June 1, 2022

Ohio Should Consider Creating Regulatory Sandboxes

Ohio House Financial Institutions Committee
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Chair Jordan, Vice Chair Ferguson, Ranking Member Crossman, and distinguished members of the committee, thank you for the opportunity to submit this testimony in relation to Senate Bill 249.

My name is Brian Knight, and I am a senior research fellow at the Mercatus Center at George Mason University. My expertise is in financial technology, and I have done research on regulatory sandboxes. I have attached a scholarly article I coauthored with Trace Mitchell discussing some of these issues in more detail.

Today I would like to offer the following takeaways about regulatory sandboxes:

  1. Regulatory sandboxes offer potential benefits, including increased innovation and competition.
  2. Regulatory sandboxes also have potential risks, including risks to competition and consumer protection.
  3. Proper sandbox design and execution can help mitigate these risks while securing the benefits.

Defining Regulatory Sandboxes

Regulatory Sandboxes are an increasingly common feature in global regulation. Although the exact nature of a regulatory sandbox depends on the legal environment and policy preferences of the jurisdiction, as a general rule sandboxes can be defined as “a decreed state of exception within a regulatory regime that allows firms to offer products or services for a limited time to a limited number of customers in a modified regulatory environment for the purpose of allowing the firm to test a product or service before it is offered more broadly.”

Beginning with the United Kingdom’s Financial Conduct Authority in 2016, numerous national and state governments have launched regulatory sandboxes. Whereas the majority of sandboxes deal with financial services, several countries, including Japan and Singapore, as well as the state of Utah have launched sandboxes for other industries or to serve multiple industries.

The state of Ohio does not currently have a financial regulatory sandbox but may wish to consider creating one, especially given that Ohio’s significant financial sector, highly educated workforce, and proximity to other major economic centers position it well to play a leading role in beneficial financial innovation.

Benefits and Pitfalls

Regulatory sandboxes were developed to achieve several important goals, including encouraging innovation, competition, and entry in highly regulated industries; providing regulators with greater insight and transparency into cutting-edge products and services; and furthering consumer protection by both helping innovators design their products to be compliant with the law and encouraging the introduction of products and services that will better serve consumer needs.

Although regulatory sandboxes are new innovations and their full effect remains to be determined, there is at least some evidence that regulatory sandboxes can help new firms enter the market. For example, they may help increase access to funding by reducing regulatory uncertainty and information asymmetries between firms and investors.

Despite the significant potential benefits of regulatory sandboxes, some risks must be guarded against. One area of concern is consumer protection. One critique of sandboxes is that they remove necessary consumer safeguards. These risks can be mitigated in a well-executed sandbox that requires applicants to have a viable plan, demonstrate their capacity to execute such a plan, and have the financial backing to make customers whole in the event of a failure. Likewise, the agency responsible for administering the sandbox must be able to conduct adequate vetting and supervision of participants and be able to compel participants to restitute customers if necessary and appropriate.

Another, perhaps less obvious, concern is the risk that a regulatory sandbox could grant an unfair regulatory advantage to firms that gain admission. This advantage could manifest itself as greater access to funding, greater exclusive access to the expertise provided by regulators, and a culture in which regulators are stricter on firms that do not participate in a sandbox, even if such treatment is not actually justified.

These risks are real and should be taken seriously, but they can be managed and mitigated. The risk that access to the sandbox becomes a “golden ticket” can be reduced by granting relatively broad access to the sandbox, making sandbox administrators justify decisions to reject applications, and providing maximal transparency with regard to any legal or regulatory guidance provided to sandbox participants. Sandboxes should be voluntary, and whereas participation in a sandbox may be evidence of good faith, a lack of participation should not be seen as evidence of bad faith on the part of a firm.

The present bill contains several provisions that recognize and seek to mitigate many of the risks described earlier. For example, the bill provides the superintendent of financial institutions with appropriate tools to vet applicants and insist that they provide a credible plan for protecting customers in the event the product fails.

Likewise, to mitigate the risk that participation in the sandbox becomes a major competitive advantage, the bill instructs the superintendent to consider whether a firm’s competitors have participated or are participating in the sandbox as a factor, presumably in favor of admitting an applicant into the sandbox. Although this provision should be clarified to make it explicit that competitor participation in the sandbox should be a factor in favor of admission, its intent helps address the risk of government-granted privilege.

The bill also requires the superintendent to publish a biennial report on the firms participating in the sandbox. This report should be used to help educate both the public and other market participants about any determinations by regulators about the application of law to new products and services that arise through the sandbox. Although this provision is valuable, the legislature may wish to consider making that educational purpose more explicit in the statutory text.

Conclusion

Financial services are evolving rapidly. This innovation has the potential to benefit both consumers and states that create a regulatory environment that facilitates innovation while preserving necessary protections. Regulatory sandboxes, if designed and executed well, can play a role in creating this environment.

Thank you for the opportunity to testify.

Attachment

Brian R. Knight and Trace E. Mitchell, “The Sandbox Paradox: Balancing the Need to Facilitate Innovation with the Risk of Regulatory Privilege,” South Carolina Law Review 72, no. 2 (2021): 445–75.