The regulatory arbitrage debate

The regulatory arbitrage debate

Larry Thompson, managing director and general counsel, DTCC

In our efforts to address the lessons of the 2008 financial crisis, we must ensure that globally consistent regulation is developed in order to promote a level playing field where competitive, innovative and stable markets can grow and thrive. Regulatory divergence or duplication has the potential to increase opportunities for regulatory arbitrage, threaten market efficiency and stability and undermine efforts to prevent the next financial crisis.

Achieving the appropriate balance in cross-border regulation is essential. Overly extraterritorial rules not only ignore the opportunity to achieve regulatory goals through policies of equivalence and mutual recognition but also increase the potential for duplicative or conflicting regulatory policies. This could lead to increased compliance costs that reduce market liquidity and subject market participants to operational and legal risks tied to conflicting local and third-country policies

The combination of these and other factors will inevitably lead to regulatory arbitrage that tilts the playing field in favor of certain jurisdictions over others. At the same time, during periods of market stress or crisis, the lack of a consistent regulatory approach and information sharing will inevitably lead to more localized and therefore less internationally coordinated regulatory responses. 

As the situation plays out over the coming years and the market settles into its new regulatory reality, it is likely that some kind of alignment between the different authorities’ efforts will prevail. By that time, however, the industry could be facing an entirely new set of challenges altogether.

Richard Baker, CEO, Cleartrade

Regulatory "Top Trumps" is my new favourite game. My SEF to see your MTF, my DCM to see your OTF? Do we understand the difference and the value these different, organised trading venues have for participants? Do participants know how and if they can access these organised trading venues across different jurisdictions?

The "Path Forward" statement, issued by the CFTC & EC Principals in July 2013, set the agenda for cross-border issues and was recently updated (February 2014) with regard to harmonising the regulatory framework for swap execution facilities (SEFs) and EU-regulated Multilateral Trading Facilities (MTFs)

The CFTC and EC Staffs agreed upon no-action relief letters for EU venues, providing temporary relief from CFTC requirements. We think this is a positive step forward. Without such an approach market issues such as liquidity fragmentation across jurisdictional lines impede business and hold off trading participants from joining and using organised trading venues. This is one of a number of cross-border issues the OTC Derivatives Regulators Group (ODRG) have been working on in an effort to establish substituted compliance.

This seems to be a more mature approach to regulatory harmonisation amongst the G20 community and one that will help trading venues, clearing organisations and market participants access liquidity pools without dual or multi-jurisdictional costly registrations. We watch with much anticipation the November 2014 ORDG meeting for further reports on the trading commitment and the timetable for implementation across broader territories.

Zohar Hod, global head of sales and support, SuperDerivatives

As a fractured regulatory landscape has emerged in the wake of the financial crisis of 2008, the headlines have primarily focused on the often-unaligned efforts of the US and European regulatory bodies. Just last week we saw yet another CFTC deadline pass as the industry scratched its collective head in the absence of clarification of what exactly was expected of them.

The deadline in question related to European MTFs applying for QMTF status – a CFTC-created category for MTFs wishing to open their markets to US participants who would otherwise only be allowed to trade on US-regulated SEFs.

Just as the FCA was working through the rules with London-based venues, the CFTC told European platforms not to apply as it was re-working its guidance on the matter. The result, potentially, is a further split in the already-fragile liquidity of the global swaps markets and the opportunity for arbitrage between them.

While this is just one of many headaches for US and European derivatives market participants, the bigger story in the global arbitrage saga is undoubtedly Asia. The geographical and regulatory patchwork of this region is so vast and so varied – and often so unaligned with US and European efforts - that the opportunities for arbitrage are endless.

Asia’s financial markets are growing in strength and sophistication and becoming increasingly attractive to foreign buy- and sell-side trading operations. Add to that mix a favourable regulatory environment in jurisdictions such as Singapore, and the scene is well set for intercontinental arbitrage. China, of course, is a different beast altogether, and is undoubtedly the big “what if” in the whole debate.

Anne Plested, head of regulation change programme, Fidessa

Capitalising on loopholes to circumnavigate unfavourable regulation has held the headlines in recent years, particularly in terms of arbitrage opportunities presented by geographic relocation. With no end in sight to the vast swathes of regulatory reform taking effect around the globe the possible implications on the derivatives landscape continue to be debated.

