Crypto Regulatory Sandbox: What It is, How It Works

What Is a Crypto Regulatory Sandbox?

A crypto regulatory sandbox is a live-like testing environment used to ensure regulatory compliance and security checks for financial operations, including cryptocurrencies and blockchain networks.

How Crypto Regulatory Sandboxes Work

A sandbox is a commonly used term in the field of software development. A sandbox refers to an isolated—but fully functional—testing environment where software, applications (apps), and programs can be tested. If a programmer writes a new piece of code, they may use a sandbox to test it. For example, if a programmer working on updating the Uber ride-sharing app adds a new feature to more accurately locate the passenger using GPS, or a team of developers at Facebook enhances the site's functionality, before such updates and features are launched, they may be tested in an isolated and controlled environment called the sandbox.

Regulatory Sandboxes

Regulatory sandboxes involve a coordinated effort to create and improve existing regulations for a particular industry by working with all of the regulatory agencies and companies involved in that industry. Regulatory sandboxes can help companies understand the regulatory requirements in a country. Sandboxes can also be used in the early stages of writing regulations when there isn't an existing framework in place. In other words, regulations can be tested in an environment to determine how best to regulate a particular industry and build a network of cooperation from the regulated companies.

Some sandboxes can be broad in nature—a focus on the financial services sector—while other sandboxes can be more targeted. Targeted sandboxes can include creating testing environments for improving payment systems and developing digital authentication to prevent fraud, system hacking, and cyber attacks. Beyond testing features and functionality, a sandbox also allows security aspects of new code to be verified.

Blockchain Sandboxes

Regulatory sandboxes have also been used to test blockchain technology and how to effectively introduce and implement cryptocurrencies within a financial system. Blockchain is a distributed-ledger system similar to a shared database in which financial transactions are verified before being added to the publicly-viewed ledger as a permanent record.

Transactions in a blockchain must be approved and validated by its participants and once a transaction has been completed, a new block is added to the network. Although blockchain technology is typically used as a shared ledger for public use, private blockchains can also be created, which would only allow access for certain participants that meet the authentication requirements.

The interest in blockchain technology by governments and regulators is on the rise. For example, in 2018, the European Commission announced that more than 21 member states of the European Union signed a declaration creating the European Blockchain Partnership (EBP) to develop the European Blockchain Services Infrastructure (EBSI). The blockchain initiative is designed to provide access to digital public services such as regulatory reporting, energy, and logistics to benefit companies and citizens.

Regulatory Sandboxes in the Financial Sector

Sandboxes can help regulators learn about new technologies, such as financial technologies (or fintech), which offer financial products online and through mobile devices. Many banks and financial technology firms are using digital products to improve their customer's experience. The digitization of financial services includes the following services:

• Access to account and financial information
• Transfer money
• Automate processes, such as stock trading, direct deposits, loan payments, and transfers
• Online loan and credit card applications

Although fintech is usually reserved for the banking sector, other industries such as education and government agencies have used the technology to facilitate electronic payments. However, since the financial sector is heavily regulated by securities and banking laws in many countries, regulatory compliance is a must.

The functions that come under compliance scrutiny include monetary transactions, lending, payments, insurance, and trading processed through straight-through processing (STP) technology. Regulatory authorities must balance digital innovation and consumer protections, which is why regulators in many nations have adopted a “regulatory sandbox” based approach.

The use of a regulatory sandbox allows authorized businesses to test their innovative products, services, business models, and delivery mechanisms in the real market, with real consumers, on a trial basis. It helps reduce the time to market at a low cost, improves access to capital, and ensures adherence to compliance requirements. Such regulatory sandboxes allow room for direct communication between fintech developers and businesses and regulatory officials while mitigating the risks of unintended negative consequences such as security flaws. 

Crypto Regulatory Sandboxes

As blockchain technology and various cryptocurrencies have gained popularity, adherence to regulations and the security of digital assets is gaining importance. Repeated incidents of cryptocurrency thefts, hacking attempts, and scams are also acting as a deterrent to mass adoption.

