Attempts to impose unreasonable regulation may simply shift business outside the United States than solve the fundamental problem, market experts say. But is regulatory arbitrage a given, or even a bad thing?

All the calls for more regulation of derivatives in light of the 2008 economic crisis may be satisfied by one of the many proposals circulating Capitol Hill. But if history is any guide, it likely will not police the problem, just handcuff U.S. institutions in the global marketplace, states derivatives expert Christopher Culp, an adjunct professor at the University of Chicago Booth School of Business.

“The temptation in the wake of the financial crisis for politicians and regulators to appear proactive is understandable,” Culp says. “But a lot of what is being discussed would create a very uneven playing field that could badly hurt the competitiveness of the U.S. derivatives business.”

The concern is regulatory arbitrage, the natural movement by the regulated to less restrictive oversight elsewhere. While the government reaction is to clamp down on derivatives and over-the-counter (OTC) instruments, it may simply force market participants to abandon the United States for more agreeable regulatory regimes. The largest market participants have global operations and so have the needed infrastructure in place to support these activities in more than one country.

“Unless they literally can’t trade it somewhere else, they will tend to trade it where costs are lowest,” explains Culp.

In some sense, regulatory arbitrage is omnipresent throughout the interactions of businesses, individuals and the government. For instance, a married couple can decide to file their tax returns separately instead of jointly, which could afford them a lower tax rate and more access to tax-advantaged retirement accounts than if they filed jointly. In financial services, a bank can elect to be state chartered or nationally chartered, giving them the ability to switch charters should they feel an overbearing regulatory regime. In neither example is any wrongdoing occurring. The parties simply make an economic choice. In this sense, regulatory arbitrage actually lends benefits to the market, because it generates competition among regulators, which in turn streamlines the business environment, adds Culp.

Defining gray

According to a recent paper by Victor Fleischer, a professor at the University of Colorado Law School, there are three readily identifiable arbitrage opportunities:

• The same transaction receives different treatment under different regulators;
• Similar transactions with identical cash flows receive different regulatory treatment; or
• The same transaction receives different treatment from overseers today than it will in the future.

These types of arbitrage occupy a gray area, with many corporate attorneys believing it their professional obligation to identify arbitrage opportunities to the benefit of their clients.

Additionally, an acute problem with forcing derivatives traders to use central counterparty clearing, levying a financial transaction tax or eliminating the presence of speculators in energy and food commodities – all recent proposals – is that the global nature of financial markets means the behavior of participants will not be stopped, but rerouted outside U.S. jurisdiction, Culp contends. Simply look at the large number of offshore hedge funds, which formed to sidestep less desirable U.S. and European financial market regulations.

Ambiguity reigns

Others are less certain that operations and capital will flow so freely away if U.S. regulations are tightened on derivatives and other OTC instruments.

“To the extent a company has a U.S. nexus, it is going to be hard for anybody to move business that the regulators don’t want them to move,” says Christian Johnson, a professor at the University of Utah S.J. Quinney School of Law. “Those aren’t the problem children anyway. It’s the entities that don’t have any U.S. ties that will shop elsewhere, and which might have come to the United States otherwise.”

How serious that would be is difficult to quantify. For example, while the imposition of Sarbanes-Oxley anecdotally appears to have discouraged non-U.S. companies from cross-listing their stocks, there remains little hard data to prove it has materially affected the equity markets. And if a firm has to be in a particular market, studies show even hedge funds are willing to be regulated, explains Johnson.

The question then is, can firms find the same market opportunities outside the United States, with less regulation, without incurring too high an increase in costs? Ideally, cooperation among the major economic centers of the world would make any regulation more enforceable while keeping the playing field level for financial firms to do what they do best – compete by services and execution, rather than operate by government fiat.

Problem defining the problem

According to Johnson, the debate over what regulations, if any, to impose on the OTC and listed derivatives markets stems in part from an incorrect assumption that derivatives were the cause of the financial implosion of 2008.

“If you say the financial crisis was caused by over-the-counter derivatives, with the  exception of AIG, they had nothing to do with it,” Johnson says. Yet there remains a vocal contingent, such as University of Maryland Law School professor Michael Greenberger, who argues that OTC derivatives have played a part in every recent major fiscal crisis – from Long-Term Capital Management to the recent southern European sovereign debt problem – and therefore need to be forced to boost transparency through regulations, regardless if regulatory arbitrage may occur.

“A market that now has the notional value of many times the world’s GDP is a completely bi-lateral financial market wholly opaque to the world’s market regulators,” Greenberger writes in the recently published book Make Markets Be Markets.

As intractable as opinions on both sides of the issue may be, assigning blame and attempting to regulate individual products may be beside the point, Culp says. As it stands, the U.S. regulatory system has gaps and overlaps between agencies with slightly differing goals and responsibilities. After all, AIG was not unregulated, it was overseen by the Office of Thrift Supervision and in parts by a dozen other federal and state agencies, none of which seemed to identify the risk AIG represented. In effect, the complex network of domestic regulation generates its own regulatory arbitrage, in which even the regulators themselves are unclear what to enforce and whom they can enforce it on.

In such an environment, it is no wonder market participants are compelled to take their business elsewhere.

“You get some stuff that falls through the cracks and with others you get extremely excessive costs for regulators and taxpayers, as well as institutions,” says Culp, adding that another layer of regulation won’t improve the current regulatory framework. “In attempting to increase coordination you often just increase bureaucracy. One of the overriding goals of a financial regulatory system has to be clarity.”

The question then is, can firms find the same market opportunities outside the United States, with less regulation, without incurring too high an increase in costs?