India: Role Of Special Economic Zones In Fostering Innovation: Global Adoption Of Regulatory Sandboxes – Part II

* In Part II, we expand our discussion to include the role of regulatory sandboxes in fostering FinTech innovation within SEZs like GIFT

Introduction

India has emerged as a hub of entrepreneurship and innovation in the financial technology (fintech) sector over the past few years.¹ Since 2013, India has been home to more than 2,000 fintech companies, placing it in the second position globally in terms of fintech adoption². In the financial sector, disruptions and innovations have frequently transpired within a regulatory grey area characterized by inadequately defined rules. Mobile wallets, for instance, were created in a regulatory grey area during the late 2000s, following the telecom industry growth. As a response, the Reserve Bank of India (RBI) implemented operational guidelines for wallets, including a restriction on the maximum balance that could be retained in a wallet. This measure effectively mitigated the potentially more significant systemic risks associated with wallets.

The RBI's forward-looking approach towards fintech reflects a strategic response to the evolving financial landscape, aiming to balance innovation with regulatory prudence. In 2016, the Reserve Bank of India established an inter-regulatory working group tasked with "examining and reporting on the intricacies of fintech and digital banking in India and its ramifications in order to reassess the regulatory framework."³ The RBI issued guidelines for a regulatory sandbox in August 2019⁴, in accordance with the working group's recommendations. The concept of sandboxes originated in the information technology industry, where novel products undergo testing with the database isolated from critical system resources and not yet live. In contrast, regulatory sandboxes are designed for the evaluation of live products in a controlled environment.

By providing a space for experimentation, these sandboxes contribute to the development of a more resilient and technologically advanced financial ecosystem in India. Financial Regulators such as the Reserve Bank of India (RBI), Securities and Exchange Board of India (SEBI), Insurance Regulatory and Development Authority (IRDAI) and the International Financial Services Centres Authority (IFSCA) run their own sandboxes in India.

A regulatory sandbox, is a framework that permits the live, time-bound testing of innovations under the supervision of a regulator particularly those in emerging and technology-driven sectors. Entrepreneurs and new entrants who established companies to test novel concepts and ideas that exist on the periphery of or beyond the current regulatory structure.

The Part II discusses about the transformative influence of Special Economic Zones (SEZs) on the global business landscape with the advancement of innovation through the utilization of regulatory sandboxes while exploring the successes and challenges associated with these various regulatory sandbox frameworks.

In April 2015, the International Financial Services Centre (IFSC) was established at the GIFT Multi Services SEZ by the Government of India. The IFSC was granted a competitive tax regime at GIFT SEZ by the Union Budget of 2016⁵. The vision of the Honorable Prime Minister is for the GIFT IFSC to become a center for activities pertaining to international financial services.

Unveiling the Landscape of Regulatory Sandboxes

Regulatory sandboxes provide financial regulators with an opportunity to collaborate with fintech innovators and gain an insider's perspective on potential proof of work concepts, thereby mitigating future risks. In contrast, fintech firms have the ability to pilot new services, products, and business models with consumers in a "live" setting, subject to specific regulations and supervision. Notably, it is anticipated that the sandbox will foster productive discourse between the regulatory body and the entities being regulated.

The regulatory sandbox has been adopted by regulators worldwide as a method to test emerging technologies in a dynamic, evidence-based regulatory environment. There are a total 73 Sandboxes operated by the Regulators Globally⁶.

1. RBI Regulatory Sandbox: Pioneering Financial Innovation

The Inter-regulatory Working Group (IRWG) was set up by the RBI in 2016 to look into and report on the granular aspects of FinTech and review the implications of regulatory framework. IRWG responded to the dynamics of the rapidly evolving FinTech scenario, set to introduce an appropriate framework for a Regulatory sandbox within a well-defined space and duration where the financial sector regulator will provide the requisite regulatory guidance, to increase efficiency, manage risks and create new opportunities for the Regulatory Sandbox⁷.

