Regulatory sandboxes

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Should States Create Their Own ‘Regulatory Sandboxes’?

Brian Knight | July 7, 2017

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Before the JOBS Act became federal law in 2012, Kansas and Georgia already allowed investment crowdfunding within their borders.  Today, more than 30 states have adopted intrastate crowdfunding laws, underscoring their role as experimental laboratories of democracy. One forward-thinking state, Michigan, has passed a complementary local stock market law. Could regulatory sandboxes be next? In this guest post, Brian Knight of the Mercatus Center explores the idea of creating state-based safe zones for financial innovation. 

Regulatory sandboxes are all the rage these days. The term refers to laws that promote responsible innovation by allowing financial startups to experiment with new models—without fear of running afoul of regulators. The idea of a place where firms can try out new products or services with limited regulatory exposure, in collaboration with the regulator, has obvious appeal for innovative firms operating in the highly regulated area of financial services. The most famous is the UK sandbox run by the Financial Conduct Authority, the UK’s version of the SEC. But other countries are getting into the mix.

How about the United States? Where is our sandbox? Well, it is tricky, because the United States financial regulatory system is extremely diffuse. Not only do we have numerous overlapping regulators at the federal level, but the states also have considerable authority to regulate financial services. This presents a problem for a federal sandbox, including one proposed last year. Even if a company were to work with federal regulators in exchange for the regulatory benefits provided by a sandbox, state regulators could bring their own enforcement actions.

Related: Legislation to Buoy Crowdfunding, Fintech This Year

Rep. Patrick McHenry’s Financial Services Innovation Act of 2016, introduced in the last Congress, sought to address this by limiting the ability of states to bring enforcement actions against companies who had entered into “enforceable compliance agreements” with a federal regulator. Some sort of limitation will be necessary for a federal sandbox to work.

But what about the states? Aren’t they supposed to be “Laboratories of Democracy”? While I have been a skeptic of state regulation of fintech in many contexts, there is a potentially large role for them to play. One such role could be establishing their own regulatory sandboxes for fintech. To do this however, we would need to address the inverse of the problem above. How do you protect state sandboxes from inconsistent federal regulation?

This would likely require federal action, and could take a variety of forms:

1. A prohibition or limitation on federal regulators bringing enforcement actions against firms engaged in a state sandbox.

2. A clear grant of discretion to federal regulators that they can refrain from bringing enforcement actions based on conduct done by a firm as part of a state sandbox.

3. An affirmative defense against an enforcement action the firm could assert if the conduct giving rise to the enforcement action was done in compliance with the requirements of a state sandbox. This should also apply to private suits in cases where the law grants a private right of action.

In fairness, there would need to be some criteria a state sandbox would have to meet to make this work. Some possible suggestions:

1. There is a reasonable basis to believe that only residents of the sandbox state are customers for the product or service in the sandbox.

2. There is a reasonable basis to believe that the product or service will not cause harm to people outside of the sandbox state.

3. The sandbox has a reasonable limit as to the number of customers and duration of the test.

4. The state sandbox has credible requirements to ensure customers will be properly compensated for losses sustained as a result of the product or service violating consumer protection law.

5. The state sandbox’s entrance and exit criteria are fair and do not unduly privilege some firms at the expense of others.

It remains unclear whether any state would want to set up such a sandbox, but the law should at least accommodate the possibility.

Brian Knight is Senior Research Fellow at the Mercatus Center at George Mason University, a research center dedicated to bridging the gap between academic research and public policy problems. This post originally ran on his FinRegRag on Medium.

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