It’s only been six years since Ruben Lee wrote his thought-provoking treatise “What is an Exchange?” but you can’t help but wonder: If he wrote it today, would the title be “Who, when and where is an exchange an exchange?”
He’d have plenty of material now that regulators and market participants from the United States and Europe have so publicly stated their opinions on how to define an exchange’s location for regulatory purposes.
“The Commodity Exchange Act (CEA) was written and designed for a set of market circumstances that have evolved significantly since it was enacted,” declared Commodity Futures Trading Commission (CFTC) Chairman Reuben Jeffery at a politically-charged hearing he chaired in late June to frame the debate on global regulations. “The challenge for us today is to understand how to apply these statutory labels, like ‘located,’ when exchanges are no longer bricks and mortar and where the Internet has made ‘location’ an awkward and outdated statutory concept.”
CFTC Commissioner Walter Lukken added: “Twenty-four years ago when this statutory language was adopted, it was much easier to draw such bright-line distinctions between exchanges located in the U.S. and those located outside of our borders. But regulators no longer live in this bright-line world. Determining where an exchange is located is difficult, if not impossible, with its server, board of directors, customers, clearing and self-regulators scattered around the globe.”
The common theme struck at the hearing is that the CFTC’s current practice of issuing so-called “no-action” letters (see “No-action letters” below) is as good a procedure as any, especially when it comes to protecting retail customers.
“We are not talking about risks to the customers as far as I can tell,” says Lukken. “We are not recognizing a clearing firm through this no-action process, so these transactions still have to go through futures commission merchants (FCMs) or our Part 30 foreign regimes with its capital requirements and customer asset protections and disclosure requirements.”
However, participants weren’t convinced the current system protected against systemic risk.
“One can envision a situation in which U.S. participation…on a foreign exchange were sufficiently large…that a problem in the foreign clearinghouse could trigger a wave of defaults, which could spread throughout the U.S. financial markets, even among institutions which were not participants in that foreign market,” said Benn Steil, a senior fellow and director of international economics for the Council on Foreign Relations.
But what about regulatory arbitrage? “When those no-action letters were permitted, there was no direct competition,” says former CFTC Chairman and current Nymex head Jim Newsome. “The fact that we now have direct competition on products brings to light some of the more subtle differences between the regulatory schemes.”
Richard Berliand, chairman of the Futures Industry Association, gently agrees in principle, but disputes Newsome’s claim that traders are flocking to ICE Futures to avoid the CFTC’s reporting requirement. “Jim’s point is absolutely correct, that the biggest public interest here is around competition,” he concedes. “I would say, however, that in my experience, the press and many less well-informed commentators in the marketplace fail to really drill into enough of the detail, and therefore will claim there are elements of regulatory arbitrage that are at work here that are driving activity in the marketplace, when in many cases, they are not the primary driver.”
As chairman of JP Morgan’s futures division, he says he’s in a position to view the flow of activity between ICE Futures and Nymex. “While there is some element of position-limit concern, that is not the primary driver of market activity,” he says. “That having been said, there are plenty of examples, and I am on the record as having commented on this before, of where regulatory arbitrage has a huge impact on flows.”
Jeffery’s predecessor as acting chairman and commissioner, Sharon Brown-Hruska, also concedes the reality of regulatory arbitrage.
“It’s easy to use the rule book as a barrier to competition,” she says. “That is certainly what some incumbent players would like their regulator to do to block foreign competition (as was the case with Eurex US or now in the case of ICE Futures).”
Euronext compliance boss Nick Weintreb says the common goals of all regulators makes no-action work. “All regulators have obligations to protect market integrity, to protect the interests of investors and in most cases to foster competition,” he says. “It is much easier to get cooperation and information sharing because ultimately people recognize why you want the information, you recognize why they are willing to give it and why they may want reciprocation.”
The idea of no-action is an acknowledgement that other agencies could find other means to meet the same goals. However, with direct competition, any difference in regulation, could impact that competition.