For the restricted purpose of testing, regulators will have the discretion to allow some regulatory relaxations in a controlled/test environment known as a Regulatory Sandbox. Through the Regulatory Sandbox, all parties involved in the financial innovation process—the regulator, the innovators, the financial service providers, consumers (as end users) and Regulatory Sandboxes itself are able to undertake field tests, gather evidence on the pros and cons of the innovations, and keep the risks under control. To promote the provision of pertinent and affordable financial products, it is possible to establish a systematic pathway for the regulator to interact with the ecosystem and develop regulations that either facilitate or address innovation.

Mr. Shaktikanta Das, the current governor of RBI, at the advent of 4th edition of the Global FinTech Festival (GFF) has recognised that with the transformation of FinTechs, financial services have become faster, cheaper, efficient, and more accessible.⁸ Retail payments, cross-border payments, MSME lending, and financial fraud prevention comprised the first four cohorts. In its announcement of the fifth cohort, the RBI maintained a neutral theme with the eligibility limited to innovative products, services, or technologies that span multiple functions within the regulatory domain of the RBI in order to qualify⁹.

The regulatory sandboxes in Thailand, Taiwan, Malaysia and Australia specify a 12-month test period, while the UK's sandbox testing lasts six months¹⁰. In India, The Sandbox process ideally is of around 6 months which contains the stages such as- Preliminary Screening, Test Design, Application Assessment, Testing, Evaluation. The detailed end-to-end sandbox process, including the testing of the products/innovations by FinTech entities, shall be overseen by the FinTech Unit (FTU) to assess the outcome report on the tests and decide on whether the product/service is viable and acceptable under the Regulatory Sandbox.¹¹

The Regulatory Sandbox promotes "learning by doing." By obtaining empirical data directly from the sources, regulators are able to assess the implications and benefits of emergent technologies. This enables them to formulate informed opinions regarding potential regulatory changes or the development of new regulations that are necessary to foster beneficial innovation while mitigating the associated risks. Additionally, established financial service providers, such as banks, enhance their comprehension of the potential functionality of emerging financial technologies. This knowledge enables them to effectively incorporate these technologies into their business strategies. By utilizing the Regulatory Sandboxes, FinTech firms can enhance their understand the regulations that govern their offerings and subsequently mold their products in response.

The mandatory requirements where RBI does not provide with the relaxations are Customer privacy and data protection, secure storage of and access to payment data of stakeholders, security of transactions, KYC/AML/CFT requirements and statutory restrictions.¹² It has explicitly excluded certain areas from the sandbox testing which includes Crypto currency/Crypto assets services and trading/ investing/ settling in crypto assets, initial coin offerings, etc. and any product/services which have been banned by the regulators/Government of India.¹³

In addition to potential time and flexibility losses, innovators may encounter certain constraints when utilizing regulatory sandboxes. Tailored authorizations and regulatory relaxations on an individual basis may necessitate the exercise of discretion and time. The RBI's Regulatory Sandbox lacks the authority to grant legal waivers, and successful experiments may still necessitate regulatory approvals before widespread implementation. Legal concerns that regulators might encounter include those pertaining to consumer losses resulting from unsuccessful experiments and those emanating from competitors situated beyond the Regulatory Sandbox, particularly those whose applications have been or may be denied. However, if the Regulatory Sandbox framework and processes are transparent and have clear entry and exit criteria, these may not have much legal support. In this context, RBI will not bear any liability arising from the experiment by the applicant as a sandbox entity.¹⁴

• SEBI Regulatory Sandbox: Promoting Innovation in Securities

With continuous efforts in promoting innovation in the securities industry, SEBI issued the Regulatory Sandbox framework which provides specific privileges and accommodations to SEBI-regulated entities in order to enable them to conduct trials of FinTech solutions on a restricted number of actual users in an operational environment for a specified duration. All organizations enrolled with SEBI in accordance with Section 12 of the SEBI Act of 1992¹⁵ are eligible to participate in the regulatory sandbox. The application may be submitted either independently or in collaboration with another entity. Regardless of the situation, the principal applicant shall be the registered market participant, who shall also bear exclusive responsibility for testing the solution.

The Testing is conducted in two stages:

Stage I Testing: During this initial phase, the applicant engages a limited and identified set of users. The maximum user quota is determined based on the applicant's specific needs and is subject to SEBI's approval on a case-by-case basis.

