December 7, 2021

Ohio Should Consider Creating Regulatory Sandboxes

Ohio Senate Financial Institutions and Technology Committee
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Thank you, Chair Wilson, Vice Chair Hottinger, Ranking Member Maharath, and distinguished members of the committee 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 appreciate the opportunity to testify today. I have also 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 against these risks while securing the benefits.

Defining Regulatory Sandboxes

“Regulatory Sandboxes” are an increasingly common feature in global regulation. Though the exact nature of a regulatory sandbox varies depending on the legal environment and policy preferences of the jurisdiction, as a general rule they 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. Though 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. This is particularly true 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.

Though 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 asymmetric information issues between firms and investors.

Although there are very real potential benefits to regulatory sandboxes, there are also potential risks that 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 on 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 although 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.

Conclusion

Financial services are evolving rapidly. This innovation offers 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 (2020): 445–76.