July 19, 2021

Pennsylvania Should Consider Creating Regulatory Sandboxes

Testimony before the Pennsylvania House Democratic Policy Committee
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Click here to view Mr. Knight's testimony (16:43–27:40), and answers to questions (46:40 & 58:00).

Chair Bizzarro and distinguished members of the committee:

Thank you for the opportunity to testify today. 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 attached a scholarly article I coauthored with Trace Mitchell that discusses some of these issues in more detail.

Today I would like offer three takeaways for 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. There are ways to mitigate against these risks while securing the benefits of a regulatory sandbox.

Defining Regulatory Sandboxes

Regulatory Sandboxes are an increasingly common feature in global regulation. Though the exact nature of regulatory sandboxes 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. 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 that serve other industries or multiple industries.

The Commonwealth of Pennsylvania does not currently have a financial regulatory sandbox, but it may wish to consider creating one, especially given that Pennsylvania’s robust financial sector, highly educated workforce, and proximity to other major economic centers such as New York 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, at least some evidence suggests that regulatory sandboxes can help new firms enter the market. For example, sandboxes may help increase access to funding by reducing regulatory uncertainty and information asymmetries between firms and investors.

Although regulatory sandboxes carry significant potential benefits, some potential risks must be guarded against. One area of obvious concern is consumer protection. Some critics believe that regulatory sandboxes would remove necessary consumer safeguards. However, a well-executed sandbox, which would require applicants to have a viable plan to make customers whole in the event of a failure and to demonstrate the capacity and financial backing to execute such a plan, would help guard against such risk. In addition, the agency responsible for administering the sandbox would 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 the possibility that regulators may develop a culture of being stricter on firms that do not participate in a sandbox, even if such a culture is not actually justified.

These risks are real and should be taken seriously, but they can also 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 their 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 though 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.

I appreciate the opportunity to testify and am happy to answer any questions to the best of my ability.

Attachment

Brian Knight and Trace Mitchell, “The Sandbox Paradox: Balancing the Need to Facilitate Innovation with the Risk of Regulatory Privilege,” South Carolina Law Review 72, no. 2 (2020): 445–75.