Regulatory Arbitrage Fears Over OTC Derivative Regulations

Terry Flanagan

As regulators around the world busily try to meet their G20 commitments to reforming the $700 trillion over-the-counter derivatives markets, there are real worries that the application of the new rules will lead to either regulatory arbitrage or increased costs for many international firms.

Regulators across different jurisdictions are currently in the process of implementing new regulations that aim to standardize many OTC derivatives contracts and push them on to exchange-like venues where they will be cleared centrally and reported to trade repositories in a bid to improve transparency and mitigate systemic risk. The G20 demanded that this process be complete by the end of this year, although it appears that this deadline may not now be met.

In Europe, the European Market Infrastructure Regulation (Emir), which is the European Union’s attempt at better regulating the region’s OTC derivatives markets, is not now likely to be in place before July 2013 at the earliest, while the Dodd-Frank Act, the U.S. version, is further advanced following the publication of swap definitions earlier this month, which initiated a 60-day countdown for compliance to key parts of the Act. Asia, meanwhile, is more up in the air as there is no single regulator overseeing the region.

“Dodd-Frank is a little bit ahead of Emir in terms of the G20 commitments,” Dr Christian Voigt, business solutions architect at Fidessa, a trading technology company, told Markets Media.

Dr Christian Voigt, business solutions architect, Fidessa

Dr Christian Voigt, business solutions architect, Fidessa

“Asia is more complicated. In the U.S. at least you’re dealing with just one jurisdiction while with Asia, you are talking about so many different countries. You’ve got Singapore, Hong Kong, Tokyo and Sydney all operating under different regulatory regimes which makes it even more difficult. The risk of regulatory arbitrage is very high and we have seen this through history a number of times.”

There are fears that many firms may set up in parts of Asia where the regulations are more lax in a bid to capitalize on potential regulatory loopholes.

“Regulatory arbitrage is a somewhat inevitable part of any global business in so far as managers will seek the simplest way to operate under existing rules,” said Voigt. “So it is definitely a huge risk, especially for Europe which is facing considerable economic challenges and could potentially lose out to the global markets. Europe needs to be very careful on how it goes forward on this.”

On the subject of extraterritoriality, calls are growing for individual jurisdictions to get their house in order first, before solving the thorny issue of applying the OTC derivatives rules across borders.

In a joint letter last week to U.S. regulator the Commodity Futures Trading Commission (CFTC), Japan’s Financial Services Agency (FSA), its financial regulator, and the Bank of Japan, its central bank, urged the CFTC to ease back on its application of extraterritorial OTC derivatives rules.

“We urge the CFTC to consider deferring the application of its regulations on cross-border transactions until an internationally consistent approach on how to address cross-border regulation of OTC derivatives would be developed,” said Masamichi Kono, vice-commissioner for international affairs at the FSA, and Hideo Hayakawa, executive director of the Bank of Japan.
Market participants are also worried that extraterritoriality will bring with it unnecessary costs.

“There are a number of different approaches between regulators,” said Voigt at Fidessa. “Third country discussions have not been resolved yet. What do the U.S. regulators [CFTC and Securities and Exchange Commission] require from European businesses in order for them to operate in their jurisdiction and vice versa? There is the real risk that a number of large international players will face massive overheads because they have to adhere to multiple regulations.

“This topic will definitely come under discussion [in Europe] between now and mid-2013 as Europe has to implement Emir and people will start to ask questions [such as] how do I do business in the U.S. or how does a U.S. company do business with me in Europe?”

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