International Capital Market Fragmentation – The Risks Are Real

By Ian Russell

The 2008 global financial crisis, setting in train financial bankruptcies and causing credit markets to seize, shook the global financial system to its core. In response, the G20 tasked the Financial Stability Board (FSB) with identifying vulnerabilities and finding the right policy responses to strengthen the system. Massive regulatory reforms ensued, the result of intense dialogue and cooperation between national authorities and international standard-setting bodies, such as the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO). These reforms centred on making financial institutions more resilient, tackling the problem of ‘too big to fail’, making over-the-courter (OTC) derivatives markets safer, and ensuring shadow banking is subject to appropriate oversight and regulation. The reforms laid the foundation for a safer global financial system.

Now, recent developments threaten to weaken cooperation on financial regulations and the process of reform. The U.S. Administration has announced a policy of relaxing financial regulation, despite resistance from other jurisdictions, and some UK officials have signalled they will seek to develop a distinct regulatory framework from the EU after Brexit.

Regulatory divergence and fragmentation among jurisdictions increase the risk of fragmenting international financial and capital markets, impairing markets efficiency and capital flows, just as financial markets get back on their feet. Cross-border trade and investment suffer. Inconsistent and divergent regulation also creates uncertainty which undermines financial institutions’ ability to conduct business. It results in higher intermediation costs for market participants (financial institutions and their clients).

The OTC derivatives market is a perfect example of what can happen when reform efforts are not coordinated. In the immediate aftermath of the financial crisis, the G20 leaders agreed to improve the integrity of trading, clearing and reporting of OTC derivative transactions. Individual regulators responded—some more quickly than others—to introduce new rules for dealers and clearinghouses in the derivatives market. These reforms were introduced without much coordination among the regulators, resulting in rule duplication for similar types of transactions. Markets Balkanized along regional geographic lines, with derivatives traders unable to execute with foreign counterparties and clear through offshore clearinghouses, without being subject to multiple regulatory regimes. The balkanization of the global market led to less choice, less liquidity and higher compliance costs for derivatives users.

Deregulation winds blowing in Washington

U.S. President Trump’s agenda to roll-back financial regulation and hesitancy to advance internationally agreed rules and standards threatens to erode cooperation on financial regulations.

The President came to office pledging to dismantle the Dodd-Frank financial regulatory reform legislation passed in 2010 in response to the financial crisis. While a sweeping overhaul is unlikely, aspects of Dodd-Frank, such as the Volcker Rule and the criteria to determine whether banks are considered systemically important, will be reshaped and softened.

The Volcker Rule bans banks from engaging in proprietary trading—i.e. accumulating speculative high-risk investments on the balance sheet financed with FDIC-insured deposits, saddling taxpayers with potential massive losses. The rule applies to both domestic and foreign activity of U.S. banks and the U.S. activity of foreign banks, and contains some exemptions. In mid-November, the U.S. Senate reached bipartisan agreement on a bill proposing that smaller banks with less than $10 billion in assets be exempt from the Volcker Rule.

A U.S. Senate bill also proposed to raise the asset threshold at which banks are deemed systemically important financial institutions (SIFIs), or ‘too big to fail’, from $50 billion in assets to $250 billion. This would reduce the total number of U.S. banks considered SIFIs (and, therefore, subject to stricter oversight, stringent capital requirements and stress tests), from 38 to 12, according to the Office of Financial Research.

President Trump’s plans to ease banking regulations prompted a strong reaction from the European Central Bank (ECB). “The last thing we need at this point in time is the relaxation of regulation,” ECB President Mario Draghi said. “The idea of repeating the conditions that were in place before the crisis is something that is very worrisome,” he added.

Will the U.S. retreat from global rule-making?

In its October 2017 report to the President, the U.S. Department of the Treasury emphasized U.S. regulatory agencies should “advance American interests in international and financial regulatory negotiations and meeting,” and recommended that “U.S. members of standard-setting bodies (SSBs) continue to advocate for and shape international regulatory standards aligned with domestic financial regulatory objectives”—in other words, put America first.

The U.S. Treasury also recommended delaying the domestic implementation of two significant components of the Basel Committee’s reforms, pending further study—the Net Stable Funding Ratio (which ensures banks have a minimum amount of stable funding) and Fundamental Review of the Trading Book (which aims to reduce potential risks in banks’ trading activities). Both were introduced to promote a more resilient global banking system.

