of SEBI.

Applicability and Exemption

Only the entities registered under SEBI Act 1992 are allowed to participate in the regulatory sandbox to test their solutions. Some changes have been made in the framework by adding that an entity may either apply on its own or in partnership with another entity (which can also include a FinTech company). However, in any case, the registered entity will be considered as the principal applicant and shall be accountable for the testing. Decisions regarding the inclusion of entities not registered with SEBI, FinTech firms, or entities in the regulatory sandbox will be taken depending on the response that will be received.

One of the main aims of the regulatory sandbox is to allow the companies to test their solutions without any regulatory requirements. SEBI has mentioned in its framework to provide merit-based exemption in respect to net worth, track record, registration fees, financial soundness, and SEBI guidelines (technology risk management and outsourcing guidelines). However, the exemption will not be provided in case of investor protection, KYC (Know Your Customer) guidelines and Anti- Money Laundering rules, the confidentiality of consumer data, managing consumers’ assets, risk checks, etc. Selective Exemption can be considered on a case-to-case basis.

Risks Involved in SEBI Regulatory Sandbox

There are certain risks involved in the usage of regulatory sandbox such as:

  • In this framework, SEBI is mute on the topic of insurance and losses. Unlike the RBI, SEBI does not require the company to take out an insurance policy to cover any losses that may occur during live testing. Participants are afraid that their business model will be revealed to the public. In its 2021 regulatory sandbox circular, SEBI clarified the situation by advising applicants to enter into confidentiality agreements to protect their FinTech firms’ intellectual property, and that no claims regarding IPR of the sandbox frame will be applicable because there may be multiple solutions with similar ideas.
  • Consumer protection is also an element of the regulatory sandbox. The flaw in this structure is that no safeguards are in place to protect consumers from any damages incurred during live testing. In the event of a failed experiment, there is no mention of who will be held liable for customer losses. The guidelines state that applicants must acquire prior agreement from consumer participants stating that they are aware of the risks associated with such testing. However, the foregoing procedures should be taken to guarantee that customers are not harmed.

Conclusion

In simple terms, the regulatory sandbox is a safe space by which companies- start-ups, mature growth firms to financial service incumbents, can test their innovative products or services in a limited area. The use of regulatory sandbox by companies is going to be better for consumers also as these innovations are going to make consumers’ lives better. It can make them more financially literate, save more and get better disclosures. There may be a need for some reforms or strengthening, which regulators might address by interacting more with FinTech companies and better understanding their nature, needs, and requirements. However, this is only the beginning of a new age in the financial sector’s evolution, and the inclusion of the Regulatory Sandbox idea demonstrates that government institutions are interested in experimenting and bringing the goal of Digital India to life.

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