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Monday, April 24, 2006Regulatory Arbitrage in Exchanges
I posted about comments made by former Fed Chairman, Alan Greenspan regarding his "alarm" at the negative impact Sarbanes-Oxley have had on the US capital markets. Here is another take on the same subject from the Economist:
...the Intercontinental Exchange (ICE), a fast-growing, all-electronic operation based in Atlanta, which earlier this year began to compete against the tradition-bound New York Mercantile Exchange (NYMEX) in oil futures. [Charles Schumer, a Democratic senator from New York] is agitated about a perceived advantage for ICE that has broader implications for financial markets: the use of regulatory arbitrage. This is the idea that an exchange may operate in one jurisdiction rather than another so as to gain commercial advantage from more favourable regulation.
This strikes Mr Schumer as wrong, especially now that ICE has closed its trading floor in London and started to offer a contract in West Texas Intermediate crude oil, thus competing directly with NYMEX. James Newsome, president of NYMEX, says one regulatory difference that worries him is that ICE places no limit on the size of outstanding positions, while his exchange is subject to position limits under the CFTC. The New York exchange has responded by unveiling plans this month to list its energy contracts on the electronic trading platform of the Chicago Mercantile Exchange, in a deal intended to blunt ICE's technological edge.
ICE provides one example of how regulatory differences increasingly matter to exchanges. For another, take the (now suspended) bid by America's NASDAQ for the London Stock Exchange (LSE). The LSE has had success in attracting listings by overseas firms, often at NASDAQ's expense, in part owing to American laws such as the USA PATRIOT and Sarbanes-Oxley acts. Greater financial disclosure and the obligation for bosses to take responsibility for accurate reporting are two examples of rules that seem onerous to many...
At a time when hedge funds and other active investors are eager to move their money around the world and technology allows it to happen faster, regulators remain one of the last barriers to seamless global capital flows. Exchanges, meanwhile, are consolidating and accelerating their shift from floor to electronic trading, leaving them less tied to particular locations. “Exchanges aren't geographic concepts any more, they're legal concepts,” says Benn Steil, an exchange expert at the Council on Foreign Relations in New York.
What I found especially disturbing about this article was the reference to position limits as a competition dynamic. The implication is that, in an era of increased federal regulations, exchanges and exchange regulating bodies are feeling pressured into weakening the bulwarks of financial stability. As I see it, this, coupled with an alternative investment community that is constantly pushing the envelope in a quest for alpha, plus highly volatile markets for derivatives, is a very dangerous mix.