Is regulatory harmonisation a worthy and attainable goal?

7 Jun 2011

Regulation of OTC derivatives update: the FSA's focus will be to guide international and European decision-makers towards a commercial and globally consistent regulatory solution. Vital issues (identified by the FSA and the Treasury in 2009) include a move towards greater standardisation of OTC derivative instruments; standards for central clearing counterparties, and international consensus on clearing eligible products.

The desire to avoid creating opportunities for regulatory arbitrage is, as we would expect, an extremely complex exercise. The question of whether greater levels of regulation will actually make the financial world a safer place is one that cannot be answered definitively. It can be argued that regulation is necessary to provide a level playing field, promoting healthy trading practices amongst all market participants (although there is a stage at which excessive regulation becomes stifling to the activity that it attempts to facilitate).

As the regulatory net continues to expand into the space of financial derivatives, we need to return to the fundamentals and question the purpose of further regulation. I don't deny the need for a regulatory framework, but it should not kill the business activity that it is supposed to help to facilitate.

The harmonisation of financial regulation is essential to the smooth running of inter-connected markets. Historically, it has been a challenge for the US regulatory bodies; the Securities & Exchange Commission (SEC) and the Commodities Futures & Trading Commission (CFTC), to maintain consistent rules for the related financial instruments, i.e. options on stocks are regulated by the SEC whereas options on futures are regulated by the CFTC. 

Complicating matters further, some instruments, such as 'single stock futures,' are regulated by both the SEC and the CFTC. Arguments have been made for the merits of such a framework of regulation given the varying strengths of each of the regulatory bodies. Knepper states that the "simple inevitability [of dual regulation is] due to the fact that the United States has bifurcated securities and futures regulation between two competing federal agencies". Given the existence of disparate bodies both overseeing a single product type, there are inevitably further challenges in reconciling these opposing points of view. The international nature of trading OTC derivatives will now require not only the harmonisation between the two major US regulatory authorities, but also the individual national regulatory bodies overseeing financial centres around the globe.

Since June 2006, the CFTC and the SEC have co-ordinated efforts to align their rule sets, as well as to bring about a level of consistency with the UK Financial Services Authority (FSA). Major steps were taken in late 2009 when the SEC and the FSA agreed to "identify a common, coherent set of data to collect from hedge fund advisers / managers to help the SEC and FSA identify risks to their regulatory objectives and mandates." 

They also discussed other critical issues including:

  • OTC derivatives markets and central clearing
  • Accounting issues
  • Regulatory reform
  • Credit rating agency oversight
  • Short selling
  • Corporate governance and
  • Compensation practices

Chairman Mary Schapiro of the SEC and Chief Executive Hector Sants of the FSA recognised the need to "achieve coherent oversight of global actors and limit opportunities for playing the regulatory seams" i.e. avoiding regulatory arbitrage. To achieve this, the SEC and FSA have worked on a bilateral basis, as well as taking part in discussions with organisations such as the International Organisation of Securities Commission (IOSCO).

In the paradigm of centrally cleared derivatives, product types in the US have been shared between the SEC and the CFTC; the SEC has been mandated to regulate all security based swaps, whereas the CFTC will be responsible for regulating index based swaps. This has created a confusing overlap of regulatory coverage in the credit derivatives landscape which will inevitably create duplicate teams of specialist expertise within each organisation. Differing principles applied to the regulation of credit derivatives by each of the regulatory bodies will lead to trading being encouraged / discouraged in one type of Credit Default Swap (CDS) product versus the other, for example, 'single name' versus 'index CDSs'. In addition, the regulatory rules adopted by the UK's FSA and other global regulators will also lead to regulatory arbitrage if their treatment of these products differs from that of their US counterparts.