Stage II Testing: Advancing to the second stage, the applicant assesses a larger set of identified users. The maximum limit on the number of users is again determined by the applicant's requirements and is subject to SEBI's approval on a case-by-case basis.¹⁶.

In order to promote innovation while minimizing regulatory burden, SEBI has the responsibility to contemplate exemptions or relaxations, if applicable. These exemptions may be case-specific exemptions or comprehensive exemptions from certain regulatory obligations. Similar to RBI Sandbox, no exemptions are granted from the KYC, AML and investor protection regulations. In total 11 Applications have been received by the Regulator as on 17.01.2024 of which only 1 has been approved, 4 have been rejected, 5 have been withdrawn and one is under process¹⁷.

• IFSCA Sandbox: Nurturing Innovation in International Financial Services Centres

The FinTech Innovation Sandbox of the International Financial Services Centres Authority (IFSCA), with a limited use authorization, enables applicants to develop and test their FinTech concepts or solutions either in Innovation Sandbox¹⁸ or Regulatory Sandbox¹⁹. Foreign FinTechs that are interested in entering India may apply for the Inter-operable Regulatory Sandbox (IoRS), which is supervised by the IFSCA as the principal regulator. IFSCA's overseas regulatory referral Mechanism and FinTech bridges facilitate the use of the overseas regulatory referral mechanism. To participate in Overseas Regulatory Referral Mechanism /FinTech Bridges of IFSCA, the applicants must comply with the guidelines outlined in the Memorandum of Understanding (MoU), collaboration agreement, or special arrangement established between IFSCA and the pertinent overseas financial sector regulator²⁰.

The objective of the "Framework for FinTech Entity in the IFSCs" is to facilitate the development of a FinTech Hub at GIFT IFSC that is on par with those found in other International Financial Centres. The proposed framework encompasses two types of technological solutions advanced or innovative technological solutions that support and aid activities related to financial products, financial services, and financial institutions and FinTech solutions that generate new business models, applications, processes, or products in domains or activities associated with financial services regulated by IFSCA.²¹ The framework enables IFSCA to grant Limited Use Authorizations within the FinTech Regulatory Sandbox to eligible Fintech entities in IFSC and establishes a dedicated Regulatory Sandbox. This would empower them to submit grant applications and receive funding through the IFSCA FinTech Incentive Scheme 2022.²²

• Web 3.0 Regulatory Sandbox: Fostering Web 3.0 Ecosystem

In the ever-evolving landscape of Web 3.0 technologies, the Telangana government has emerged as a proactive player, aiming to foster innovation and collaboration within the burgeoning ecosystem. The latest initiative from the government involves the establishment of a regulatory sandbox dedicated to testing novel Web 3 solutions. This sandbox, designed as a secure testing ground, seeks to facilitate product testing for organizations within a regulated environment, ensuring a seamless transition to the next phase of the internet ecosystem.

Blockchain firms in Telangana, classified as IT units, benefit from the state's ICT industry incentives, granting them certain regulatory relaxations. These companies are not subject to routine regulatory inspections across several Acts, except when driven by specific complaints. Instead, they are empowered to use self-certification to comply with statutory obligations. The legislative acts covered by this exemption include The Factories Act, 1948, The Maternity Benefit Act, 1961, The Telangana Shops and Establishments Act, 1988, The Contract Labour (Regulation and Abolition) Act, 1970, The Payment of Wages Act, 1936, The Minimum Wages Act, 1948, and The Employment Exchanges (Compulsory Notification of Vacancies) Act, 1959. This policy underscores Telangana's proactive approach to nurturing an innovation-friendly ecosystem.²³

The regulatory sandbox, a cornerstone of the Web 3.0 promotion effort particularly caters to emergent technologies like blockchain, aligning with the principles of Web 3.0 that emphasize peer-to-peer interaction and user rights. Interested companies can apply to join the sandbox, which operates on a cohort structure with two cohorts per annual cycle, each lasting for six months.²⁴ The primary objective of the sandbox is to contribute to the development of a comprehensive framework that facilitates the proper implementation of blockchain and Web 3.0 technologies.²⁵

