Wave of new regulation brings inconsistencies and loopholes
Inconsistencies in new regulations both across borders and within the regulations themselves are giving rise to concerns of regulatory arbitrage and exploitation of loopholes
The past few years have seen swathes of new regulation being drawn up in response to the financial crisis of 2008. In the US, the Dodd-Frank Wall Street Reform and Consumer Protection Act has thrown up much debate around the restriction of banks’ activities in areas such as over-the-counter (OTC) derivatives and trading activities of investment banks. In the EU, the European Markets Infrastructure Regulation (Emir) is being finalised to regulate the OTC derivatives market in Europe, while the Capital Requirements Directive (CRD) has been updated for a fourth time and the Markets in Financial Instruments Directive (Mifid) has also been reviewed.
But there are concerns. Key parts of Dodd-Frank simply don’t exist in Emir. New regulations regarding remuneration differ significantly between jurisdictions. And individual pieces of regulation are riddled with loopholes just waiting to be exposed. These inconsistencies, both between jurisdictions and within individual pieces of regulation, are giving rise to genuine concerns that these regulatory efforts, for all their good intent, are creating the possibilty of loophole exploitation and regulatory arbitrage.
Dodd-Frank
One area in Dodd-Frank that doesn’t exist in Emir is the Volcker rule, which prohibits banks from engaging in proprietary trading – large prop trading losses hit many banks hard in the lead-up to the crisis, but despite the urgency behind regulation concerning this area in the US, it doesn’t exist in the EU.
“There isn’t anything equivalent to the Volcker rule in Emir,” says Verena Ross, executive director of the European Securities and Markets Authority (Esma). “Until we really see how Volcker is implemented, I find it difficult to see whether there would be any room for regulatory arbitrage.”
The Volcker rule also restricts banks’ market-making activities, and for some, this is a much greater area of concern than restrictions on proprietary trading.
“Everyone knows that pure proprietary trading is not going to be permitted and given the tiny amount of proprietary trading that’s been going on recently, this might not be the real issue for banks,” says one banking analyst at a leading investment bank. “But market-making is different. You’re not trying to take a view or a position on the markets, you’re trying to facilitate the flow and provide liquidity, and that basically means using the balance sheet and capital. Market-making activities are a really big chunk of an investment bank’s revenue and trying to limit that could have a potentially significant impact on such revenues. But a European investment bank won’t have to do that.”
If US banks can’t engage in market-making activities, they fear losing that business to European banks. “Let’s say that your hedge fund wants to buy a certain position and regulations tell you that a US bank has to hold that position for two days and beyond that it’s proprietary trading,” says the analyst. “The result is simple; the hedge fund won’t look for liquidity with a US bank.”
This is, according to some, a question of geography. “With Volcker there is an exception for activities conducted by non-US entities outside the US,” says Dwight Smith, US capital markets partner at global law firm Morrison & Foerster. “It would therefore be possible for a large global bank to move problematic operations outside the US. This wouldn’t be easy, but it might be possible.”
But whether this straightforward inconsistency within regulations will give rise to such an opportunity for competitive advantage or regulatory arbitrage remains to be seen, as Ross points out.
Dodd-Frank gives rise to another point of discrepancy between the US and EU with its Section 716, also known as the Lincoln amendment or the pushout rule. The main objective of this rule is to require certain types of derivatives trades to be placed in a separate legal entity from the main bank – in theory preventing a threat to customer deposits by moving the riskier activities outside the bank.
“The Lincoln amendment could be an issue for some,” says Smith. “It might be possible to move some derivatives operations outside the US and avoid some of the issues there, but this is not as clean a break as the Volcker rule, it’s more complicated. Furthermore, derivatives are not unregulated elsewhere, so you have to question whether it would be worth it”.
For many though, the Lincoln amendment is not a serious issue. “I don’t think from the US perspective Section 716 is such a big problem,” says the banking analyst. “I think it falls into the area of additional hurdles the regulators are putting down.”
The effects for US banks of Section 716 will depend largely on where the derivatives activity sits within a group. For those that already have it outside the bank, necessary adjustments will be limited. Those that still have it within the bank will have to think about changes to their legal structure. But, as the banks analyst puts it, “The EU doesn’t have to apply this, so [EU banks] wouldn’t need to change their structures to accommodate such regulation.” And this inconsistency could be exploited.
Compensation
Remuneration is another area of debate. Legislators recognise this is an issue that needs to be dealt with, but the differences between the rules devised in the EU and the US have led to questions over competitiveness, for the EU market in particular.
“There is a risk people will move to the place where they get paid the most,” says Clifford Smout, co-head of the Centre for Regulatory Strategy at Deloitte UK. “The EU rules are quite a lot more prescriptive than the US rules, and that could lead to some people relocating”.