Eyebrows were also raised when U.S. Congressman Patrick McHenry, the Vice-Chairman of the U.S. House of Representative’s Financial Services Committee, wrote to Federal Reserve Chair Janet Yellen stating the Federal Reserve has no authority to negotiate international regulatory standards and that “continued participation in international forums such as the Financial Stability Board, the Basel Committee on Banking and Supervision, and the International Association of Insurance Supervisors is predicated on achieving the objectives set by the new Administration. That will likely require a comprehensive review of past agreements that unfairly penalized the American financial system in areas as varied as bank capital, insurance, derivatives, systemic risk and asset management.”

Some believe the U.S. Treasury may increasingly withdraw from the leadership role it played through international institutions, such as the FSB, and rely more on bilateral relationships. On the other hand, the U.S. Federal Reserve, being an independent regulator, will be very reluctant to give up its leadership role in international institutions, such as the BCBS.

EU-UK regulatory divergence

Brexit has implications for European and global capital markets. The majority of UK financial services legislation derives from EU directives and regulations. To improve the competitiveness of the UK market, the UK regulators could begin to adjust the EU regulatory framework. This could result in significant regulatory divergence between the UK and EU27, arbitrage and renewed financial instability. Fragmentation would be exacerbated if trading marketplaces and Central Counterparties (CCPs) are required to be domicile and operate in the EU27 area.

The UK could look to establish greater rule convergence and regulatory cooperation with the U.S. through mutual recognition or passporting (an arrangement that is based on a common set of rules, usually under international treaty or similar legal instrument, to permit market access without requirement for further authorization). Such effort would be difficult, both because of the natural intransigence of the U.S. regulators, as well as put in jeopardy the regulatory arrangements with the EU.

New risks and vulnerabilities

IOSCO has identified the most pertinent risks in global markets to its objectives of financial stability, market efficiency and investor protection.

First: the growing sophistication and frequency of cyber-attacks is viewed as an increased threat to investor protection from financial loss and breach of confidentiality. Cyber-attacks could also interfere with trading venues and capital markets more generally. Regulators around the world are focusing on increasing the cyber resilience of financial systems.

Second: the prevalence of outsourcing by investment dealer and asset managers to enhance efficiencies, compensate for scale and lower cost may act as a point of vulnerability in the financial services industry, as the firms’ standards of financial integrity and cyber security fail to extend to third party vendors. IOSCO will undertake a comprehensive study to better understand the range of outsourcing services and related risks, and develop a template of good industry practices to assist regulated firms in carrying out proper due diligence and oversight of outsourcing services to manage risk.

Third: both IOSCO and the FSB note that weak corporate governance within financial institutions can undermine financial stability, investor protection and fair, efficient, and transparent functioning of markets. The FSB has developed a work plan to address these risks.

Fourth: there has been significant growth in exchange-traded funds (ETFs) and passive investing. According to Bank of America Merrill Lynch, U.S. stock market trading volume is now one-quarter ETFs and three-quarters single stocks. These investment vehicles have always been of interest to retail investors and households to reduce investment risk and costs, but large institutional funds and asset managers are investing in these securities. The scale of money involved could move markets more easily. ETFs have not been tested in the extreme conditions of a collapsing market. The question is, what happens if economic fundamentals sour, or a shock prompts massive selling and steep price declines, and everybody is trying to get out at the same time? Banks and investment dealers have limited scope as market-makers to absorb panic selling — particularly by asset managers faced with massive exposure to falling asset prices, accelerating withdrawals of client funds, and limited liquidity to avoid major asset sales.

Finally, the role of CCPs has increased substantially. These entities provide clearing and settlement services for trades in foreign exchange, securities, options and derivative contracts. CCP members (large banks, for example) contribute financial resources (collateral and default funds) as well as financial services to CCPs. The 20 largest clearing members account for 75% of financial resources provided to CCPs. Close to 90% of financial resources are concentrated in 10 CCPs. Eighty percent of CCPs are exposed to at least 10 systemically important financial institutions. These concentrations suggest that a shock to one element of the CCP network could have serious consequences for the rest of the network and financial market stability.

Continued regulatory cooperation and coordination will be important as the rule-making process continues to address these and other emerging issues.

Ian Russell is President and CEO of the Investment Industry Association of Canada (IIAC) and Past Chairman of the International Council of Securities Associations (ICSA)