How State ‘Regulatory Sandboxes’ are Laboratories for Innovation

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With the nation moving to a post-coronavirus living and working environment, the question confronting policymakers is: How to stimulate the U.S. economy to encourage entrepreneurship, growth, and expanded employment? In our Federalist system, the most effective avenue for managing this economic challenge is found at the state level of governance. State governments are not simply “laboratories of democracy,” but also “laboratories of innovation” that test creative policy ideas that—if evaluated as successful—could be transferred to other states, and perhaps adopted at the federal level. And in the case of local and regional “innovation hubs,” these creative policy ideas can have a significant impact on creating an environment conducive to state (and regional-level) technological entrepreneurship and corporate innovation.

One recent public policy concept that has generated public interest in incentivizing technological economic development is the “regulatory sandbox.” The first such regulatory sandbox was launched in 2015 in the United Kingdom by the government’s Financial Conduct Authority and focused on the country’s emerging financial services technology (“fintech”) industry. A regulatory sandbox creates a “test area” for developing public regulation that stays current with the rapid pace of innovation.

This regulatory sandbox allows established firms and entrepreneurial challengers to test the societal introduction of emerging technologies and/or business models at the leading edge or outside of the existing public regulatory framework. While evaluating demonstration projects and collecting data, technology innovators and public regulators are learning in real-time from each other and better understanding the data results before developing public regulation. Each regulatory sandbox is designed with its own terms and conditions for entry, exit, relief, reporting, and timeframe specific to the establishing government. This “win-win” situation should create more effective and efficient regulation, which is implemented faster and, therefore, benefits society.

Regulatory sandboxes offer a potential solution to the “barrier to entry” challenge by assisting innovative, entrepreneurial businesses in commercializing their products and services with the collaboration of public regulators. Thus, by lowering the initial regulatory costs for new market entrants, these firms have the opportunity to develop into competitors that can absorb standard compliance costs, at which point they “graduate” from the sandbox or, if their business model fails, the entrepreneurs exit without losing as much investment. Yet, regulatory sandboxes also entail risks, as regulatory sandbox critics point out that relaxation in regulatory standards will increase the probability that consumers are harmed. Furthermore, any benefit accrued to one firm in a developing market may result in a disadvantage to all of that firm’s competitors.

The intellectual foundation for governments to embrace the concept of the regulatory sandbox can be found in “Martec’s Law,” an organization/technology relationship first introduced by marketing technologist Scott Brinker in 2013: technological change is exponential, but organizational change is logarithmic. Translated, this “law” means that innovative change is rapid and accelerates as it develops, but for a firm or public regulator organizational change is slower, i.e., gradual.

In pre-coronavirus 2019, there were six state governments—Arizona, Kentucky, Nevada, Utah, Vermont, and Wyoming—that enacted legislation creating fintech regulatory sandboxes within their respective states. In 2020, Florida also enacted legislation creating a fintech regulatory sandbox, and in 2021, both the North Carolina and Tennessee state legislatures are presently considering similar legislation. However, Utah is now considering new legislation expanding its current range of industry-specific regulatory sandboxes—financial technology, insurance, and legal services—to encompass all industries, and thus opening up opportunities for its citizens to take entrepreneurial advantage of a greater range of technological innovations and entrepreneurial opportunities both in and outside innovation hubs.

In 2015, a research group called “Entrepreneurial Spaces and Collectives” conducted inductive observations of innovation hubs and related collaborative organizations worldwide. Their findings focused on four key characteristics that define innovation hubs: first, hubs build collaborative communities with entrepreneurial individuals at the center; second, they attract diverse members with heterogeneous knowledge; third, they facilitate creativity and collaboration in physical and digital space; and fourth, they localize global entrepreneurial culture.

Moreover, researchers at the University of New South Wales, Faculty of Law, published a 2019 study that reviewed over fifty jurisdictions that announced or established fintech sandboxes and other jurisdictions that announced or established innovation hubs. The study results suggest that stand-alone regulatory sandboxes are not the most effective policy approach to building fintech ecosystems, as innovation hubs are overall more effective. Nevertheless, the paper does highlight three key benefits of implementing a fintech regulatory sandbox:

First, the message it sends to the market, i.e., signaling a regulator’s flexibility, approachability, propensity to support innovation, and engage with innovative enterprises.

Second, the boost to innovation, and the incentivizes it provides financial services firms to accelerate their digital transformation programs, while also promoting competition among financial centers to publish—and review—their dispensation policies.

Third, relates to how much the regulator stands to learn about innovation from fintech firms due to their freedom to operate and communicate openly.

This study concludes that in many cases, the “maximum benefit” can be achieved by integrating an innovation hub with a fintech regulatory sandbox “as part of a strategy support the evolution of an innovative fintech ecosystem.”

Regulatory sandboxes may be structured for a particular industry, e.g., financial services, or more generally, e.g., across industries, as is being considered by legislators in Utah. Utah is an early example of the next phase in the evolution of the regulatory sandbox concept, where it will be integrated in support of emerging state-level innovation hubs, potentially creating regional, border-spanning economic opportunities. In the latter case, potential across-state regulatory and economic development alliances will also need to be negotiated for industrial ecosystem harmonization. The opportunities for developing new, smaller innovation hubs in previously non-traditional geographic areas may now be feasible.

In conclusion, states are considering establishing non-industry-specific regulatory sandboxes designed to encourage “smart” public regulation of entrepreneurial activities, while creating a business environment built upon the future prospects of evolutionary industrial ecosystems offering new products and services.

Thomas A. Hemphill is David M. French Distinguished professor of strategy, innovation, and public policy in the School of Management, University of Michigan-Flint.

Image: Reuters.

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