By Josh Herndon
Global Legal Law Firm
The financial services industry contends with enormous regulatory hurdles and compliance costs that can stifle and discourage innovation. It costs tens of thousands of dollars, and many months of compliance work, for a startup to establish itself in just one state. Moreover, fintech firms must also obtain licenses across all 50 states to operate nationally, which can take several years and cost millions of dollars.
Fortunately, fintech regulatory "sandboxes" at the state level will allow participating companies to experiment with, develop and test innovative financial technology products and services in a controlled environment that affords adequate consumer protection without requiring the participating companies to incur the time and expense required to become fully licensed under state law.
Fintech regulatory sandboxes are nothing new. Numerous countries, including Australia, Canada, Russia, Switzerland and a number of countries in Asia and the Middle East, have utilized this concept since the United Kingdom implemented the first sandbox in 2015. Earlier this year, Arizona was the first U.S. state to implement a "sandbox" program. Illinois introduced legislation to establish its own sandbox program. Others will likely follow.
An applicant to Arizona's sandbox program must demonstrate it has a new kind of technology that addresses a problem or provides a benefit that is not known by the state's attorney general to have a comparable widespread offering in the state. An applicant must also include information about the benefits and risks to consumers of using its product, and how its innovation is different from other products or services available in Arizona. Each applicant must provide a detailed plan for testing and monitoring its product, as well as ensuring consumer protection if its product fails.
In addition, each applicant must also demonstrate it has established a location, whether physical or virtual, that is adequately accessible to the attorney general and from which testing will be developed and performed, and where the applicant will maintain all required records, documents and data.
Arizona's program will be open to companies with products that would normally require licensing from Arizona's Department of Financial Institutions, for example, money transmitters, consumer lenders, debt management companies, mortgage brokers and deferred presentment companies. Participants must also comply with all other Arizona laws, including consumer fraud and any other state laws applicable to financial products or services as determined by the attorney general.
Each participant in Arizona's sandbox program will be allowed to have two years in the sandbox, with the possibility for a one-year extension. Up to 10,000 Arizona residents can use a participant's product or service, although a participant may be able to serve up to 17,500 Arizona residents if it demonstrates sufficient capitalization and risk management. A participant may also enter into transactions with an Arizona resident of up to $15,000.00, and up to $50,000.00 in aggregate transactions per Arizona resident.
The Arizona Consumer Fraud Act also remains applicable to program participants, as do all statutory limits and caps in Arizona law related to financial transactions. For example, payday lending is prohibited in Arizona, and other small dollar loans are capped at a 36 annual percentage rate.
One promising provision of Arizona's program is "passporting" (which is currently available under European Union law between Member States) which will allow a participant in Arizona's program to operate in other jurisdictions with similar programs, and likewise allow participants in another state's sandbox to enter into Arizona's sandbox program. Once additional states establish comparable programs, that provision will allow participants in Arizona's program to operate in other jurisdictions with similar programs, which will provide additional markets and opportunities.
Despite the obvious business opportunities that sandbox programs offer innovative fintech entrepreneurs, the programs are not without controversy. Consumer advocacy groups have expressed concerns that these programs could put customers at risk of predatory or failed fintech products. Moreover, not all states are eager to allow sandbox programs in their jurisdictions.
Maria T. Vullo, the head of the Department of Financial Services of New York, stated, "The New York State Department of Financial Services fiercely opposes the Department of Treasury's endorsement of regulatory 'sandboxes' for financial technology companies. The idea that innovation will flourish only by allowing companies to evade laws that protect consumers, and which also safeguard markets and mitigate risk for the financial services industry, is preposterous."
Nevertheless, other states will explore sandbox programs as a way to attract and support fintech innovators to develop their own fintech ecosystems. As the first U.S. sandbox program, Arizona's program may serve as a model for other states looking to implement similar programs.
The potential business opportunities presented by state-level fintech regulatory sandboxes are obvious. Innovative fintech entrepreneurs have an opportunity to launch and test new products, services, business models and delivery mechanisms without incurring the typical regulatory costs and burdens. Now is the time to reap the benefits of playing in the "sandbox."
Josh Herndon is an attorney at the Global Legal Law Firm, whose attorneys are well recognized as top payments industry experts. Herndon works in the compliance field helping electronic payment companies avoid violating rules, as well as avoid being fined, arrested or sued from internal or external threats. He is also involved in litigation in the payments space. He can be reached at jherndon@attorneygl.com.
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