By Andrea O’Sullivan, Director of the Center for Technology and Innovation, The James Madison Institute
As policymakers seek to boost innovation within their borders, forward-looking national and regional governments have embraced “regulatory sandboxes” as a means to afford a market-centered opportunity for experimentation under the watchful eyes of regulators. Florida has been a leader in the advance of regulatory sandboxes, implementing a financial technology or “fintech” sandbox in 2020, which will begin operations on January 1, 2021.
The speed of Florida’s embrace of regulatory sandboxes has been as cutting-edge as it was admirable, as the state adopted its own fintech licensing relief just four short years from the time that the United Kingdom first initiated the concept of a fintech sandbox under its Financial Conduct Authority.1 As the UK’s sandbox has been around for roughly half a decade now, we can draw lessons of what Florida might expect: products get to market sooner, participants attract key partnerships and funding, and consumers are served by more innovative products from both participants and market incumbents.
Floridians can benefit from more market innovation in non-fintech applications as well. As such, Florida policymakers should consider extending the successes of the regulatory sandbox model to more industries such as legal services or insurance, or even undertake an industry-neutral sandbox to which any innovative entrepreneur can apply.
What is a regulatory sandbox?
There are many ways that regulations constrain business. Some industries must apply for, obtain, and maintain a government license before they are able to legally operate. Others must submit to certain reporting, oversight, auditing, and data maintenance requirements. Sometimes there are special fees or taxes. And of course, different businesses may be subject to different combinations of the above.
Economists have long pointed out that regulation can sometimes have the counterproductive effect of serving as a barrier to entry for potential market competitors. The reasoning is simple: market incumbents are usually better funded and more able to handle regulatory costs than potentially more innovative startups. Because new companies lack the capital and lawyers to navigate established regulatory structures, they are often preemptively shut out of the market. This is not only costly for affected firms, it robs society of innovative new products, services, and companies while seriously stalling our potential for economic growth.
Wholesale regulatory reform is difficult for many reasons.4 Government and private incumbents may be opposed to the change. The public may prefer the status quo, therefore constraining political actors’ opportunities for reform. Or perhaps the regulations are indeed socially beneficial for market incumbents with the unfortunate side effect of limiting new entrants.
Regulatory sandboxes offer a solution to the “barrier to entry” problem by helping innovative new firms fast-track their products and services to market with the collaboration of expert regulators. As the name suggests, a sandbox is a defined environment where innovative companies may safely experiment under the watch and guidance of regulatory agencies. Firms that successfully complete a sandbox program will grow enough to become a full-fledged business that is regulated similar to every other incumbent.
By lowering the initial regulatory costs for market upstarts, these firms may have the chance to grow into competitors that can capably shoulder normal compliance costs, at which point they “graduate” from the sandbox. Alternatively, firms whose business models are found to be unworkable or unprofitable may fold without losing as much investment as they otherwise would if they had to comply with the full regulatory burdens from the start.
There are many ways to structure a regulatory sandbox. It may be targeted to a particular industry, as is Florida’s fintech sandbox, or it may be general purpose; other proposed and established sandboxes have included energy firms, environmental efforts, and data protection software. A sandbox may be established for a set period of time or it may be variable. It may completely absolve participants of regulatory requirements or it may simply offer a more limited regulatory framework. Most regulatory sandboxes require that businesses inform potential customers of the participation in the program in the interest of transparency and consumer protection. Each sandbox will have its own terms and conditions for entry, exit, relief, reporting, and timeframe that are tailored to the goals of the establishing government.