February 3, 2022

Virginia Should Consider Creating Regulatory Sandboxes

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Virginia Senate Committee on General Laws and Technology

Chair George Barker and members of the Committee on General Laws and Technology:

Thank you for the opportunity to provide testimony 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.

Today I would like to offer these 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 these risks while securing the benefits of a regulatory sandbox.

I have attached a scholarly article I coauthored with Trace Mitchell discussing these issues in more detail.

Defining Regulatory Sandboxes

“Regulatory Sandboxes” are an increasingly common feature in global regulation. 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. Although most sandboxes deal with financial services, several countries, including Japan and Singapore, have launched sandboxes for other industries or to serve multiple industries. The state of Utah was the first US state to launch a general, industry-agnostic regulatory sandbox.

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 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.

Although regulatory sandboxes have significant potential benefits, some potential 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 guarded against in a well-executed sandbox that requires applicants to have a viable plan, have the ability to execute on the plan, and 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 force a participant to make customers whole if necessary and appropriate.

Another, perhaps less obvious, concern is the risk that a regulatory sandbox could grant an unfair regulatory advantage to those firms lucky enough to 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 develop a culture of being 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 fortunately they can be somewhat mitigated. The risk that access to a 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 the risks described earlier. For example, requiring applicants to demonstrate a credible plan to protect consumers in the event of failure can help protect customers, and considering a competitor’s admission into the sandbox as a factor in favor of admission can help prevent the sandbox from providing an undue first-mover advantage. However, the effectiveness of these protections will ultimately depend on the quality of execution on the part of the relevant agencies charged with administering the sandbox.

Conclusion

The Commonwealth of Virginia has demonstrated a willingness to change its regulatory environment to welcome innovation and competition. This bodes well for the people of Virginia. There is reason to believe that carefully designed sandboxes may be part of a policy effort to foster a more dynamic, competitive, and rich economy for this state.