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The Trading Mesh

Avoiding Prying Eyes? Facing Down Regulatory Arbitrage

Mon, 08 Dec 2014 03:12:55 GMT           

This article originally appeared on TabbFORUM at http://tabbforum.com/opinions/avoiding-prying-eyes-facing-down-regulatory-arbitrage and is reproduced here with the author's permission

By Theo Hildyard

As the US and Europe scramble to enact rules to rein in risk in the capital markets, there remain parts of the world where regulation is still nascent. This can offer irresistible attraction to banks wanting to do business without the Big Brothers of the financial markets looking over their shoulders.

If money makes the world go around, then regulatory arbitrage might be the next big thing – especially if new regulations stifle the free flow of money in capital markets in compliant countries.

Market volatility might be the canary in the coal mine. There is a fear that volatility is increasing because big banks are less willing to buy when others want to sell, according to the editors at Bloomberg. Investors say that big U.S. banks are pulling back from market making because of new regulations. This includes Basel III, which requires banks to have higher capital reserves, and the Dodd-Frank Volcker Rule, which limits speculative trading.

The global financial crisis of 2008 demonstrated all too clearly that banks needed to be less leveraged, more transparent and less prone to taking on excessive risk, says the Bank for International Settlements. During the credit crisis banks and dealers could not sell the mortgage-backed instruments that were collapsing. Their capital reserves were illiquid, therefore, and could not be called upon – leaving the federal government to bail them out.

Both Basel III and Dodd-Frank are intended to ensure that banks are less likely to get themselves into the fragile positions they were in. This meant building larger capital reserves and eliminating some of the riskier elements in their portfolios.

Banks that were trading commodities, for example, went running for the exit after the Dodd-Frank Volcker Rule, which bans proprietary trading and ownership of physical commodities assets, was put into action earlier this year.  JPMorgan, Morgan Stanley, Deutsche Bank and others have only marginal participation in the business today.

In addition to already stringent rules, a new regulation from the Basel Committee on Banking Supervision will require in 2018 that internationally active banks limit their more volatile short-term borrowing to fund illiquid assets. The Committee, which brings together regulators such as the U.S. Federal Reserve and Bank of England, will make these banks meet net-stable funding rules that force them to take into account the maturity of their assets. This again limits their choices.

As a result of the new regulations and restrictions there may be less leverage and more capital in reserve, but less making its way into the marketplace. And trading relies on leverage. Few banks, oil companies or hedge funds could trade the massive positions they do without using leverage. But stringent capital requirements limit the amount of leverage these institutions can deploy. So, is it possible that these institutions might look to less-regulated regimes to build their trading floors in the future?

As the U.S. scrambles to enact Basel III and the rest of the western financial world tries to comply with Dodd-Frank (so they can do business with the U.S. without being sued), there remain parts of the world where regulation is still nascent. This can offer irresistible attraction to banks wanting to do business without the Big Brothers of the western financial markets looking over their shoulders.

Singapore, long considered a “light touch” regulatory regime, made a beeline to become a commodities hub in 2012 as the Volcker Rule loomed, even offering tax incentives to trading companies and traders, says the FT. 

At the British Bankers Association annual meeting in London earlier this month, the deputy governor of the Bank of England, Jon Cunliffe, warned about regulatory arbitrage. He asked whether it is possible for the world’s key regulatory police to ensure that there is consistent implementation across jurisdictions.

If regulators can’t do that, he said, there could be “regulatory arbitrage and a race to the bottom,” or regulators will ring-fence operations and “build walls around institutions.”

The answer may lie with real-time monitoring, similar to that used in surveillance. Using trade data, historical data and real-time analytics, a bank can watch every market position in real time and match these to new positions, marking everything to market, and flagging any breaches in capital reserves. Taking this further, the bank can factor in capital reserves in the pre-trade environment, ensuring that each and every trade passes the capital adequacy test before the trade is completed. It could also monitor its positions for the net-stable funding rules.

That way the bank is compliant at any given time during the global trading day, and has less of an excuse to seek out a looser regulator regime.

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