A novelty in Europe and Latvia – cross-border testing of innovative financial technologies in regulatory sandboxes

Both new and experienced financial technology (FinTech) companies whose operations require a licence or registration (for example, payment institution, e-money institution), when developing a new product, a new way of presenting an existing product or an operational process, will likely need to verify their operation in practice, in order to carefully develop internal control mechanisms, ensuring the protection of customer funds, risk management and compliance with regulatory requirements. Compliance with these requirements is assessed by a national financial market supervisor, both when the company applies for a licence and afterwards, within the scope of regular checks.

Application of regulatory requirements on an individual basis is often challenging even for companies with a comparatively traditional business model. It becomes even more challenging in cases when a new product or process of a company is innovative and does not directly correspond to any particular set of regulatory requirements or provides for an approach other than the one the company has been using up to now, and it is necessary to verify the new product or procedure. In such cases, the authority supervising financial market in Latvia, the Financial and Capital Market Commission, can assist through its support mechanisms: consultations in the Innovation Hub or via the Regulatory Sandbox. Moreover, we are also joining the new European initiative – cross-border testing of innovative financial products and services in regulatory sandboxes. It is especially useful for companies planning to offer their innovative product or service in several European countries.

What is a regulatory sandbox?

A regulatory sandbox is a possibility for FinTech companies to test a new product or to develop internal processes in a controlled environment, in order to apply regulatory requirements suitable for the new product. It is useful if the new product or process of the company does not directly correspond to the applicable legal framework, or, alternatively, it is not clear how exactly the new product or process should be applied in practice. The company can apply for a regulatory sandbox both before the receipt of the licence, as well as if it is already licenced and has developed a new product or service and wishes to start offering it to users.

The testing plan of a company for the sandbox and the results to be achieved during testing is coordinated and approved by the FinTech supervisory authority, providing the company with competent support and a possibility to form, from even an early development stage, a uniform understanding with a supervisor regarding the conformity of the financial innovation of the company to the requirements and internal control system. Such cooperation allows for identifying the necessary upgrades so that the innovative product, during its lifecycle, would be safe for its users, and the company and its owners would not suffer financial losses or face any reputational risks.

The regulatory sandbox is offered by several European countries, and their objectives and operational approaches are quite similar. Nevertheless, a common market also incorporates certain local nuances arising out of the requirements of legal acts, market supervision, and consumer behaviour in each country. Operational principles may also differ slightly across the regulatory sandboxes of different countries. Therefore, the companies willing to use this support tool with different national supervisors must get acquainted with the specific features of each country. Testing process, namely, applying to the sandbox and admission thereto, period of testing, form of support, etc., may differ slightly across the countries, as well.

Why test a product in a sandbox?

Cooperation with the supervisory authority is important for regulated companies for the entire period of their lifecycle. To easen the understanding of the specifically applicable requirements of laws at the beginning of a regulated activity of the company and to create safe internal governance systems in the company, the supervisory authorities of the member states of the European Union (EU) have developed innovation hubs, and the regulatory sandboxes are also available in certain member states. In the innovation hub it is possible to receive consultations from experts of the supervisory authority from a pre-licencing stage, so that both parties–the supervisor and the company–can understand the specifics of the company and requirements for establishment of internal control mechanisms, in order to ensure stable and safe service provision to customers.

In turn, when testing the innovative solution in a sandbox, the specific features of the internal control mechanism are being determined in detail jointly with the experts of the supervisory authority. The benefit of both parties working together is a gain of time and the possibility to flexibly react from an early development stage, in order to upgrade the product, manage IT risks, ensure the fulfilment of anti-money laundering (AML) requirements and corresponding internal control mechanisms.

What does cross-border testing in regulatory sandboxes mean?

In order to facilitate the emergence of new and innovative products and provide the possibility for the companies to more quickly develop on a larger scale, a new pan-European possibility has been created–testing of a service or product in regulatory sandboxes of several countries. In case of cross-border testing, the coordination of supervisors of various countries will take place in a new EU Digital Finance Platform. This platform has been created by the European Forum for Innovation Facilitators, joining European FinTech supervisory authorities with a common objective–to facilitate the development of this area and to cooperate in order to promote the growth of the sector.

In which situations is it worth testing a service or a product at an international level?

When testing a service or a product in several countries, the company, from an early development stage, may lay the groundwork for scaling the product on an international level and expand the geography of its activities.

On an international level, the testing takes place so that the company determines its target markets in the countries of the European Economic Area (EEA) and applies to the regulatory sandboxes of such countries. Even though the testing rules may differ across the countries, the company can use its resources more efficiently, because the supervisory authorities involved in the particular project will constantly coordinate their communication. The company may engage the countries during the period of testing both as observers and as the recipients of test results. In such case, these countries will not be actively involved in the planning of the testing, consulting, and approval of results, nevertheless their experts will be informed about the technology, its peculiarities and the type of product, which can make it easier for the company to acquire target markets of a new product in the future. If the company attracts the supervisory authorities of various countries from an early development stage, its key benefit would be the involved parties’ understanding of the new solution or product, enabling faster creation of suitable product functionality and documentation at the time as the company decides to receive a licence or expand its operation in the particular country.

