Securities Services: Regulatory arbitrage: herd mentality

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Systemic wrisk has to be limited say industry bodies, inter-dealers, consultants, lawyers and those on the operational side of the OTC market. But they also say that, following the financial crisis, there have been changes in markets that are heading in the exact direction that the regulators would want. They also say that efforts to intensively regulate the market will lead to adverse consequences, such as regulatory arbitrage.

One example of the market adjusting on its own is that many more OTC derivatives are being cleared in the wake of the crisis. David Jenkins, the European energy manager at interdealer broker Tradition, says that whereas two years ago an OTC derivatives contract would simply be between two parties, today a clearing house is usually involved. Jenkins says: "There would be a straight contract between, for example, BP and Goldman Sachs, but instead of there being a contract between the two, they would each have a contract with a clearing house or central clearing counter-party (CCP). Now, instead of having an obligation to each other, they have an obligation to the CCP."

Jenkins' area of expertise is oil, the market in which he estimates has gone from 10% cleared to more than 60%. "It's likely that regulation will force it to be nearly 100%, but the market participants are forcing the change in any case."

In the wake of the crisis, the market has backed away from the products that lost institutions - and eventually the taxpayer- billions. These products include derivatives relating to mortgage collateralisation, such as credit default swaps.

"OTC markets are not opaque," says Alex McDonald, CEO of the Wholesale Market Brokers Association (WMBA), which represents inter-dealer brokers in the OTC markets. "What were opaque structured products in credit have largely disappeared because people didn't want to buy them. They couldn't value them, so they couldn't sell them. That market died a death. In the past few months we've seen some ordinary asset backed securities return to the market, but these are old-fashioned asset backed securities; ones that are based on secure mortgages."

But the ambition for all OTC products to be cleared is fraught with danger, according to the WMBA. That danger can be summarised in the term: regulatory arbitrage. This acknowledges that capital moves into areas where regulation is weakest and hence the argument goes that systemic problems will reoccur.

"Overly stringent rules in the EU and the US risk causing banks to move into other regimes, such as Singapore and the UK," warns WMBA chairman David Clark.

Some consider that the more immediate concern is the divergence between the two biggest markets of Europe and the US. "There is an increasing likelihood that the US legislation will be more interventionist than the European, which will probably be more pragmatic," says Ruben Lee, CEO of the consulting firm, Oxford Finance Group, and author of a new report on the governance of financial market infrastructure.

The Dodd-Frank Act in the US, signed in July, mandates the clearing of OTC derivatives that a clearing house will accept and that regulators believe should be cleared. Although legislation has not been passed, this is an indication of why the US is seen as adopting a more ‘prescriptive' approach compared to Europe.

According to Clark, capital will migrate to countries whose capital charges are lowest. This is an issue that saw more than 160 European companies write to Brussels in January, asking for exemption from a requirement that OTC derivatives be cleared.

On the issue of regulatory arbitrage, Principal Global Investors' chief operations officer, Barb McKenzie, is more sanguine: "I would like to think that the regulators are coming together to avoid arbitrage opportunities," she says.

"There are no guarantees, but it kind of played out that way after Enron and Sarbanes Oxley, where other regulators adopted similar practices, albeit slightly differently. In markets, the herd rule is everything."

The herd rule may be everything in the future, but right now the uncertainty will prompt speculators to try to take advantage.


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