Thursday, 12 June 2014

Two-Speed Regulatory World

The City has always made its buck by arbitraging the regulatory environment. Tax laws keep tax advisors busy, accounting laws keep accountants busy, regulations keep regulators busy and all of it keeps investment banks busy. If rules and regulations are seen as the dams preventing efficient equilibriums in water levels then investment banks are the turbines in those dams taking energy out of the system as they find ways to profit in constructing complex ways to bypass the rules and regulations. However the current and upcoming regulatory overload would appear to be testing even the most creative of institution to find ways around the dam. Flow is drying up and with it the power that it generates. Layoffs are abounding in the City especially in Fixed Income and the currency markets as profits dwindle and banks continue along their path towards 'Post Office' status.

From the outside this would seem like a positive development as it could be said that all the money these institutions are taking out of the system is a tax on the rest of the world. An increase in the application of IQ towards 'proper' jobs rather than nuancing the finest fraction of a basis point from a mythical price makes perfect sense (even for the biggest pricks) but there is a core function that these markets provide for the world on which all the excess froth formed.

As posted recently here, the FX markets are under the regulatory cosh and a concern is that if garrotted to within an inch of their life then the regulatory hurdles become a serious cost and barrier to entry, reducing competition as the few main players become similar to oligopolic utility companies providing the end user with services priced far away from efficiency (energy prices falling, but UK utility bills staying high). Even the user starts to suffer - well someone has to pay for all the changes and restrictions somewhere along the line.

There is a lot in the news at the moment about how BNPParibas' $10bio fine is already testing relationships between friendly states and has brought into question how enforceable or even correct it is for one country's rules and morals to be enforced upon an other (Frank Dodd being another prime example). There may be a case of hypocrisy here where countries refuse to have foreign ways of life imposed upon them, surfacing through nationalistic expectation of immigrants to leave their rules of behaviour behind when they come in, but at the same time imposing their own rules of behaviour on other countries.

It is worth asking if a global homogeny of regulation has to assume a global homogeny in beliefs, values, ethics and historical upbringings as at the moment the world is still very diverse. Shock at the way the cultural differences interface is probably most visible with Western interactions in Afghanistan, Iraq and a plethora of other 'hearts and minds' conquering failures. They are just different and enforcement of foreign ideals in the short term doesn't work. If it is to work it more likely takes generational change coming from cultural morphing probably via social melding internet services. Note to Europe - The English language will probably be the uniforming force in Europe rather than the Euro or any EU Parliament imposed edict.

With a world full of cultural differences, just as with regulation, there are attractions to effectively arbitraging these differences. We have seen companies moving offshore to minimise tax burdens, ship owners register under far off flags to reduce regulatory loads, clothing manufacturers move production to deathtrap sweat shops to reduce labour costs and even FIFA declaring itself super-regional and above the law with respect to corruption, so it may be worth considering how far the regulatory market can squeeze an industry before the market feels enough is enough and packs its bags to set up shop in a new less ethically bound but much more profitable world. How far can you push a market before the path of efficiency is to move to the dark side and stick two fingers up at the world it is leaving behind?

Where would they go? There are plenty of grey states around the world that could develop their own competitive financial markets but let's have some fun and think about what would ideally be needed. You want an unregulated, cheap, empty and undeveloped country that can effectively be bought and start again in. A green field site. Somewhere to build a new financial hub in the European time zone, unsaddled by monstrous debt (US, UK, EU) and irrevocable old laws (Dubai), yours for the moulding. I have had in the back of my mind for many years that a country like Eritrea with a low population, large size and pretty empty, should put itself up for sale to a large consortium of the mega-rich, private and corporate, and build a low tax, regulation free Utopia. The Country motto being 'Caveat Emptor' with the only rule being, in Mad Max style, "Bust a deal, face the wheel".

It would immediately place responsibility solely on the purchaser to do their own due diligence with no crying to rating agencies, regulators, government or personal claim lawyers if they mess-up. The low-cost airline of the financial world. No frills and you know that price is low at the cost of service and guarantees. You want guarantees? Sure you can have them but it will cost you. No doubt a secondary insurance market would naturally evolve (Like CDS's) to cater for those that didn't want to bother with their own due diligence and this would become a reference point for implied risk ( as set by the market) rather than the theoretical risk that rating agencies uselessly peddle. You want regulation? Sure we can offer you a regulated version but it will cost you. It's available but not compulsory and that is the key.

But there is always a concern - Upset the old world enough and they will first impose sanctions and then physically close you down (invasion). Sanctions are only effective, like a siege, if they cut off enough sustenance to cause serious damage. If the new grey world state is big enough and self-supporting enough then sanctions may well not be effective. As for security against invasion? Well, next-door in Somalia are a bunch of easy to rent guys who for the last 20 years have been running rings around all-comers. Job Done..

But on a less tangental level is it not possible to introduce a halfway house of regulation where an institution can offer two versions of a trade - the regulated or the not regulated? It already happens in the electronics stores where you are offered an extra three year warranty at a cost. We know what most people say to that.

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