With the Dodd-Frank legislation on derivatives in place in the US some years ahead of Europe, there was always the possibility of regulatory arbitrage based on trading location. But now the EU timeline is rapidly catching up and the threat of regulatory arbitrage between the US and Europe is perhaps not as great as once feared

Asia, in contrast, consists of a number of different countries with independent jurisdictions and so achieving harmonisation to avoid regulatory arbitrage is much more challenging. Closing loopholes and perhaps more directly increasing the costs associated with avoiding the regulation can go some way to reducing the threat; more important, though, is working together on the reforms. Over the last 4 years the industry has witnessed a true strengthening in global co-operation between regulators.

One example is IOSCO working with the G20 and the Financial Stability Board on the global regulatory reform agenda. The world's regulators are increasingly seeking to exchange information on their respective experiences, at both global and regional levels, in order to help the development of markets, strengthen market infrastructure and implement appropriate regulation. Assuming these efforts succeed, the threat of regulatory arbitrage is considerably less than it once was. 

Hans-Ole Jochumsen, President of Global Trading & Market Services, NASDAQ OMX

Given the economic interdependence of the US, Europe, and Asia, regulatory arbitrage between these regions has the potential to pose a grave threat to the well-functioning nature of global markets and, ultimately, the wider global economy. If certain players are given an unfair advantage, this will inevitably skew the market. And that can only undermine the core functions of our global capital markets – price discovery, the reduction of risk, and, ultimately, the ability of companies to access capital

As such we are encouraged by any initiative aimed at facilitating convergence in the implementation of regulation, such recent progress in co-operation between the CFTC and the European Commission relating to the 2013 Path Forward Statement.

Since the G20 agreement there has been a distinct trend towards determining regulation on a global level. However implementation is still done at the national level since supervision is (typically) performed locally. This is the right approach. It is important that the supervisor and supervised entity have a close relationship. Centralisation is an important part of harmonisation, but it can also increase time to market. If the wrong things are centralised, market innovation may be hindered, to the detriment of end users. The challenge is to balance the local and the central, to allow for local specificities without undermining the level playing field.

David Clark, Chairman, WMBA

There is always a threat of regulatory arbitrage, especially where national or regional regulators have local political agendas to satisfy. All major financial centres buy in to the G20 aspirations, but do not necessarily seek to achieve them in the same way, and this gives the appearance of vulnerability to regulatory arbitrage. The markets which would benefit from divergences in regulatory approach would be major financial centres, most of which it is commonly accepted are in Asia such as Singapore, Tokyo and Hong Kong.  Other major financial centres such as Dubai and Toronto would also attract more business

 The specific differences between regulatory regimes focus on capital, liquidity and resolution and recovery, and those engaged in trying to change market infrastructure. These approaches may well produce different outcomes which would most likely be that in Europe and North America there will be more focus on trading venues and trying to regulate them and less on the imperative of improving capital and liquidity.

John Nicholas, Global Head of New Regulation Monitoring and Implementation, Newedge

The potential for regulatory arbitrage between the US, Europe and Asia is significant, particularly in the derivatives space, and driven by a number of factors, including the different timing across these regions and the lack of harmonization among the changes.

As a general matter and notwithstanding the edict of the G-20, the US moved first, the EU is approximately 6 to12 months behind the US, and Asia is approximately 6 to12 months behind the EU.  Secondly, and perhaps more importantly, there are and likely will continue to be regulatory arbitrage opportunities as a result of the lack of harmonization among derivatives regulatory reform in the US, EU and Asia.  For example, in the US, FX forwards and swaps are deemed out of scope for many Dodd Frank requirements, however, in the EU, they are fully within scope under EMIR.

In the US, there are no individual segregation accounts for cleared derivatives, in the EU, individual segregated accounts must be offered to all direct clearing clients under EMIR, while in Asia, individual segregated accounts are mandated in Singapore for cleared swaps and in Australia on a voluntary basis.  Similarly, in the US, OTC derivatives are reported unilaterally by swap dealers in both real-time and on an end-of-day basis, while in the EU they are reported bilaterally by each EU counterparty at T+1.

Nonetheless, regulatory arbitrage opportunities do not always result in a "race to the bottom". Many financial intermediaries and their clients prefer a more robust regulatory structure. Moreover, it should also be noted that while the current prevailing view that an "result-driven approach to mutual recognition -- where one jurisdiction accepts another's regulatory structure notwithstanding material differences between their respective rulebooks -- will facilitate cross-border trading on a more expedited basis, it will also present regulatory arbitrage opportunities in the long run.  This is a trade-off that regulators must understand.