Traders Eye Regulatory Arbitrage Opportunities

Terry Flanagan

As regulators around the globe continue to take slightly differing approaches to reducing the systemic risk generated from the $700 trillion global over-the-counter derivatives market, some market participants believe that the threat of regulatory arbitrage is growing.

The G20 group of nations has called for consistent implementation by global regulators to push through far-reaching reforms to better monitor this opaque sector, which currently accounts for 95% of all derivatives trades, and wants laws in place by the end of the year.

The G20 is demanding that all OTC derivatives trades are processed through clearing houses and trade repositories to lessen the risk of default. Derivatives trades have been blamed for the global financial crisis and the collapse of Lehman Brothers in 2008.

“If you look globally, the Europe and US are largely, whilst not totally in step, broadly in step in terms of regulation,” one London-based market source told Markets Media. “There are other market places, such as Asia, that could seize this opportunity. There is the prospect of regulatory arbitrage.”

In Europe, the European Securities and Markets Authority (Esma), the pan-European financial regulator, is responsible for implementing the European response to the mandate under the European Markets Infrastructure Regulation (Emir). While in the US, the OTC derivatives legislation falls under the scope of the Dodd-Frank Act although Emir goes further than Dodd-Frank in that it lays down a regulatory framework for overseeing European Union clearing houses.

In Asia, meanwhile, a more nationalistic approach is being taken by regulators, with concerns that without a central regulatory body national regulators will work separately to formulate their own rules.

“To avoid regulatory competition, where regions are undercutting each other with laxer but also more risky regulation, we need to co-operate to achieve the same level of robust regulation,” Steven Maijoor, chair of Esma, told a conference in Beijing on May 16.

“Competition is the right model for markets, not for regulation and supervision. Common regulation also increases the acceptance by the financial industry in our local markets of the far-reaching consequences of regulatory reforms. The additional costs of new regulations are more palatable when the industry knows that their international competitors are confronted with the same costs.

“I am very much in favor of a strong international community of securities markets regulators driving the international policy debate on financial market regulation. In popular words ‘we need to be ahead of the curve’. We need to identify possible future areas of regulation and offer possible regulatory frameworks.”

Some traders, though, are already looking to exploit these loopholes.

“We’ve seen a trend of big bank prop traders, who will bear the brunt of the regulation, already physically moving out to various parts of Asia,” another market source based in London told Markets Media.

“What they can do from there is continue to trade in products they are familiar with in the US and Europe but as the telecoms links are much much better now than they were 10 years ago they can continue to trade in what they are familiar with. There is also a perception that while they are out there they are physically regulated by a different authority so they think they may or may not be subject to Emir.

“Also, as the Asia markets start to develop and open up they may take the opportunity to enter these markets too from out there.”

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