Local Rules Bring Pain to Market Users

Terry Flanagan

As the world’s financial markets become ever more interconnected and with capital and securities markets set to power ahead in Asia, Latin America and Africa in the coming years and decades, market users warn that a lack of agreed standards across all jurisdictions now is causing trading problems and that the problem could also sow the seeds of another, and possibly much larger, global financial crisis.

“Leaving aside the current difficulties on global accounting convergence, or cross-border conflicts of laws for auditors, or OTC derivative implementation—margin requirements and swap dealer registration, or the timing and uncertainty of Basel III implementation, let’s consider the toolbox that global regulators have available to ensure consistent implementation,” said David Wright, secretary-general of Iosco, an umbrella group of global regulators, in a December speech in Washington.

“The tools can at best be described as soft: peer review, transparency, monitoring and, depending on your faith, perhaps the most potent of all—prayer. There are no binding tools whatsoever at the global regulatory level. No legally binding enforcement; no disputes settlement, like in the World Trade Organization; no sanctions. In short, any jurisdiction can basically do what it wants and face no effective or deterrent repercussions.”

And what market users have learnt from this current financial crisis is that in times of stress, national regulators think more for themselves and their home market rather than adopt an ‘in it together’ mentality with other watchdogs. This, too, is affecting how and where firms trade today.

“The financial crisis has moved national financial stability to the very top of the regulatory agenda, and has therefore caused a shift away from the global integration of financial services and towards more localized regulation instead,” said Julian Korek, founding member of Kinetic Partners, a consultancy firm.

“As a result, we can already see some diversity between regulators, leading to significant cultural differences in interpretation across several countries or regions.”

In a recent survey, Kinetic found that over three-quarters of senior managers in the financial services sector would consider ending relationships with foreign clients in a particular jurisdiction due to local legislative requirements and their potential global consequences.

“A move towards centralized, cross-border regulation is inevitable for banks, but the debate about its suitability for the rest of the financial services industry is still on-going,” said Korek. “The industry’s argument is that national regulators better understand the culture of their own jurisdictions, and many regulators have accepted the legitimacy of this argument. As a result, it’s unlikely that we’ll ever see centralized regulation for the entire industry.”

However, markets are becoming ever more interconnected due, in part, to advances in technology and markets are emerging on the scene that could rival, or even usurp, the likes of New York and London in the coming decades. But all this brings with it added risk sharing and risk transfer.

“A crisis in one affects others, and as we have seen can be quickly amplified into dangerous global contagion,” said Wright at Iosco. “It does indeed matter if the U.S. allows the selling of trillions of dollars of mortgages irresponsibly, like subprime, with the resultant packaged securities flogged around the world with AAA ratings.”

In today’s world, where there are only a handful of truly major financial centers across the globe, loose agreements can be more easily reached between regulators in times of stress. But fast forward 20 years and there could be another 10 or so big capital markets thrown into the mix, and this fragmentation could cause even greater problems.

“This future interconnected world—with the distinction between developed and developing countries more and more blurred—will have many more big financial markets and could be much more prone to shocks and cross-border contagion,” warned Wright.

“More vulnerable, perhaps, to new forms of capital protectionism; far more prone to widely different interpretations of global standards, with a higher propensity for overlapping laws and cross-border legal disputes. And certainly with the risk of much higher frictional costs for business who could face multiple sets of regulatory rules.”

Wright suggests the future holds three possible paths: the law of the jungle and survival of the fittest, the status quo we have today or a global institutional framework with authority over enforcement and disputes.

Of the three, Wright argues that only a future with truly effective global regulatory institutions will suffice. “The alternatives contain unacceptable long-run risks to global financial stability,” said Wright.

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