Flat out: why regulators are rushing to keep up with mergers by exchanges
By Jeremy Grant
Published: July 13 2006 03:00 | Last updated: July 13 2006 03:00
Walter Lukken is a futures industry regulator. For four years the quietly spoken native of Indiana has toiled away at the Commodity Futures Trading Commission in Washington handling dry regulatory issues well out of the public eye. Until now.
Mr Lukken recently described a moment of inspiration after reading economist Thomas Friedman's best-selling book, The World Is Flat. In it, the author describes how technology has empowered people to compete with each other across national borders and time zones, thus "flattening" the world.
Then, chatting with the chairman of the Chicago Board of Trade, Mr Lukken learnt how its new electronic trading system was being accessed 24 hours a day by traders in the unlikely location of Gibraltar. Dealing in CBOT products used to mean standing in its trading pit.
"This made me think back to Friedman's analogy," Mr Lukken says. "Would I rather be a mediocre open-outcry trader in Chicago or a brilliant electronic trader in Gibraltar? Clearly, a flat world gives the advantage to the Rock over the Windy City."
He concluded that a flatter environment would force regulators of the world's stock and derivatives exchanges to "rethink how we have traditionally approached market regulation". In other words, physical location had become almost irrelevant in thinking about where exchanges were based - and thus how they should be regulated.
Mr Lukken's normally quiet realm of exchange regulation has been jolted as exchanges jump to take advantage of this shifting dynamic - a process known as regulatory arbitrage. Marketplaces are shopping round the world for regulatory regimes that will allow them the most flexibility to expand their businesses by attracting traders eager to deal in assets of all classes as easily and cheaply as possible.
In the most striking example, John Thain, chief executive of the New York Stock Exchange, wants to merge his exchange with Euronext, Europe's second largest financial exchange. The prize is access to a listings business free from the choking effects of America's newSarbanes-Oxley compliance and auditing rules.
The second example involves a controversial examination by Mr Lukken's agency into whether futures exchanges based abroad - but offering contracts considered of economic importance to the US - should fall under American jurisdiction. The debate was sparked when ICE Futures, unit of an Atlanta-based group, captured almost a one-third share of trading in the West Texas Intermediate crude oil futures contract from the New York Mercantile Exchange after basing an electronic exchange in London, under UK regulation.
The events throw up a barrage of questions. How do regulators oversee markets whose customers are in multiple time zones and whose trading platforms operate in cyberspace? What are they to make of a NYSE-Euronext combination, which creates the first global stock and derivatives exchange, straddling the jurisdictions of multiple regulators? And under what circumstances could US regulators - the world's most powerful - extend their reach abroad?
Kathleen Cronin, Chicago Mercantile Exchange general counsel, says the issue is "how to allocate and/or manage regulatory jurisdiction in an era in which exchanges and clearing houses can manage their choice of domicile and in which cross-border trading and clearing proliferates". For many Europeans in the industry, the answer brings with it a suspicion of US regulatory "creep". Anthony Belchambers, chief executive of the UK-based Futures and Options Association, says: "It looks as if we have a wave of regulatory uncertainty that must be resolved."
Exchanges are not waiting for answers to emerge from the regulators - as the NYSE-Euronext proposal and Nasdaq's recent stake-building in the London Stock Exchange show. Benn Steil, director of international economics at the Council on Foreign Relations, says: "I very much interpret Nasdaq's and the NYSE's forays in Europe as efforts to acquire foreign jurisÂÂdictions, not just foreign exchanges, for the purpose of getting outside of Congress's and the SEC's jurisdictions - and reclaim their listings business."
Regulators are starting to work out how they should react. So far the US Securities and Exchange Commission and its main foreign counterparts appear to agree that the only workable solution is regulatory co-operation. It is a departure for an agency which, according to Bill Brodsky, Chicago Board Options Exchange chairman, has long been seen as "the most heavy handed of regulators". Christopher Cox, SEC chairman, says it is inevitable that "our parochial national market system will give way to the reality of a global market".
While there are "still many areas of significant difference between our standards and those of other countries", Mr Cox adds, the key to success is "to recognise that harm to investors will be minimised if we agree to adhere to high-quality securities regulation and there is a strong degree of co-operation and co-ordination among regulators".
Such rhetoric has been backed up with action. Two weeks ago the SEC and its counterpart in South Korea unveiled terms for regulatory dialogue between the two agencies. Last month, the SEC signed a memorandum of understanding with the UK's Financial Services Authority on co-ordinated inspections and "greatly enhanced" sharing of information. The US agency also took the unusual step of issuing a fact sheet designed to help investors understand the regulatory issues created by exchange mergers such as that intended for the NYSE and Euronext.