The Hyderabad airport, recognizing the complex aspects of aviation, is a leader in adopting advanced technology. Notably, the airport has embraced paperless boarding and is currently at the forefront of adopting facial recognition technology, known as "Digi Yatra."²⁶ In a strategic move, GMR Hyderabad Air Cargo (GHAC) has partnered with the Singapore-based blockchain technology startup "StaTwig" to introduce a technology-based solution for tracking and monitoring vaccine shipments at the airport's cargo terminal. This collaboration exemplifies the commitment to leveraging innovative technologies to enhance efficiency and accuracy in data transmission within the aviation sector.²⁷

CONCLUSION

The FinTech sector has experienced phenomenal expansion over the years, as pioneering startups have transformed the manner in which financial products and services are provided to end-users. While minimizing entry barriers into the FinTech ecosystem, regulatory sandboxes are intended to foster innovation. Nevertheless, these endeavors present regulatory obstacles that may impede their expansion and restrict their potential influence. Regulatory sandboxes serve as a viable solution, offering FinTech start-ups a controlled setting in which to evaluate their products and services without incurring the complete financial and logistical burdens associated with regulatory compliance. A key advantage of the regulatory sandbox is the risk reduction it affords.

Globally, the Regulatory Sandbox is a tried-and-tested mechanism, with its introduction in the United Kingdom possibly dating back to 2016. Following that, nations such as Canada and the United States adopted a comparable approach by establishing a regulated setting that closely resembles reality but is not as expansive as the market's target audience. The regulatory sandbox is highly advantageous in the Indian context, as steps taken by the RBI and IFSCA in its implementation. Although the concept of FinTech is still in its infancy in India, the market potential can be maximized by providing entities with tangible opportunities from the real world. From my perspective, the Regulatory Sandbox is an exceptional mechanism characterized by exceedingly calculated and restricted risk. As previously mentioned, this approach to evaluating innovations that have the potential to enhance the experience of the general public on the Indian market enables innovators to "learn by doing." Engaging in practical exercises while receiving immediate feedback and performance reports undeniably enhances the final product that the pioneers are striving to refine.

To conclude, the regulatory sandbox contributes to the transformation and evolution of the financial ecosystem. Participants, armed with regulatory knowledge and increased consumer confidence, play a crucial role in shaping the future of the financial industry. This symbiotic relationship benefits all stakeholders, fostering a landscape that is not only innovative but also secure and inclusive for consumers. As a result, the regulatory sandbox becomes a cornerstone for the ongoing development and sustainability of the financial sector in India. By gaining knowledge, regulatory backing, and consumer confidence, participants foster the development and metamorphosis of the financial ecosystem, which is advantageous for all stakeholders in the industry and consumers.

* This is the Second article in our series on Role of Special Economic Zones in Fostering Innovation. Our first article is available here.

Footnotes

1 Vivek Belgavi, Ashootosh Chand, Arvind V Arryan, Avneesh Narang, Emerging technologies disrupting the financial sector, 9 May, 2019, PricewaterhouseCoopers and ASSOCHAM, accessed 16 January, 2024.

2 Ben Shenglin, LV Jiamin, Qian Xiaoxia et al, The Future of Finance is Emerging: New Hubs, New Landscapes, 14 November 2018, Academy of Internet Finance, Zhejiang University and Cambridge Centre for Alternative Finance, accessed 16 January, 2024.

3 RBI sets up Inter-regulatory Working Group on Fin Tech and Digital Banking dated 14.07.2016 available at https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=37493, accessed 16 January 2024

4 "Enabling Framework for Regulatory Sandbox" dated 13.08.2019 available at https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=47869, accessed 16 January 2024.

5 Gujarat International Finance Tec-City (GIFT) -A Global Financial Hub, https://www.giftsez.com/gift-financialhub.aspx, accessed 16 January 2024.

6 Key Data from Regulatory Sandboxes across the Globe, The World Bank, https://www.worldbank.org/en/topic/fintech/brief/key-data-from-regulatory-sandboxes-across-the-globe, accessed 16 January 2024.

