Financial regulatory reform has been slower to take shape than anticipated. Regulators continue to mull over key provisions ranging from what defines a systemically important financial institution to the clearing of over-the-counter derivatives. Of equal concern, misaligned financial regulations in the United States, Europe and Asia could result in a less-attractive U.S. trading environment.
In an ideal world, global financial regulators would function something like a team of horses, with policymakers in the United States, Europe, Asia and elsewhere all pulling at once in the same direction, and moving toward a common goal.
Reality is turning out be far more chaotic. Regulators and lawmakers are having a tough time forming a consensus even within their own national borders, let alone across international boundaries. The result is turning out be a patchwork of overlapping and often inconsistent approaches to regulation in the aftermath of the financial crisis that gripped global markets in 2008 and 2009. Many financial experts fear that the inconsistent global regulatory framework will alter the flow of capital around the world, as trades are directed to the cheapest jurisdiction, a process known as regulatory arbitrage.
One step ahead
U.S. regulators are moving faster than their counterparts in Europe to develop and implement new financial regulation, and appear likely to take a stricter view when it comes to granting exemptions to the new rules. The United States has passed the legislative phase and is now implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act, albeit a bit more slowly than Congress intended. In Europe, the legislative process is still under way.
Tom Riggs, a managing director at Goldman Sachs, sounded an alarm about that gap at an industry roundtable convened this past summer by U.S. regulators. "Once you have this gap period between when the U.S. goes live and the rest of the world goes live, it creates a period in which business will flow someplace else," Riggs said during that discussion. "When the rest of world harmonizes with the U.S. approach, the question is, can you get it back?"
U.S. regulators do not appear particularly susceptible to such pressure. "Why should we wait until other countries initiate it five years down the road? Then the momentum goes away," Ananda Radhakrishnan, the head of clearing and intermediary oversight at the U.S. Commodity Futures Trading Commission (CFTC), asked Riggs. "I realize some of you want that momentum to go away, but from our perspective, we can’t let it go away."
Industry concerns are nowhere more pronounced than in the $600 trillion market for over-the-counter (OTC) derivatives, where U.S. and European regulators are headed down separate paths. "The difference will be capital," says Simon Gleeson, a partner with the law firm Clifford Chance, in London.
Regulators in the United States want to see as many derivatives transactions as possible go through a clearinghouse, in which performance bond — deposits required to ensure that a counterparty can cover the trading position’s potential losses — is a requirement, prices are transparent and losses are absorbed by member institutions, not the taxpaying public. "The U.S. takes the view that clearing is a positive good and should be required as widely as possible," says Gleeson, who specializes in financial markets law and regulation.
The result will create a cost disparity between OTC transactions in the United States and Europe because submitting a trade to a clearinghouse, for clearing and settlement, could be more expensive than conducting an OTC trade for certain market participants. Clearinghouses apply the same performance bond requirements to all members, across the board. Positions are mark-to-market twice a day, with performance bond requirements adjusted to reflect current market conditions. In contrast, OTC trades rely on the individual counterparty’s creditworthiness, rather than market conditions, to determine margin requirements. The result is that many institutional traders, such as pension funds and sovereign wealth funds, simply do not post collateral.
The prospect of higher costs compounded by confusion and uncertainty over the yet-to-be-completed regulatory overhaul is a source of anxiety and frustration for derivatives users, according to Andrea Kramer, a partner with law firm McDermott Will & Emery in Chicago. "I have clients who are about to throw up their hands," says Kramer, head of the financial products, trading and derivatives group.
So far, Europe appears to be taking a more fluid approach to OTC margin and capital than the United States. In the U.S., for example, derivatives users will face clearing requirements if they have more than $50 billion in assets. In Europe, clearing requirements for corporate users will be based on a less cut-and-dried "business assessment test," according to Anthony Belchambers, chief executive officer of the London-based Futures and Options Association. "The European approach has been a bit more pragmatic and consultative. I think that is the main difference," he says.
It is not clear that all the advantage will flow to one jurisdiction or another. There are instances in which U.S. markets may be at an advantage, according to Ruben Lee, founder and chief executive officer of Oxford Finance Group, a consulting firm in London. The European Parliament may extend the scope of derivatives clearing requirements in the European Market Infrastructure Regulation (EMIR), which would make them more consistent with Dodd-Frank rules in the United States. In a similar market, the United States may be viewed as relatively more efficient, according to Lee, a former fellow at Nuffield College at Oxford University, and author of Running the World’s Markets. Part of the reason is market structure: the United States has essentially one major clearinghouse while there are about 30 in Europe. A multitude of clearinghouses can lead to economic inefficiency and higher costs. "The clearing argument may yet play out in favor of America," he says.
After the European Parliament completes the EMIR legislation and the European Commission completes its Markets in Financial Instruments Directive, the U.S. and European markets could still end up looking more similar than dissimilar. In that case, the OTC derivatives market could shift to a market in Asia, such as Singapore, where margin and capital requirements are likely to remain relatively inviting.
But if there is an opportunity for regulatory arbitrage, traders will take it. "And there is very little that regulators can do about that," Gleeson says.
While regulators cannot do much to curtail corporations in their countries from shifting their business to other countries, they can crack down on cross-border business, according to Gleeson. "They can tell them that if you are going to conduct business outside of the U.S., you must conduct it entirely outside of the U.S.," requiring them to set up foreign subsidiaries for offshore booking. That might not be a problem for large multinational corporations, but it could be a major hindrance and expense for the increasing number of small and mid-sized companies that do business abroad. The extension of Dodd-Frank margin requirements to international businesses is also a source of concern for U.S. banks. The International Swaps and Derivatives Association sketched out the problem in Senate testimony. It posed a hypothetical situation in which an Italian bank does business with the U.K. subsidiary of a U.S.-owned bank, and is subject to Dodd-Frank margin and collateral requirements. An Italian bank doing business with a U.K. bank would likely be subject to less stringent margin requirements. That difference could create a competitive disadvantage for U.S. banks. And the global nature of the derivatives market could become more domestic.
"I think five years down the road, the markets may largely separate," Gleeson says. "You may have a U.S. market, for U.S. companies doing business domestically, and a non-U.S. market made up entirely of people that are not counterparties in the U.S. and not subject to its regulation."
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