Mr Steil says: "There's no doubt that Cox has the same concerns as [former SEC chairman William] Donaldson about the competitiveness of US exchanges. You could perhaps argue that Cox is pushing that agenda a bit more aggressively, particularly now that the NYSE is in a position to go on the offensive, which it wasn't in the early days of Donaldson's regime. The SEC has a very different attitude now, no doubt."
One reason why it is in the interest of the SEC to co-operate is to avoid a free-for-all as regulatory arbitrage encourages countries to make their jurisdictions as attractive as possible to exchanges. Tom Feeney, a Florida Republican congressman, regularly refers to the effect of this in speeches, pointing to a danger that the US is "outsourcing 100 years of leadership in capital formation" to other countries.
Perceived success for the London Stock Exchange in marketing itself in the US as a Sarbanes-Oxley-free zone is not lost on such politicians. In Asia, regulatory arbitrage has long been used to stunning effect by SGX, the Singapore exchange. To attract capital to Singapore, SGX started offering futures contracts on Japan's Nikkei 225 stock index and on Taiwan's main stock index. The moves exploited a regulatory weakness: both countries restricted foreign participation in their capital markets.
Stephen Cutler, a former SEC enforcement head and now co-chairman of the securities department at WilmerHale, a US law firm, argues that the time has come for "some level of [global] regulatory convergence, otherwise there will be a race to the bottom" in standards.
Peter Clapham, recently chief counsel for TIAA-CREF, a financial service provider for public sector employees, says: "The US does not operate in a vacuum and they need the co-operation of regulators in other countries."
Lessons could also be learnt from brokerages, which have long had to deal with multiple jurisdictions as they act on behalf of clients worldwide.
Yet while many applaud the idea of regulatory convergence - pointing to converged accounting principles as an example worth following - that is where the consensus stops. "We're getting there," says Mr Cutler, but it "could take another 20 years before it's there in a way that's completely seamless".
Co-ordination among national securities regulators has, beyond simply information-sharing, "not been marked by stunning breakthroughs", says Robert Glauber, chairman of NASD, the private US provider of regulatory services. "This is hardly surprising when you consider that national regulators are, after all, national and subject to national political oversight and pressures."
Co-operation could derail if any domestic US crisis diverted regulators' attention inwards. The problem for the SEC in any co-operative relationship will meanwhile be to balance the need for flexibility towards other regulators with its strict conÂÂgressÂÂional mandate to protect US investors. One official of the agency asks: "What if something blows up? Will we be able to go to a US investor who's affected and say, 'we delegated that responsibility to a [foreign] counterpart'? That congressional hearing is not one I'd want to be present at."
Further doubt over the future of regulatory co-operation has been fuelled by a current CFTC study of the idea that certainforeign-based futures exchanges might need to be brought under its jurisdiction. The CFTC is under pressure from energy industry associations and some US lawmakers to bring ICE's WTI oil contract under its remit on the grounds that foreign regulations are insufficient oversight of a futures contract based on a commodity of such economic importance to the US as West Texas crude. Jeff Billings, manager of risk management at the Municipal Gas Authority of Georgia, says: "We're very concerned that we could have a situation where there are regulatory inequalities . . . that directly affect the American consumer."
Ultimately, it will be hard to draw a line between the applicability of US and foreign regulation until combined exchanges spell out how they plan to develop, either by harmonising trading platforms or having cross-listings - or both. Paul Boyle, chief executive of the Financial Reporting Council, the UK accounting standards watchdog, says of the NYSE/Euronext deal: "Whereas it would be possible to continue to preserve the US and European regulatory approaches where you had two separate exchanges, the logic of increased liquidity and lowered costs would drive you to create a single exchange. And at that point there would presumably have to be a single regulatory regime. The question is, which regime would that be?"
Annette Nazareth, an SEC commissioner, says the regulatory questions posed by exchange consolidation "all sound so new and frightening". But she adds: "In all business the world is becoming small and flat and, with technology, geographical boundaries less relevant. You can keep having these separate rules in separate countries but the real challenge is to come up with a convergence of consistent rules so that the geographical boundaries themselves become less relevant to commerce.
"That's the trick. And that's what all the regulators are working very hard to achieve."
Copyright The Financial Times Limited 2006 |
