February 9, 2021

How to Build Beneficial Regulatory Sandboxes

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Chair Thatcher and 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 also attached a scholarly article I coauthored with my colleague Trace Mitchell discussing these issues in more detail.

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

Defining Regulatory Sandboxes

Regulatory Sandboxes are an increasingly common feature in global regulation. While the exact nature of regulatory sandboxes varies depending on the legal environment and policy preferences of a 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. Although the majority of sandboxes deal with financial services, several countries, including Japan and Singapore, have launched sandboxes dealing with other industries or to serve multiple industries.

Utah is one of the first states to launch a regulatory sandbox for financial services, and it is now debating the creation of a general, industry-agnostic regulatory sandbox. This would be a significant innovation and position Utah as a national leader in terms of reforming regulatory processes to encourage innovation and competition.

Benefits and Pitfalls

Regulatory sandboxes were developed originally 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 comply 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.

Whereas regulatory sandboxes carry significant potential benefits, some potential risks must also be guarded against. In the area of consumer protection, one concern is that regulatory sandboxes will 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 failure and require the ability to execute on that plan, would help guard against such a risk. Likewise, the agency responsible for administering the sandbox must be able to conduct adequate vetting and supervision of participants and be able to force a participant to make customers whole, if necessary and appropriate.

Another, perhaps less obvious, concern is 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 practice of being stricter on firms that do not participate in a sandbox, despite such a practice being potentially not justified.

These risks are real and should be taken seriously, but fortunately they can also be at least somewhat mitigated against. 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. Further, legislators and regulators must ensure that regulators do not treat nonsandbox firms unfairly owing to those firms’ lack of participation. 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.

The present bill contains several provisions that recognize the risks described earlier and seek to mitigate them. For example, requiring applicants to demonstrate a credible plan to protect consumers in the event of failure can help protect customers, and treating the prior admission of a firm’s competitor into the sandbox as a factor in favor of the firm’s 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 state of Utah has demonstrated a willingness to change its regulatory environment to welcome innovation and competition. If done well, there is reason to believe that the people of Utah will benefit through a more dynamic, competitive, and rich economy.

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 (2021): 445–75.