[By Sarthak Virdi]
The author is a student at the National Law School of India University, Bangalore.
Introduction
Regulatory Sandboxes (RS) are artificial environments used to test innovations and have been relied on in the fintech sector. The RBI defines them to be testing environments with regulatory relaxations, the purpose of which is to gauge the viability of products by estimating benefits and risks. The benefits of RS have generally been that first, they help in foreseeing the risks of emergent technologies and the appropriate legal strategies to contain them; second, they are cost-efficient methods of testing products before a market roll-out and third, they enable financial inclusion and help regulators maintain control.
The current literature on RS analyses their viability from two perspectives – first, the role of regulators as promoters of innovation or ‘opportunity-based regulation’[1] and second, the shift towards a principles-based regulation instead of a rules-based regulation.[2] However, there is a dearth of literature addressing RS in the Indian fintech market, especially in the context of cryptocurrencies. This paper fills this gap by arguing for RS for cryptocurrencies by first, taking the two perspectives to show that RBI is already operating with an opportunity-based and a principle-based regulatory approach. Second, it shows that across the RS models employed worldwide, the legalization of cryptocurrencies is not a prerequisite to promoting innovation in cryptocurrencies through RS, while protecting consumers. India by not allowing RS for cryptocurrencies and conflating the question of legalisation with experimentation can miss out on a big opportunity in the fintech market.
Regulatory Approaches
Opportunity-Based Regulation & Experimental Legal Regimes
The role of regulators is generally understood to not be one that engages in active promotion of innovation and supporting entrepreneurs, but rather one that controls market disruption.[3] RS problematize this conception by making them active participants in the creation and promotion of market disrupters.[4] The benefits of RS however make it worthwhile for regulators to engage with them. They activate and increase the inflow of venture capital while simultaneously reducing the regulatory uncertainty and risk that can arise as a result of disruptive technology. The success of RS in kickstarting innovation has been well-documented, especially in the context of the UK, where RS have increased average venture investment amounts by 6.6 times.[5]
The RBI has already made a shift towards opportunity-based regulation by promoting competition in Payments and Settlement Systems in India through sandboxes. It recognized the role sandboxes can play in promoting innovation while avoiding systemic risks. In the absence of any principled opposition to such an approach to regulation, the justification for not excluding cryptocurrencies from RS lies in a mistrust of the technology in itself. However, the question of the legality of cryptocurrency as a form of legal tender needs to be separated from the promotion of blockchain technology, for as Imelda Maher argues, competition has entered regulatory domains and the role of regulators has shifted to that of ‘steering’ from that of ‘rowing’[6] and the RBI must not miss the opportunity of experimentation.
Rules-Based Approach v. Principles-Based Approach
Strict, rule-based regimes post compliance costs that act as barriers to entry and thus discourage innovation, which is highly disadvantageous because fintech can drive growth in other industries while simultaneously addressing concerns like financial inclusion. Principle-based regulation, which implies adherence to broader principles instead of hard rules, provides regulatory flexibility which reduces compliance costs while creating a collaborative relationship between regulators and private firms. RS employ the principle-based approach, for regulators exempt them from adherence to legislation while agreeing on principles they must comply with. Principle-based regulation helps contain the disruptive effects of unanticipated innovations for it provides regulators sufficient exposure to the technology to develop a legal framework to respond to it, instead of completely distancing themselves from emerging technologies. Further, given that innovations in fintech are fast-paced, RS create temporary regulatory frameworks that can help contain disruptive effects, instead of disincentivizing innovation.
In the context of RS, the principles regulators generally require adherence to include consumer protection, market competition, and investor protection.[7] The table below summarizes the approach worldwide to show a move towards opportunity-based regulation, with regulators involved in promoting disruptive technologies, even cryptocurrencies. Further, the principle-based approach employed in RS does not lead to ignorance of consumer interests, for as shown, all jurisdictions build strong measures to protect consumer interests.
| Jurisdiction | Conditions to Apply for Inclusion in a Regulatory Sandbox | Is the regulator promoting disruptive technologies? | Is Cryptocurrency a part of the RS Program? | Legal status of cryptocurrency | Protection of Consumer Interests |
| Hong Kong | Innovative technologies need to be utilized along with an increase in the range and quality of products. | Yes | Yes | No law to regulate cryptocurrency; not accepted as legal tender. | Compensation for financial losses and the option to exit the trail lies wits consumers.[8] |
| United Kingdom | The product must support businesses in the financial services market or any regulated activity, it must significantly differ from existing products and must produce consumer benefits.[9] | Yes | Yes | Cryptocurrency exchanges are legal. | Compensation for losses and the business must prove adequacy of capital to cover the losses. |
| Australia | The product must be new in itself or an adaptation or an improvement of an existing service or product.
