Chair Wilson, Vice Chair Crosby, and members of the House Economic Matters Committee:
Thank you for the opportunity to submit informational testimony on House Bill 1204. 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 conduct research on regulatory sandboxes.
I would like to offer these takeaways for regulatory sandboxes:
- Regulatory sandboxes offer potential benefits, including increased innovation and competition.
- Regulatory sandboxes also have potential risks, including risks to competition and consumer protection.
- There are ways to mitigate these risks while securing the benefits of a regulatory sandbox.
I have also 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. The state of Arizona was the first US state to launch a financial 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 risks must be guarded against. One area of obvious 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 that 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 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 the risks described earlier. For example, the bill requires applicants to demonstrate a credible plan to protect consumers in the event of failure. The bill also appears to require that the Office of the Commissioner of Financial Regulation consider a competitor’s admission into the sandbox as a factor in favor of an applicant’s admission, though this provision should be made more explicit. Such a provision 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.
There are a couple ways in which the legislature may wish to amend the bill. First, as previously mentioned, it could be made clearer whether a competitor’s prior admission to the sandbox is a factor in favor of an applicant’s admission. Second, the legislature could consider expanding sandbox eligibility to products or services beyond just those that require a license or other authorization. Doing so may allow the sandbox to be more useful to innovative firms and allow regulators more insight into future products and services.
One amendment that the legislature should strongly consider is language establishing that a participant in the sandbox is deemed to have an appropriate state license for the purposes of federal law. Such a provision would be important because it is a federal crime to conduct certain types of financial transactions without a state license under certain circumstances. A provision holding that sandbox participants are deemed to hold a license for the duration of their participation is commonly found in other states’ sandboxes to address this concern. It is possible that there is already language in the bill that speaks to this issue, but such is unclear.
The state of Maryland has expressed interest in changing its regulatory environment to encourage innovation. 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.
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.