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Comment: Regulatory arbitrage – the case of credit default swaps

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Dr Richard Reid (pictured), director of research at the International Centre for Financial Regulation in London, says the controversy surrounding the role of credit default swaps in allegedly aggravating Greece’s fiscal problems illustrate differences between countries in Europe and beyond on the priorities for financial sector reforms.

One of the persistent issues facing the implementation of international regulatory reform of financial services is the danger of regulatory arbitrage. Given the volume of global capital flows, the ease with which the financial sector can adapt, and, in some cases, the political will of some countries to either underpin or promote their own financial services centres, the difficulty of achieving a co-ordinated international response is ever present. This is all the more so when an issue becomes highly politicised.

This problem has been thrown into the spotlight with the plight of Greece, its budget deficit and the controversy surrounding the trading of credit default swaps in its sovereign debt. Some European politicians are pressing for restrictions on “purely speculative naked” trades, a move which has been resisted by both the US and the UK.
As Bloomberg has reported, opposition in the US is well established, with Treasury Secretary Tim Geithner saying last year: “My own sense is that banning naked swaps is not necessary and wouldn’t help fundamentally…. It’s too hard to distinguish what is a legitimate hedge that has some economic value from what people might just feel is a speculative bet on some future outcome.”
It’s not uncommon for countries that get into fiscal problems to lash out at financial markets, and sometimes indeed the rhetoric is aimed at affecting market behaviour. It’s clear, though, that the spreads on Greek CDSs owe at least something to a fundamental problem, in this case, its ballooning budget deficit and market doubts about the authorities capability of addressing it.
European Union finance ministers are set to discuss this issue next week. Whether or not the topic makes it onto the G20 discussion in June depends on how long Greece’s crisis lasts. By then the worst of its strains may be over.
But what this whole episode has highlighted once again is the frequent clash between the priorities of different jurisdictions for reform of the financial sector. We’ve seen it with regard to how to make banks pay for the costs of financial crises, on hedge funds, on compensation and even optimal regulatory structure.
In the case of the CDS market, this is a prime example of a business that can migrate relatively easily if a common regulatory response is not found. Reuters reported on Friday that the UK is pushing a solution to be included in proposals next week that would allow short selling of CDSs but would require more information on “secretive investors”.
The Financial Stability Board and the IMF will be releasing studies on a whole range of issues surrounding regulatory reform over the coming weeks. There’s little evidence at present that there’s been much progress in bridging gaps between the overarching G20 agenda and the often conflicting domestic agendas of certain countries.
Indeed, there is even a suspicion that some authorities are seeking to influence the global debate by “placing a stake in the ground” on certain key issues. For sure, in some cases the ends are similar. but the means for getting there may differ significantly. It will be a major task for the FSB to demonstrate that the strategic G20 objectives are on track.


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