Review. The sandbox paradox: Balancing the need to facilitate innovation with the risk of regulatory privilege

Knight B. and Mitchell T. (2021), The Sandbox Paradox: Balancing the Need to Facilitate Innovation with the Risk of Regulatory Privilege, South Carolina Law Review, 72(2): 445-475.

Review by Gabriel Rizza Ferraz

Introduction

The paper by Brian Knight and Trace Mitchells from the Mercatus Center of George Mason University discusses how the regulatory instrument that was first used by the Financial Conduct Authority (FCA) of the United Kingdom in 2016 became popular among regulators and spread to different jurisdictions including the United States. According to the authors regulators face a paradox with sandboxes: for the sandbox to be effective it must offer regulatory relief to the participants, but this relief may result in economic privileges at the expense of rival firms.

Sandbox concept, design and potential costs

Concept – In the first part the authors establish their concept of regulatory sandbox as “regulatory sandbox is a legal construct that allows firms to offer products or services for a limited time and to a limited number of customers in a modified regulatory environment so that those firms can test a product or service before it is offered more broadly” (p.8)

The paper then proceeds to discuss the regulatory sandbox design and common criteria adopted across different jurisdictions. The three main aspects shared are related to the sandbox purpose, the entry criteria and the relief offered.

Design – The sandbox purpose is influenced by the economic and policy goals of each regulators. Encouraging innovation to promote business development is a common goal among them. Broadening the range of services and products offered to consumers and increasing protection from potential harmful effects is another common objective among jurisdictions. Promoting the exchange of knowledge between regulators and companies and allowing a better understanding of new products in the development phase is the third aspect highlighted by the paper. Finally, most jurisdictions aim to directly support innovative activities and attract innovative companies with the sandbox signaling effect.

The second design feature with common characteristics among different jurisdictions is the entry criteria and process. Regulators usually require that the firm operates under their jurisdiction to participate in the sandbox. Policymakers limit the participation to certain types of products (e.g. e-payment, consumer lending) and can adopt a more broad and subjective criteria requiring that the product is considered “innovative”. The FCA considers a product innovative if it is significantly different of those offered by competitors. Arizona and Utah adopt a similar criterion comparing similar products in the market and accept firms that make use of technology in their business models. Limiting the number of consumers that can access the new product is a common feature as well.

The entry process consists of an application sent to regulators providing details about the firm new product, potential benefits, and regulatory reliefs applicable. The regulator evaluates the application with broad discretion to select the sandbox participants. Australia is the limited exception and the regulatory sandbox works as a class waiver for certain activities. Firms need to notify the regulators about their participation and the regulator has 30 days to block the company from operating within the sandbox if the requirements are not met.

The type of relief offered by regulators varies according to policy objectives and can consist of restricted authorization, no-action letters, rule waivers and modifications and individual guidance.

Potential Costs – The adoption regulatory sandbox has potential costs and risks that should be considered by regulators. Regulatory resources are scarce and that they could be used to fund more efficient projects to promote innovation, such as more general innovation hubs. The risk that consumer protection is reduced with more flexible regulation is another potential cost identified by the paper.

Risks and costs of economic privilege

Risk – The privileged treatment granted to firms that participate in the regulatory sandbox can be detrimental to competitors. Granting special treatment to a firm can harm market competition and that will reduce consumer benefits. This is the paradox regulators must face: granting benefits to a specific company can promote innovation and bring benefits but the negative effects on market competition and potential harm to consumers can outweigh the gains. The unfair advantage could be in the form of “the-first mover advantage”, easier access to investment or privileged guidance from government officials. The risks do not make the regulatory sandbox undesirable, but regulators must understand them.

Costs – The authors identify different costs associated with the potential economic privileged granted to some firms within the sandbox framework. Unjust economic privilege granted to a firm competing in the market could lead to an inefficient allocation of resources and be detrimental to competition. It may be a necessary evil but should be avoided whenever possible.

Government granted privilege can work as a signaling mechanism and distort the market and its function as a knowledge process. Firms participating in the sandbox could appear to perform better or be more efficient just because of the reduced regulatory burden which could lead to inefficient choices by consumers and investors.

The economic literature discusses regulatory capture by interest groups. The regulatory sandbox could create a market for economic privilege and there is a risk that government granted privilege could lead to cronyism. Firms could have incentives to seek preferential treatment or block rivals from participating.

Mitigating Risks – The authors propose to tackle the issue of the lack of access by lowering or eliminating procedural restrictions to mitigate risks. A second option considering competitors as a factor in favor of entry or not. The third option would be setting objective criteria like the Australian model. A fourth option is allowing industry groups and third parties to facilitate the entry of their members in the sandbox. The duration of the sandbox and the expansion of the access the information gathered inside the sandbox are also crucial to achieve the policy objectives.

The potential of differential treatment in enforcement by the regulators should also be mitigated. The risk that good faith firms that are outside the sandbox are treated differently than the ones inside can lead to undesirable results, such as different liabilities for the same behavior. To address this risk regulators should establish both formal and informal guidance to enforcement staff to treat firms in this situation in a similar way. It should be clear that the lack of participation is not a sign of bad faith.

Conclusion

Sandboxes are still a developing regulatory tool and the paper identifies risks for future analysis by researchers and policymakers. The creation of sandboxes can generate legitimate benefits that are bigger than the costs imposed by the potential economic privilege, but this risk should not be ignored by regulators.