Each commission has acknowledged industry initiatives to develop various approaches to achieve client risk-based portfolio margining, facilitating the holding of cash securities, futures, options and other derivatives in a futures portfolio margin account. One of the complications preventing the aggregation of positions into consolidated portfolio margin accounts was the lack of clarity on the protection available to investors in the case of a Future Commission Merchant (FCM) / Broker-Dealer bankruptcy. Investor protection is covered by Securities Investor Protection Act (SIPA) for market participants regulated by the SEC as opposed to the futures insolvency regime as defined by the CFTC. This is just one example of the detailed matters which would need to be resolved for consistent global harmonisation of regulation.

In February 2010, the SEC and the FSA held their fifth meeting of the SEC-FSA Strategic Dialogue, originally initiated in 2006.  Issues discussed included:

  • Corporate governance and executive compensation
  • Regulation of hedge funds and investment advisors, and the protection of customer assets
  • Disclosure regimes around client asset risks
  • Market infrastructure, particularly relating to central counterparties for OTC derivatives
  • Market supervision
  • Co-operation on cross-border supervision.

Once again it was recognised by Schapiro of the SEC, Sants of the FSA and also the FSA's Chairman, Adair Turner, that given the interconnectedness between the UK and US financial markets, it is critical to enhance co-operation by the overseeing bodies.

Most recently, in May 2011, David Lawton, Head of Market Infrastructure and Policy at the FSA, spoke at the Xtrakter Annual User Conference and Forum, and highlighted that the European policy agenda for markets regulatory reform is the "EU's vehicle for implementing G20 commitments". He added that "High-quality, transparent and open markets remain vital for the UK's position as a leading international financial market centre" demonstrating the importance being placed on the regulatory reforms and ensuring they are effective.

The regulatory roadmap

The agenda that is shaping the future regulatory landscape for Europe includes:

  • Detailed measures for implementing the Alternative Investment Fund Management Directive
  • Registration of credit rating agencies (CRAs) under the new legislation, as well as a possible further round of legislation aimed at reducing the over-reliance that regulators and investors may place on ratings
  • Restrictions of uncovered short sales of equities and sovereign debt, as well as increased disclosure requirements for short-selling
  • European Markets Infrastructure Regulation (EMIR), which will define the regulation of OTC derivatives, central counterparties (CCPs) and trade repositories
  • Update of the Markets in Financial Instruments Directive (MiFID), and the Market Abuse Directive (MAD)
  • A review of the Transparency Directive (TD)
  • A draft directive on securities law
  • A regulatory framework for Central Securities Depositories

In a recent speech by Nout Wellink, Chairman of the Basel Committee on Banking Supervision, he stated, "A common misconception is that Basel III is intended only for industrialised economies with large, complex banks."  He added, "when developing Basel III, the Committee's objective was to address these deficiencies, which are not only the domain of big banks, but of all banks, regardless of size, complexity, and geographic location."

The SEC and CFTC's history over the past decade seems to indicate that, because of the complexity of the derivatives landscape, numerous challenges remain even though there have been attempts at harmonising the rules between just the two US overseeing bodies. It remains questionable as to whether it is even possible to harmonise regulatory rules across all agencies involved worldwide.

In an interim report published in April 2011 by the Independent Commission on Banking in the UK, Chairman Sir John Vickers highlighted that reforms to banking regulation will be needed to maintain the sector's competitiveness on the global playing field. Improving competitiveness implies the need to develop an environment which is stable, yet still able to provide global financial institutions with reasons to increase their activity within the UK.

Regulatory harmonisation aims to remove differences in oversight that can lead one financial centre to be favoured over another, though some industry players may perceive this as the removal of strategic market advantages. Given that the banking industry is a major source of tax revenue for most governments, it seems that the full alignment of regulatory frameworks may inevitably take a back seat when considered against the need for industry competitiveness.

We have witnessed that it has been near impossible for even the two US regulatory bodies to agree on a consistent approach to new regulation, despite working at this for many years. As such, it seems somewhat ambitious to imagine that multiple national and international bodies are likely to come to any sort of regulatory agreement in the foreseeable future.  However, considering the possible futility of the harmonization exercise, a focus on improving competitiveness might be just what the industry needs right now.