Applies the Net Public Benefit Test and the Innovation Test. |
Yes | Yes | Cryptocurrency exchanges are legal. | Consumers are to be compensated for losses.[10] |
| Singapore | The financial service should include a new or emerging technology or use the present technology in an innovative way while bringing some benefits to consumers. | Yes | Yes | Not accepted as legal tender, but can be legally exchanged. | Boundary conditions are to be clearly defined in order to protect consumer interests. |
| Arizona, United States of America | The product must be innovative and should be based on an emerging technology or be a reimagination of existing technology. | Yes | Yes | Not accepted as legal tender, but can be legally exchanged. | Arizona consumer protection laws remain applicable and laws relating to consumer lending are incorporated within the RS.[11] |
Lessons From Foreign Jurisdictions
This section highlights some of the practices employed by the UK, Hong Kong, and Australia that India can employ in its own RS. These jurisdictions have been chosen primarily because of four reasons, first, none of them accepts cryptocurrency as a legal tender and their RS models can be employed by India to legalise cryptocurrency exchanges, without getting into the question of cryptocurrency as a legal tender. Second, India’s financial markets are highly integrated with the financial markets of these countries[12] and RBI’s interest in cryptocurrency can draw in investment from these areas because of blockchain technology. Thirdly, even though the UK, Australia, and Hong Kong are economic giants, the success of their RS can offer lessons that India can incorporate, given their RS have been the most successful and have kickstarted interest in RS worldwide. Lastly, given that the RBI has started employing opportunity-based and principle-based regulation, these countries have already employed these models and can offer the theoretical framework for developing RS for cryptocurrencies.
United Kingdom
In the United Kingdom, the move toward RS began with Project Innovate which aimed to foster competition in the financial services market.[13] Before a firm is allowed access to an RS, it must first prove the inventiveness of its product and the consumer benefit it can produce. Further, authorised firms can be granted a waiver of rules if not doing so is ‘unduly burdensome’ for the firm. This, however, does not extend to a waiver of EU Legislation.[14] The FCA thus balances innovation and regulatory concerns by relaxing rules, while simultaneously agreeing on some crucial legislation that cannot be overlooked.
Hong Kong
The Hong Kong model of RS is unique insofar as it takes into account the inter-sectoral nature of fintech products. A firm seeking to apply for an RS, in the case that its product has impacts across sectors, can apply to the regulator is deems the best fit, including the Hong Kong Monetary Authority (HKMA), Hong Kong Securities and Futures Commission (SFC) and the Hong Kong Insurance Authority (IA).[15] This approach is different from India’s, which will be contrasted, in the next section of the paper.
Australia
While the legal framework across countries is largely similar, Australia mandates an additional test for firms in case they wish to gain access to an RS, which consists of two prongs –
- Net Public Benefit Test: The proposed financial service must address an existing problem and should contribute to enhancing consumer choice, experience, and efficiency and reducing costs.[16]
- Innovation Test: The proposed financial service must be new or different from those already existing within the market.[17]
The fine balancing act that the UK undertakes, the inter-sectoral approach Hong Kong employs and the two-pronged test Australia use can all be incorporated by India in its own RS framework for cryptocurrencies to allay regulatory concerns including legal uncertainty and consumer protection.
