U.S. regulators, preoccupied with modifying the decade-old, hastily put together Dodd-Frank regulatory regime, have let their guard down, potentially leaving the European Union’s (EU’s) fast-tracked regulatory regime to dominate U.S. financial institutions behavior.
Two pieces of EU regulation, EMIR (European Markets and Infrastructure Regulation) and MiFID (Markets in Financial Instruments Directive), scheduled for final implementation on Jan. 3, 2018, are forcing U.S.-based financial institutions to accommodate more onerous regulations if they are to participate in EU markets and provide services to EU clients.
EMIR forces U.S. companies that wish to do business with European counterparties to follow their rules on derivatives for trading venues, central counterparties and trade repositories. MiFID sets out the rules for trading, market research, investment firms and sets data standards for trade and market data reporting.
U.S. capital and derivatives markets had for long been the gold standard, thought to be the fairest, most liquid and best managed. Regulation and oversight of U.S. markets and their financial institutions, up to the financial crisis, was thought to be first class.
Now, European rules are setting a new gold standard, more comprehensive than U.S. ones, reversing the decades-long dominance of U.S. markets and their financial institutions having the best-in-class risk and regulatory regimes.
The EU as a key global market cannot be ignored by U.S. investors. It is a formidable trading parting with GDP of the 28 EU member nations approximately the same size as the US — each about 17 percent of global GDP.
The EU’s evolved trading markets — equities, bonds, derivatives and foreign exchange, serve their combined population of 512 million people, potentially providing more trading depth and liquidity then the U.S. markets 325 million population.
Another determinant of EU’s rising prominence is their adaption of the Basel Committee on Banking Supervision’s (BCBS’s) capital and risk regimes, a global framework for implementation by sovereign regulators, that is being adhered to closely in the EU but not so in the U.S.
Boosting the rising prominence of EU financial service markets is the U.K.’s Brexit decision. Brexit has placed its London financial center at risk of moving to the EU. Prominent global banks have already decided to relocate their U.K. financial centers to EU capitals.
To understand the potential of the U.S. to evolve to an EU-centric financial system, we need to understand some of the changes to practices of U.S. financial institutions fostered by EU rules:
- OTC derivatives trades forwarded to U.S. regulators by a single counterparty are accepted as matched (completed). Those same transactions in the EU must be sent by both counterparties to the trade, thereafter to be matched to confirm completion.
- Foreign Exchange forward contracts need to be margined for the first time.
- Implementation of new risk models and historical data is to replace earlier risk models and simulations used by U.S. banks, reflecting EU’s lending finance orientation vs. the U.S.’s capital market financing culture.
- All trades placed by U.S. firms with EU financial institutions must register their identity and parental owner.
- No new issues or contracts will be registered on an EU trading venue without obtaining newly constructed product identifiers and legal entity identifiers.
- No trades will be accepted unless firms provide personal identification information of traders initiating a financial transaction.
EU infrastructure rules for capital markets trading is another area of significant difference that U.S. firms need to accommodate:
Whereas in the U.S. there is centralized market data dissemination allowing equal access to multiple trading venues, in the EU each market is accessible separately setting up arbitrage opportunities that will inevitably attract order flow from trading firms into EU markets.
Best execution defined for U.S. equities solely on best price is expanded in the EU for all asset classes, setting an "all sufficient steps" criteria to include price, costs, speed, likelihood of execution and settlement, size, reason for choosing one trading venue over another, etc.
Research costs usually bundled with trading costs in the U.S. must be separated and sold or identified separately in the EU. U.S. firms may have to access less liquid markets in the EU to service EU clients when the same stock trades in both geographies.
The U.S. has taken other more dramatic measures to loosen its adherence to global norms. Most notably, it is rethinking the asset threshold for determining the systemically important designation of financial institutions prescribed by global guidelines.
It already has removed systemically important insurance companies headquartered in the U.S. from the global list of systemically important insurance companies.
The U.S.’s attention to unwinding Dodd-Frank rules and the loosening of risk measures is at odds with the EU's focus on more stringent trading rules and adherence to globally accepted risk measures. Will this be the slippery slope that causes the U.S. to lose its dominance as the global center of finance or be the means of creating competitive advantage?
A very prominent mitigating factor that argues against such European dominance is the strength of the existing single governance structure of the U.S. — on taxes, budgets, regulation, commerce and trade. This may be enough to overcome the emerging strength of the new structural order of the EU financial system.
The underlying weakness of the EU is its member countries’ individual nationalistic interests and internal politics as sovereign states. Can this be overcome in time by EU countries adhering to a similar central governance structure as in the US.?
Can it achieve its often stated and long-standing goal of a “United States of Europe”? Only time will tell, in the meantime doing business in Europe means adhering to the European way.
Allan Grody is the president of Financial InterGroup Advisors — strategists, consultants and researchers in financial services with particular focus on bank regulation. Grody is also an editorial board member of the Journal of Risk Management in Financial Institutions.