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Done right, regulatory sandboxes can promote competition

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Regulatory sandboxes are one of the newest and most exciting developments in the world of financial regulation. But they also pose a more subtle threat.

These sandboxes could become a form of government-granted privilege that benefits firms admitted into the space at the expense of their non-admitted rivals. This would threaten to harm not only non-privileged firms but ultimately consumers as well.

To be fair, financial agencies developed these sandboxes to lower regulatory barriers that prevent firms from bringing innovative new financial products to the market, while still protecting consumers through increased oversight and disclosure. As the pace of innovation quickens in financial services, these sandboxes are a way for policymakers to promote innovation while still maintaining regulatory protection.

So far, those who have expressed skepticism about these new regulatory experiments primarily focused on the potential for consumer harm. However, there is a greater threat.

In a competitive market, an advantage given to one firm by a regulator often serves as a disadvantage for that firm’s competitors. If one firm is granted leeway to test a product with mitigated licensing requirements and fast-tracked approval, this can be a detriment to its competitors, which likely still have to spend the time, money and effort necessary to obtain a license through the traditional process.

The favored firm can now spend those resources on research or marketing while the competition is still trying to enter the market.

Not only does this seem intuitively unjust, but it distorts the market and weakens the positive effects brought by competition. Herein lies the “sandbox paradox.”

In order for a sandbox to be worth entering, it must convey some benefit to the admitted firms. However, each benefit granted to these firms has the potential to harm overall market competition.

None of this is to say that a regulatory sandbox is a bad idea or that it inherently does more harm than good. In fact, when done well, sandboxes are an improvement over the status quo.

But the risk of economic privilege is a potential problem that will need to be addressed as these sandboxes become increasingly popular. The question the turns to what policymakers can do to mitigate this risk.

First, regulators should maximize the number of firms allowed to participate in the sandbox to the greatest extent possible. An advantage given to all is an advantage to none.

Of course, sandboxes should have requirements for entry. But those criteria should be explicit, objective and any firm which meets it should be allowed to participate. This will help prevent similarly situated firms from finding themselves at a disadvantage simply because another firm was quicker to apply.

This situation could occur if a jurisdiction conditions entry on a product being truly novel, something already done by several jurisdictions.

The goal is to minimize regulatory discretion about which firms participate, to the greatest extent possible. This would also entail establishing a clear appeals process that allows denied firms to challenge the decision reached by the regulators.

All of this would minimize the harm done to market competition as well as the potential for favoritism.

A second way to minimize risk of undue competitive advantage is to have regulators be very transparent about what they and participants learn in the sandbox.

This doesn’t mean that proprietary information should be disclosed. But to the extent that regulators effectively serve as lawyers or consultants by helping firms understand novel questions of law, the insights they produce should be shared with the public.

This will allow all market participants to benefit from the sandbox and mitigate the risk that sandbox firms will get the exclusive benefits gained by this experiment.

Sandboxes may help spur innovation and competition for the betterment of consumers. However, the risk of economic privilege is an inherent byproduct of regulation. It should not be assumed that regulatory sandboxes are any different.

Policymakers can minimize this risk by allowing as many firms to participate as possible and sharing the lessons learned more broadly. This will help resolve the sandbox paradox and maximize the benefits of this new, less-onerous regulatory environment.

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