The Indian Experience With Regulatory Sandboxes
In the Indian scenario, SEBI and IRDAI have launched their own sandboxes. SEBI too works on a principle-based regulation mechanism, where it can relax rules for participants, except for KYC requirements, investor protection, and Anti-Money Laundering frameworks. Further, RBI’s approach to RS differs from foreign regulators, for it follows the thematic sandbox approach, where the focus is not to generally promote innovation but to achieve policy aims by promoting innovation. For instance, the products and services it welcomes into its RS include those that cater to retail payments, digital KYC, and marketplace lending, all of which relate to its policy objectives of financial inclusion and digitisation. Unlike Hong Kong, India follows a sector-specific approach to sandboxes, where firms have to apply to one regulator alone in order to gain access to an RS. While the policy-tethered and sector-specific approach may not be a problem per se, it excludes from the RS those products that may not be related to any policy objective and the legal framework seems to be unaccommodating of products that can cause disruptions across markets, such as cryptocurrency.
A Working Group (WG) that was set up by the RBI in 2016 to look into the regulatory framework for fintech proposed Regulatory Sandbox as a framework to provide regulatory guidance.[18] The WG recommended the exclusion of cryptocurrencies from among the services for which an RS would be allowed. In 2018, in Internet and Mobile Association of India v RBI,[19] the Supreme Court struck down an RBI circular asking banks not to provide banking services in connection with virtual currencies. This, however, was not a determination of the legal status of cryptocurrencies in India. The bill on cryptocurrencies which is yet to be tabled seeks to ban all private cryptocurrencies and have a single official digital currency.
While there may be concerns about the misuse of cryptocurrency that prevent its legalisation, they must be separated from the possibility of allowing firms to experiment with cryptocurrency. The importance of RS can be understood in the context of regulatory capitalism which is a theoretical framework that captures the role of the state as the constitutor of the market and as constituted by the market.[20] RS for cryptocurrencies provide avenues for the State to produce better market outcomes and for the market to change the traditional notions of regulators.
Conclusion
With crypto investors withdrawing money from India, by conflating the question of legalisation of cryptocurrency with experimenting with it, India might be missing out on a major opportunity. This paper has attempted to show reasons why the RBI must involve itself in RS for cryptocurrencies by building a case for opportunity-based and principle-based regulation. Further, it has shown how this approach has been followed worldwide without compromising on consumer interests. Further, it has summarized best practices from across the world and argued that in the context of regulatory capitalism, when India has begun experimenting with RS, it must extend the same to cryptocurrency.
[1] Deirdre Ahern, ‘Regulators Nurturing Fintech Innovation: Global Evolution of the Regulatory Sandbox as Opportunity-Based Regulation’ (2019) 15 (2) Indian Journal of Law and Technology 345.
[2] Hilary J. Allen, ‘Regulatory Sandboxes’ (2019) 87(3) The George Washington Law Review 579.
[3] Deirdre (n 3) 348, 355.
[4] ibid.
[5] Jayoung James Goo and Joo-Yeun Heo, ‘The Impact of the Regulatory Sandbox on the Fintech Industry, with a Discussion on the Relation between Regulatory Sandboxes and Open Innovation’ (2020) 6 (2) Journal of Open Innovation: Technology, Market and Complexity 43.
[6] Imelda Maher, ‘The Networked (Agency) Regulation of Competition’ in Peter Drahos (edn), Regulatory Theory: Foundations and Applications (Australian National University Press 2017).
[7] Allen (n 4) 592, 600.
[8] ibid.
[9] ibid.
[10] ibid.
[11] Paul Watkins, Evan Daniels and Stuart Slayton, ‘First in the Nation: Arizona’s Regulatory Sandbox’ (2018) 29 (1) Stanford Law and Policy Review 1, 13.
[12] Sarat Dhal, ‘Global Crisis and The integration of India’s Stock Market’ (2009) 24 (4) Journal of Economic Integration 778.
[13] UK Research and Innovation, ‘Innovate UK’ < https://www.ukri.org/councils/innovate-uk/> accessed 14 August 2022.
[14] ibid 21.
[15] Baker McKenzie (n 10).
[16] AISC (n 14).
[17] ibid.
[18] RBI (n 1) [1.1] – [1.2].
[19] Internet and Mobile Association of India v RBI (2020) SCC OnLine SC 275.
[20] David Levi-Faur, ‘Regulatory Capitalism’ in Peter Drahos, Regulatory Theory: Foundations and Applications (Australian National University Press 2017).