7 Supra3

8 FinTech and the Changing Financial Landscape - Shaktikanta Das – RBI Bulletin dated 18.09.2023, available at https://rbi.org.in/scripts/BS_ViewBulletin.aspx?Id=22051, accessed 16 january 2024

9 Reserve Bank of India - Press Releases (Oct 27, 2023), https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=56637#:~:text=Press%20Releases,-(257%20kb)&text=The%20Reserve%20Bank%20of%20India,Fifth%20Cohort%20to%20eligible%20entities.

10 Lawrence, Adrian, Fuggle, Bill et al, Baker Mackenzie, International Guide to Regulatory Sandboxes, 2018, accessed 16 January, 2024.

11 Reserve Bank of India - Reports. (18 Apr 2019), https://rbi.org.in/scripts/PublicationReportDetails.aspx?UrlPage=&ID=920.

12 Ibid

13 Ibid

14 Ibid

15 Section 12 of SEBI Act of 1992: Registration of stock brokers, sub-brokers, share transfer agents, etc.

16 SEBI | Revised Framework for Regulatory Sandbox (June 14, 2021), https://www.sebi.gov.in/legal/circulars/jun-2021/revised-framework-for-regulatory-sandbox_50521.html

17 SEBI | Regulatory Sandbox, https://www.sebi.gov.in/sebiweb/other/RegulatorySandbox.jsp, accessed 16 January, 2024.

18 2 (k) 'Innovation Sandbox' means a testing environment where FinTech Entities can test their ideas and solutions in isolation from the live market that may add value to the financial products or financial services offered in IFSC based on market related data made available to them by Financial Institutions operating in IFSC; F.No. 521/IFSCA/FinTech/FE Framework/2022-23, Framework for FinTech Entity in the International Financial Services Centres (IFSCs), dated 27.04.2022, available at https://www.ifsca.gov.in/Document/Legal/fe-framework_27-04-202227042022122844.pdf

19 2 (m) 'Regulatory Sandbox' means a live environment with a limited set of real customers for a limited timeframe wherein entities operating in the capital market, banking, insurance and other financial services space in IFSC shall be granted certain exemptions / relaxations from applicability of certain regulatory provisions for experimenting FinTech ideas and solutions; ; F.No. 521/IFSCA/FinTech/FE Framework/2022-23, Framework for FinTech Entity in the International Financial Services Centres (IFSCs), dated 27.04.2022, available at https://www.ifsca.gov.in/Document/Legal/fe-framework_27-04-202227042022122844.pdf

20 International Financial Services Centres Authority, https://www.ifsca.gov.in/Document/Legal/fe-framework_27-04-202227042022122844.pdf, accessed 17 January, 2024.

21IFSCA Issues the Framework for FinTech Entity in the International Financial Services Centers (IFSCs). (2022, April 27). IFSCA. Accessed on January 17, 2024, from https://ifsca.gov.in/Document/Legal/press-release-for-fe-framework-27-04-202227042022031331.pdf

22 International Financial Services Centres Authority. (September 12, 2022). https://ifsca.gov.in/Viewer?Path=Document%2FLegal%2Fguidelines-of-ifsca-fintech-incentive-scheme_202212092022060813.pdf&Title=Guidelines%20for%20implementation%20of%20the%20IFSCA%20%28FinTech%20Incentive%29%20Scheme%2C%202022&Date=12%2F09%2F2022.

23 Telangana State Blockchain Framework 2019, ITE&C Department, Govt. of Telangana, available at https://it.telangana.gov.in/wp-content/uploads/2022/12/Telangana-Blockchain-Framework.pdf, accessed 18 Jaunary 2024

24 Telangana officially launched the Web 3.0 Regulatory Sandbox – Department of Information Technology, Electronics & Communications accessed 16 January, 2024

25 Government of Telangana Web 3.0 Regulatory Sandbox Framework Draft Concept Note available at https://intract-dashboard-files.s3.ap-south-1.amazonaws.com/telangana-sandbox/Web3.0+Sandbox+Concept+Note.pdf accessed 16 January, 2024

26 DigiYatra face recognition system to be used at Hyderabad airport for 3 months - The Hindu

27 https://gmrhydcargo.in/news.php accessed 16 January, 2024

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