The most recent revision of the CRD requires EU banks to cap the bonuses they pay to employees. Measures that have been enforced include widening the category of staff members whose bonus is subject to the new regulations and altering the structure of bonus payouts. Bonuses are deferred for payment at a later date (between three and five years) and allocated in the form of shares rather than cash. According to JP Morgan Cazenove’s March report on regulatory arbitrage, this could prompt top talent to move away from European banks.
Another effect of the new regulation on remuneration is that firms are paying higher base salaries to staff. This could be a problem for tier-two and tier-three institutions. “Paying higher base salaries reduces flexibility of the cost base, because you have to pay a lot in the first few years after recruitment,” says the banks analyst. “This means salary outgoings increase. For a tier-two or -three firm with the capacity to generate revenue that is much smaller than a tier-one firm, it means its break-even point becomes higher. This makes it more difficult to manage and gives an advantage to the larger [tier-one] banks.”
There is also concern regarding the scope for interpretation of the EU compensation rules by local regulators. JP Morgan Cazenove notes new legislation also creates opportunities for regulatory arbitrage between EU banks. “[Within] the EU rules ... in the case of the retained part of the bonus [this] is up for interpretation by the local regulator,” the report says.
Clearing rules
The clearing of OTC derivatives mandated by both Dodd-Frank and Emir has also given rise to several areas of potential inconsistency. Edouard Vieillefond, head of the international and regulation affairs division at the Autorité des Marchés Financiers (AMF), highlights this as a particular concern.
Vieillefond’s main areas of concern are the regulation of central counterparties (CCPs), their ownership models and the list of products mandated for clearing.
“If we don’t have the same list of derivatives in the US and the EU, it won’t work, it’s as simple as that,” he tells Operational Risk & Regulation (www.risk.net/2083218). “We need to have financial institutions with clearing obligations that are aligned. If, for example, we have one list of derivatives to be cleared by US banks who are also acting in the EU and another for European banks present in the US it simply won’t work.”
Vieillefond is not alone in his concerns regarding CCPs. In July a joint trade association letter was sent to Timothy Geithner, secretary of the Department of Treasury in the US, and Michel Barnier, commissioner for internal markets and services at the European Commission. The letter highlighted the need for convergence in rules for CCPs between jurisdictions. “Equivalence is critical for rules on clearing, as conflicting clearing requirements would be impossible to comply with if the rules of two different jurisdictions require a trade to be cleared in its jurisdiction,” the letter says.
The letter, signed by groups including the Wholesale Market Brokers’ Association and the International Swaps and Derivatives Association, also outlines concerns regarding potential overlap and conflict in regulation of derivatives market participants in foreign jurisdictions.
The letter says rules for licensing entities that are significant participants in the swap market need to be co-ordinated to prevent conflicting requirements for firms. “We urge global regulators to work together towards a sensible and mutually acceptable solution that reflects the legitimate interest in regulatory oversight of entities active in a jurisdiction in a manner that gives due recognition to the rules that are applicable to an entity in its home jurisdiction,” the letter says.
Regulators are listening. “We’re still at the preliminary stage of working out where there might be potential differences in the interpretation of new regulations,” says Esma’s Ross. “Areas that have been talked about as a potential difference between the US and Europe are, for example, how you deal with swap dealers and what registration requirements they would be subject to. We are talking to the US regulators about what they’re proposing to do and looking at what we’re proposing to do, and whether there are any more opportunities for alignment.”
This will be welcome news for the group of trade associations, who call for policymakers to “redouble their efforts to ensure reform of the international financial regulatory system is based on consistency of approach and on mutual recognition”.
Convergence
Trade associations are not the only ones recognising the need for convergence. “There are signs in relation to derivatives and other areas that the legislators and regulators do recognise the need for international co-operation,” says Peter Green, UK capital markets partner at Morrison & Foerster. “There is a provision in Dodd-Frank to direct international co-operation. It would be difficult for anyone to enforce but certainly the US congress had in mind there would be that sort of co-operation and it is concerned about achieving what it calls a level playing field.”
Esma’s Ross goes further. “We are working closely with the US regulators as they are looking at their implementation regulation under Dodd-Frank and we are finalising Emir. This is an area where we can work together, and see where there are potential differences of interpretation that could result in global markets being distorted.”
The industry is aware of these efforts. Revised drafts of Emir, some say, give the impression changes have been made to reflect elements of Dodd-Frank and vice versa with regards to rule-making in the US. “Although it might not be immediately transparent as to where changes have come from, or that they have come through discussion, the assumption has to be that some of the changes have been made as a result of the ongoing dialogue,” says Green.
Green’s US colleague Smith agrees. “There are high-level discussions on the need for international co-operation and the issue of what is going to happen on a day-to-day basis,” he says. “Historically and well before the crisis, the US regulators had worked with European regulators, so there’s an established history and a principle of working together.”