Which international cooperation format to choose?

Through the EU Digital Finance Platform, one can choose several ways of attracting FinTech supervisors of several countries.

The most active form of cooperation is testing of a product or process in several regulatory sandboxes. The key advantage of this solution is mutual communication between the supervisors involved in testing regarding the specifics of the company, interpretation of requirements and application of regulatory frameworks. In such a model, the approach of national supervisors in case of a particular business model and product is harmonised as much as possible. Of course, there are specific nuances in the local markets, however the company would get to know them from the beginning and would have the possibility to timely adapt its operation thereto.

Testing may be organised in several countries concurrently or subsequently–the most efficient solution must be chosen jointly with the FinTech supervisors of the selected countries. As already mentioned above, there might be nuances in the process of testing as well, depending on the regulatory sandbox of each country. It might differ in terms of period of testing, involved local authorities (for example, local data protection authority), as well as in terms of applicable requirements of a national supervisor for obtaining a licence or granting allowances. Each country has its own regulation as to the allowances applicable during the period of testing, however the allowances are mainly comparatively small, if the company performs testing in a real environment (market), because, at this stage, a responsibility towards the end consumer emerges. For example, in such a situation there might be allowances with respect to the requirements for preparation of documentation. Testing of a product in a real environment in the Regulatory Sandbox in Latvia is possible, if the company already has a corresponding licence and the activities are carried out in accordance with all requirements applicable to regulated types of entrepreneurial activity.

If the release of a product or service at an international level is not planned right away, then other international testing models can be selected, as well, to lay the groundwork for cooperation with national supervisors of other countries. The company can choose to invite the supervisory authorities of other countries as observers. In such a cooperation model, active testing may take place in the regulatory sandbox of one or several countries, while the representatives of supervisors of the countries invited as observers would be involved in a regular mutual information exchange. The supervisors of observing countries take a passive role–they do not express their opinion without being specifically invited to, but they are, nevertheless, informed about the operational model of the innovative service or product, its specifics, and would be informed about the set of eventually applicable standards in other countries where the licence would be obtained. By laying such groundwork, the company can establish a stable basis for expanding their operation in other countries in the medium term and in the long term, and the entry to such markets can be smoother during the licencing stage or by exercising the passporting rights.

The third way to involve the national supervisors of other countries is to inform them about the testing results. In such cases, the involved supervisors, upon completion of testing, would receive information from the supervisory authority (or authorities) involved in active testing and would be able to take note of such information. Such a model can be selected in cases when the expansion of the business activity is planned in the long run or, alternatively, product changes or upgrades, new regulation is expected, or similar developments can be foreseen.

As a rule, the applicant of the sandbox is free to choose the countries whose supervisors to attract and their corresponding roles. In the EU Digital Finance Platform, the members of the European Forum for Innovation Facilitators, the supervisors of the member states, have the possibility of reviewing the general overview of the existing and planned activities. Thus, the supervisors can also show initiative and join the information exchange (as observers or recipients of test results), and the testing applicant can decide upon expanding the circle of countries involved.

Please note that information exchange between the supervisors participating in different roles may be partially restricted for confidentiality purposes. The key benefit for the company is that the company does not need to coordinate the communication between the involved supervisors itself as it takes place within the scope of the EU Digital Finance Platform.

If the company has developed a new, innovative product or process, the operation whereof does not clearly fall within the boundaries of the applicable regulation or it needs to be verified before operating in practice, then the participation in the regulatory sandboxes on the EEA scale is a significant support mechanism, facilitating faster and safer introduction of the new solution on a larger scale, by ensuring the protection of both the interests of end consumers as well as the reputation and investments of the company.

How to start cross-border testing?

Filling out the application for testing in an international environment takes place online, on the EU Digital Finance Platform website.

To access the application form, the applicant must create an account. The national e-signature can be used or the EU Login profile can be created using the app. During the next step, the member states specified by the company will receive information on the application and adopt the decision on conformity of the product to the eligibility requirements of applicants of the regulatory sandbox of each country. In an affirmative decision, the parties attract expert teams and coordinate the approval of the testing plan with the company.

At the same time, other countries not specified in the testing application may also express a wish to be included in the circle of information recipients, and the company may take an additional decision to approve or reject the interest demonstrated by such countries.

During testing, the company must plan the cooperation with the regulatory sandbox of each country involved in accordance with the jointly approved action plan and time schedule. This is an investment of resources, the return whereof pays off in the further lifecycle, enabling the company to focus on development.

The Regulatory Sandbox of the Financial and Capital Market Commission ensures both the possibility to test an innovative product or service in Latvia and to engage in cross-border testing. More information on the Regulatory Sandbox of Latvia is available in the sandbox section of the website fintechlatvia.eu, where you can also apply for a consultation with the experts of the Financial and Capital Market Commission. All companies who would like to experience the possibilities offered by a sandbox are kindly welcome to contact us for advice.

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