A report issued this week by the Financial Stability Board (FSB) warns that differences between regional and national regulation is heightening the risk of market fragmentation, thus making it harder for global regulators to monitor markets and for global market participants to operate efficiently across borders. The report states, “Differences in rule-making could lead to cross-border regulatory arbitrage.”
The report highlights how the work to date by the G20 reform process has strengthened markets, but it adds, “There are, however, concerns that some markets may be fragmented along jurisdictional lines. Market fragmentation can arise for a number of reasons, including differences in national regulations and supervisory practices governing financial activities that are international in nature. This, along with differences in both the substance and timing of implementation of international standards, may disincentivise or prevent market participants from undertaking certain cross-border activities.”
The report recognises that some jurisdictional fragmentation may be the result of policies designed to strengthen domestic market resilience and while it acknowledges that this can help build resiliency in the form of barriers to cross-border shocks, there are other types of market fragmentation that may reduce the resilience of both global and domestic financial systems. “This might be the case where fragmentation limits opportunities for cross- border diversification and risk management, impairs market liquidity or prevents capital and liquidity from being channelled to where it is needed in periods of stress,” the report states. “Such market fragmentation may reduce the efficiency of cross-border investment and risk management, and thereby increase costs faced by end investors through inefficient resource allocation.”
On the latter point the report states, “It may limit the breadth or increase the cost of financial services provided to end-users. For instance, the fragmentation of financial markets into multiple trading venues that are not accessible by the same users can increase the cost of cross-border investment and risk management. In some cases, such a reduction in market efficiency may also adversely affect global financial stability, for example if it significantly impairs market liquidity. In other cases, market fragmentation may increase the costs of intermediation or reduce the availability of financial services to end- users, but without adversely affecting financial stability.”
The report does not attempt to highlight individual circumstances, rather it lays out a series of actions that may help build a more coherent and robust global regulatory framework. These include the more systematic consideration and clarification of whether there are possible fragmentary effects of regulation, both as international standards are being developed and during their implementation by national authorities. The FSB says that possible approaches could also involve greater cross-border communication and information sharing among authorities, including via existing fora such as supervisory colleges and crisis management groups, and the alignment of data collection. Fragmentation might also be addressed via measures that increase the ability of authorities to compare regulatory regimes across jurisdictions, including those that might facilitate decisions concerning recognition and deference.
This report also identifies several areas for further work to address market fragmentation. These focus on facilitating further analysis and discussion of approaches and mechanisms for more efficient and effective cross-border cooperation amongst authorities. Such areas for further work include exploring ways to, where justified, enhance the clarity of deference and recognition processes in derivatives markets; strengthening the understanding of approaches by supervisory and resolution authorities towards pre-positioning of capital and liquidity by international banks; considering ways to enhance supervisory communication and information sharing, including approaches and mechanisms to avoid future fragmentation; and considering whether there is evidence of market fragmentation with observed consequences for financial stability as part of the FSB’s ongoing evaluation of the effects of too-big-to-fail reforms.
IOSCO also released a report into fragmentation this week, in the form of its report to the G20 of the work of its Follow-Up Group to its 2015 Task Force on Cross-Border Regulation. The report finds that deference between regulators through the use of cross-border regulatory tools, particularly those identified in the 2015 report, has increased significantly and that bilateral arrangements in the form of memoranda of understanding (MoUs) are now a common tool used by regulators, particularly with respect to information exchanges.
It also notes that regulators have developed novel processes to work multilaterally to the benefit of the markets they oversee. Despite these successes, IOSCO finds that some challenges remain and strengthening cooperation between regulatory authorities could further assist in addressing effects on the financial system stemming from market fragmentation. While IOSCO recognises that deference may not be appropriate in all circumstances, its use may contribute to mitigating the risk of fragmentation for global cross-border markets.
The FSB report hints at the disadvantages faced by market participants in jurisdictions that have been early adopters of regulation, particularly Basel III. “As in other policy areas, differences across jurisdictions in the substance and timing of implementation of internationally agreed bank reforms may in some cases affect market fragmentation,” it says. “There are cases where national implementation of Basel IIIminimum standards have not been fully compliant with the Basel regulatory framework and therefore not fully consistent across member jurisdictions.18 Market participants have reported that the potential fragmentary effects from such differences may affect in particular international activities such as trade finance and wholesale banking.
“Differences in the timing of adoption of Basel III standards can also have fragmentary effects, at least temporarily,” it continues. “Banks in jurisdictions that have not implemented these standards in a timely and consistent manner may be exposed to greater risks as a result of having less prudent and robust regulatory requirements. Delayed implementation may have implications for a level playing field, and puts unnecessary pressure on those jurisdictions that have implemented the standards based on the agreed timelines.19 Market participants have pointed to potential or existing divergences in the timing of national adoption and implementation of the revised market risk framework (to be implemented by 1 January 2022) and the Net Stable Funding Ratio (which was due to be implemented on 1 January 2018) as presenting potential issues in this context.”
The FSB also urges better international cooperation around data sharing, indeed the general tone of the report is one that recommends local authorities communicate with each other in a better and more coordinated fashion.
The FSB’s work received backing from the Futures Industry Association (FIA), the president of which, Walt Lukken, says in a statement. “FIA appreciates the hard work and special attention the G-20 leaders and the FSB are giving the issue of market fragmentation, and we look forward to additional work and progress by policymakers. For FIA and its members, this discussion comes at a crucial time. Derivative markets are global, but regulation is becoming more balkanised, as FIA’s recent report acknowledges.
“It’s not just that we see conflicts and inconsistencies across jurisdictions” Lukken continues. “What is more alarming is that several national and regional regulators are moving toward more direct regulation of foreign activity and participation, making it much more difficult to run a global business. This fragmentation of the regulatory framework reduces liquidity and competition in derivatives markets by creating barriers to market access and increasing the complexities in compliance. It also undermines the resilience of the clearing system by making it more difficult for clearing firms to operate on a global basis.”
The FSB says it will further review the work studying market fragmentation in November 2019.