But they are only discussions, as Ross points out. “Clearly the areas we’re discussing with our US colleagues are the ones where we think there’s the greatest opportunity for regulatory arbitrage,” she says. “But you have to make a clear distinction between what’s happening within the EU, where Esma has clear roles and responsibilities to make sure there is no regulatory arbitrage, and the discussions we have with global players, which are about working together as far as possible to reduce the possibilities of inconsistencies.”
Within the EU
Recent European regulatory changes are being introduced as regulations rather than directives. Directives have to be transcribed into national law, but regulations are open for interpretation by national regulators.
“National regulators have to reach their own interpretation of what the rules mean in terms of their own supervision and enforcement,” says Green. “You can’t get away from the possibility of an un-level playing field in at least some respects in the EU.”
Esma is well aware of this and one of its key objectives, according to Ross, is to make sure it reduces any opportunities for regulatory arbitrage or inconsistencies within the EU. “We need to make sure we help deliver a common approach to implementation across the EU where we have specific responsibilities and powers that allow us to both monitor and act where we think there are significant divergences appearing,” she says.
Esma is most concerned about the areas that are completely new. With the legislation still going through the primary process, it is difficult to know at the moment what the key areas to monitor are, Ross warns. Esma is working to provide more detailed provisions in its areas of responsibilities, specifically to try to reduce any differences in application.
“We review how regulations have been implemented,” says Ross. “The review panel within Esma has a monitoring function for this. In addition, we talk to the industry and we talk to other people to work out exactly how people are working. We also conduct peer reviews to ensure we understand how implementation has happened on the ground.”
Ross points out that one of the most effective elements of peer reviews is that they put pressure on national regulators to align themselves with the other regulators they are reviewing.
The AMF’s Vieillefond backs peer reviews as a measure to stop regulatory arbitrage. “Real peer reviews can show who is compliant with the orientation of the Group of 20 and who is not,” he says. “We need to make progress on this, otherwise we are leaving ourselves open to the risk of regulatory arbitrage.”
Some say regulators should really be paying attention to the possibility of loopholes within pieces of new EU regulation. “Companies are not going to shift their business around in jurisdictional terms,” says Ben Blackett-Ord, chief executive of Bovill, a UK financial services regulatory consultancy. “As you’ve got a combination of European directives and national requirements, there are hundreds of areas of inconsistency firms will be looking to exploit.”
Blackett-Ord says a particular area to watch is investment regulation – specifically Mifid and Mifid II, which are designed to increase consumer protection and competition in investment services. He believes fund managers have room for manoeuvre within loopholes under Mifid.
“It’s all quite technical and there’s a certain amount of dancing on pinheads to get to the right answer. For example, the activity of operating and managing a collective investment scheme is not a Mifid activity and so falls outside of Mifid. But the activity of purely managing a fund without operating it is a Mifid activity,” he says. “Given that what is involved in operating a fund is hard to nail down, this provides scope for people to say they are both managing and operating the fund, which will place them outside the regulation.”
People will be looking at regulation and finding ways to make it suit their needs, says Blackett-Ord, pointing to the customer classifications within Mifid – treating a client as professional or non-professional based on whether they fall under the directive. “If you can argue the particular service or activity you’re providing is not a Mifid service for some reason, that is going to make your life easier in some circumstances,” he says. “You might not have to, for example, apply for retail commissions on your scope of commission, which means you will take home more in commission fees.”
Blackett-Ord agrees inconsistencies at the EU level are a serious cause for concern. “There’s much more scope within the UK and EU jurisdictions to take advantage of inconsistencies between the two systems than there is in trying to juggle the inconsistencies between the UK and US,” he says. “That’s the perspective we’re getting from our clients.”
Inconsistencies in regulation, whether in the legislative phase or at the implementation stage, are going to continue to be a cause for concern. “You’re not going to get to a point where every single word of the legislation and regulation is completely the same,” says Esma’s Ross. “It’s about making sure we understand why differences are there and what implications they could have. We have a reasonable view from having good regulatory experiences on both side of the debate but ultimately we need to continue to monitor the situation.”
Regulators might not necessarily be able to find complete consensus in new legislative orders, but there does seem to be a shared acknowledgement that such regulation could create inconsistencies, loopholes and opportunity for regulatory arbitrage.
However, as Ross points out, the EU and US can only talk to try to iron out inconsistencies, there is no legal mandate there. Further, the EU faces its own internal challenges trying to get national regulators to align the implementation of new regulations.
On top of that, national regulators will need to be mindful of the loopholes that exist within individual pieces of legislation, and regulators’ time might be better spent on that.
“There is a great deal more regulatory convergence between different jurisdictions now than there ever has been before and I think that means that the opportunities for regulatory arbitrage between jurisdictions are going to be fewer,” says Bovill’s Blackett-Ord. “But because it’s getting more difficult, there might be opportunities for arbitrage at the micro level because of the inconsistencies in detail. Perhaps this is the area we should be taking a closer look at.”
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