Regulatory arbitrage rears its ugly head
Derivatives comment: Simon Boughey
16 May 2011
When global regulators set about curing the perceived ills of the derivatives industry in the wake of the financial crisis, there was considerable effort to co-ordinate the thrust and principles
of public policy. It made a great deal of sense, they seemed to acknowledge, for everyone to be on the same page.
Two years or so on, this admirable unity of purpose and action is beginning to dissipate. Indeed, an increasingly vocal slice of the market is starting to warn that the dangers of regulatory
arbitrage are real and present.
If most of the derivatives industry was to up sticks to a more favourable regulatory regime, it would mean, first of all, that the US, or the UK, would be deprived of valuable tax revenue. Given
the low regard with which bankers are held in the US and, still more, in the UK, the general populace might not see this as a particularly grievous loss, but, hopefully, public policymakers are
rather more enlightened.
A wholesale migration to one location would not be a healthy step for the industry. The big danger of such a move is that it could create an unprecedented concentration of risk. If that happens,
all the efforts made by regulators since the crisis will have been in vain, and, ultimately be damaging. Risk will not have been mitigated; on the contrary, it will have been simply shifted and then
Derivatives bankers are concerned that each of the three major financial areas is working at its own pace, with no single date set for the implementation of global rules. The Dodd-Frank Act in the
US requires all the new rules concerning derivatives to be written by July (though this deadline will not be met and no one knows when the rules will be written) while in Europe new rules are not
expected until next year at the earliest. In Asia, regulators are working to another timetable again.
Other regimes are further behind. Canada, for example, has yet to decide whether it will establish its own domestic framework for clearing – the Holy Grail for US and European regulators – and
trade reporting. New derivatives markets, such as Turkey and Indonesia, are still at the earliest stages of considering regulations.
The prospect that such a patchwork quilt could encourage businesses to move to regimes with the fewest onerous regulations is not mere scaremongering by the anti-regulation caucus. Last month, the
Financial Stability Board, which works alongside the Bank for International Settlements to co-ordinate the work of national regulators at a global level, said it was “concerned with the substantial
variation across jurisdictions in the pace of implementation”.
Of perhaps greater concern is that regulators everywhere, but particularly in the US, are under huge pressure to produce rules and guidelines very quickly with inadequate resources. More than 200 staffers at the Commodity Futures Trading Commission are working round the clock to get the job done, but, as chairman Gary Gensler has indicated plaintively, this is still not enough. The industry also fears it is not being consulted nearly enough over the shape and format of the rules.
This pressure to get guidelines out sooner rather than later seems likely to risk the rules being not only poor, but also inconsistent with rules being produced elsewhere. Banks have shown
themselves in the past to be skilled at exploiting tax loopholes and there is no reason to suppose they will not turn their hand to regulatory arbitrage with the same dexterity.
Once again, the FSB noted the possibility of greater risk rather than less in last month’s document. “Some [members] worried that the rushed pace of implementation might exacerbate, rather than
mitigate, systemic risk,” it said.
The warning signs are already there. The European market infrastructure regulation published last December is moving towards a more inclusive approach to derivatives instruments. Many policymakers
believe that every derivative product should be standardised and cleared. Under Dodd-Frank, however, the general principle is that every derivative that needs to be cleared should be cleared. If
Dodd-Frank proves more relaxed about clearing, a migration from Europe to the US could come to pass.
Clearing is a vexatious issue. Over the past few years, since clearing was positioned by regulators to be the silver bullet to kill the ogre of financial meltdown, there has been a proliferation
of central counterparties. Each country wants its own CCP, and the resulting fragmentation could reduce liquidity and, ultimately, the effectiveness of each clearing house.
Ultimately, most derivatives bankers fear that the faith placed by regulators from all regimes in clearing houses is misplaced and even dangerous. Far from being the panacea, it could sow the
seeds of the next big crisis by the creation of clearing houses, rather than banks, that are too big to fail.
A derivatives regulation expert at a New York consultancy warned last week: “My grandchildren are going to have to pay for an even bigger crash. What we’re going to have is ill-focused rules, produced as a knee-jerk response by politicians who didn’t understand regulation.”
Bankers have been saying this in private for the past year or more. But when bodies like the BIS start agreeing, it is perhaps time for regulators to take their foot off the accelerator and make sure regulatory arbitrage is not the next thing they have to worry about.