Regulatory Arbitrage: No Fork in the Road

ISDA Chief Executive Officer Scott O'Malia offers informal comments on important OTC derivatives issues in derivatiViews, reflecting ISDA's long-held commitment to making the market safer and more efficient.

Are some Asian jurisdictions venturing down the path of “regulatory arbitrage” in order to lure derivatives business away from the (supposedly) more strictly regulated US and Europe? Some observers think so. But if you kick the tires on this claim by considering observable facts and actions, you will see this claim isn’t going anywhere.

The September 2009 G20 Summit in Pittsburgh laid out the path for OTC derivatives:

“All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.”

The APAC G20 signatories – Australia, China, India, Japan and South Korea – are all on track to meet their mandatory clearing and reporting requirements. Hong Kong and Singapore are not G20 members and could have chosen the other path by not adopting G20 standards, but they’re opting in to G20 principles, not staying out. (For an update on Singapore’s thinking see a recent Asia Risk piece by our colleague, Cindy Leiw. Registration for free trial required.)

With the exception of Japan, APAC regulators have chosen not to address the G20 plank on exchanges or electronic trading platforms at this time. This makes sense given how much less liquid APAC derivative markets are than those in the west, and the “where appropriate” language in the G20 commitments, in our view, allows for this. The drafters of Dodd Frank and EMIR have chosen to make electronic trading platforms an important part of their regulatory reforms, but that does not mean that APAC jurisdictions should have to do so or stand accused of regulatory arbitrage. Asian jurisdictions will abide by global consensus reforms, not US or European domestic regulations.

Asian regulators have energetically participated in all global regulatory coordination bodies, including the Basel Committee, CPSS/IOSCO, ODRF, and the Financial Stability Board. They are actively engaging with US and European regulators on a bilateral basis to harmonize regulation and deal with extraterritorial issues. At ISDA we work with regulators one-on-one and also organized two regulator forums in 2011. APAC jurisdictions have all committed to adoption of Basel 3 standards, and in some cases such as China and Singapore, have even called for more stringent capital standards than those prescribed by Basel 3. Contrast this with the US, which never implemented Basel 2 and and has yet to decide whether to adopt Basel 3 standards.

Another fact not considered in the debate is that prior to the financial crisis, Asian derivative markets were already much more stringently regulated than western markets. CDS were not allowed onshore in China or India at that time and, even now, are only allowed in a controlled manner that has led to minimal volume. China, India and Korea also control the amount of leverage banks are allowed to offer to clients for hedging products which also puts a damper on trading volume. China and India are also likely to mandate clearing of FX forwards while the US and Europe will likely exempt them. This hardly smacks of regulatory arbitrage to us.

The final charge against Asian jurisdictions is that much is still pending. But that’s understandable given that the FSB has not finalized standards on mutual recognition of third country CCPs or LEI standards, CPSS/IOSCO has not finalized CCP risk management standards and rulemaking under Dodd Frank and EMIR remains a work in progress. Asian regulators are wary of enacting legislation before global standards are set as it could be difficult to amend legislation once passed. Their intention is to harmonize with global regulation, not to create arbitrage opportunities.

Regulatory arbitrage is easy to assert and hard to prove. All the more reason to keep our eyes on the road and focus on the facts.

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