Regulatory sandboxes have been extended into the virtual world of cryptocurrencies, where financial regulators are offering authorized businesses the possibility of testing blockchain products. For instance, in August 2021, the U.K.'s Financial Conduct Authority (FCA) gave 20 companies access to its regulatory sandbox service.

In early 2023, the European Commission launched its own sandbox. The sandbox comprises of a diverse set of expert professionals including law firm Bird & Bird, consulting firm OXYGY, web designer Spindox, and blockchain expert WBNoDE. The European Blockchain Regulatory Sandbox will operate for 3 years with three annual cohorts of 20 use cases each, and the most innovative regulator participating in the sandbox will be awarded a prize.

In the U.S., Mick Mulvaney, the former acting director of the Consumer Financial Protection Bureau (CFPB), in September 2018 announced the launch of a regulatory sandbox aimed to encourage cryptocurrencies and blockchain technology. In early 2020, before he dropped out of the presidential race, then-candidate Michael Bloomberg called for a "fintech sandbox" to promote innovation.

In November of 2020, the government of Spain signed into law the Digital Transformation of the Financial Sector, which created a sandbox for the cryptocurrency and fintech ecosystem. As the sandbox and the subsequent regulations develop, it could lead to the further widespread use of cryptocurrencies in the country and act as a model for the rest of the European Union nations. Spain is already at the forefront when it comes to offering cryptocurrencies since the country bolsters 285 Bitcoin ATMs.

Limitations of Crypto Regulatory Sandboxes

Regulatory sandboxes typically have a limited duration and may only cover specific aspects of the cryptocurrency and fintech industry. This limited scope can hinder the comprehensive testing of innovative solutions, potentially leaving out critical use cases or technologies. For example, the European Blockchain Regulatory Sandbox has a term life of only three years and will trial run no more than 60 use cases over its lifetime.

Due to the innovated and exploratory nature of these sandboxes, it's often difficult to set specific timeframes, goals, or milestones to achieve. For instance, the Global Financial Innovation Network (GFIN) was created in 2019 as a pilot project to test regulation on 44 applications. When reporting on the expected timeline to review these applications, Baker McKenzie state it "is difficult to give a precise figure due to the limited time the GFIN has been running."

Last, there are political and geographical constraints of crypto regulatory sandboxes. Consider how political bodies are confined to their physical regions, while cryptocurrencies can be exchanged and traded around the world. This interoperability of crypto poses many regulatory challenges, and sandboxes are often confined to a country's borders related to a specific region's challenges. As noted by Stanford University, "the scope of fintech sandboxes rarely goes beyond the relatively narrow national level. Consequently, there are still no harmonized international legal standards on the legal frameworks governing sandboxes."

Future of Crypto Regulatory Sandboxes

It's likely that an increasing number of crypto sandboxes are to be adopted in the coming years as more companies and governments explore the potential of blockchain technology and cryptocurrencies. However, the findings from the existing sandboxes have yet to be finalized and implemented. Cryptos have had their fair share of challenges, including hacks in which money was stolen, such as the Ethereum hack in 2016 in which $50 million dollars was stolen. The disagreement on how to handle the hack led to the split of the network into two blockchains: Ethereum (ETH) and Ethereum Classic (ETC).

It's important to note that even though investment in blockchain technology has increased, it doesn't necessarily mean that the cryptocurrencies that are commonly traded today will be used within those networks.

For example, the Union Bank of Switzerland (UBS) has developed a sandbox exploring the use of blockchain technology for payments within the banking sector. UBS has partnered with other large banks throughout the world to develop a Utility Settlement Coin (USC), which is a digital equivalent of cash. The USC would be converted on a one-to-one basis or parity with a corresponding fiat currency, such as the euro or U.S. dollar, and backed by cash at a central bank.

The Bottom Line

Crypto regulatory sandboxes are controlled environments established by government agencies to enable fintech companies and startups to test cryptocurrency and blockchain projects under relaxed regulations. They aim to foster innovation, identify regulatory challenges, promote innovation, and protect consumers.