Nos perspectives

Addressing market fragmentation

Putting a holistic approach to rule-making on the global agenda

Prudent market regulation and supervision can play a meaningful role in mitigating systemic incidents and protecting investors, while at the same time, forging global best practices. In contrast, fragmented rule-making may create inconsistencies in how financial institutions are required to conduct themselves across different jurisdictions, and could result in broader market-wide risks going unchecked.

Key insights

  • Fragmentation adds costs to financial institutions globally as it can result in firms duplicating regulatory reporting or having to follow different standards and requirements
  • A lack of consistent regulation may exacerbate market volatility, as different agencies may adopt their own unique standards or reporting methodologies making it more challenging to assess and identify systemic risks

Market fragmentation adds to costs

A January 2019 report by the Institute of International Finance (IIF), a global industry association comprising a wide range of financial institutions including banks and asset managers, cautioned that fragmentation can result in diverging standards, uncontrolled extraterritoriality, and reduced cross-border cooperation and information sharing.1 The absence of standardized or uniform regulation is of particular concern for asset managers given the increased focus on conducting business in the most cost effective manner.

The costs of regulatory fragmentation can be significant. The International Federation of Accountants and Business at the Organisation for Economic Co-operation and Development estimates that regulatory divergence costs financial institutions USD 780 billion on an annual basis.2 These variances among regulatory agencies can amount to between five percent and 10 percent of the annual turnovers at financial institutions globally.3

“Divergence often means asset managers are subject to variable reporting requirements in different markets. In the European Union (EU), which has been at the forefront of market-wide standardization, there remain elements of fragmentation. For instance, the interpretation, and application of the Annex IV reporting requirements under the Alternative Investment Fund Managers Directive (AIFMD) is inconsistent across EU markets, while the template has a lot of overlap with other EU rules such as the second Markets in Financial Instruments Directive (MiFID II),” said Andrea Horton, Managing Director, Governance & Regulatory Solutions at RBC Investor & Treasury Services. Until these differences are rationalized, the cost of regulatory compliance will remain high.

Divergence often
means asset managers
are subject to variable
reporting requirements
in different markets

As noted in a recent report issued by the International Securities and Derivatives Association (ISDA) regulatory driven market fragmentation clearly exists. “Data and reporting is an obvious example. If all jurisdictions require market participants to report generally the same information to trade repositories, but each requires different data forms and formats in which such information should be reported as part of its rule set, then firms will incur significant expense in complying with myriad rules. Discrepancies such as those related to data standards will also impact the ability of regulators to monitor risk on a global basis.”4

Another unintended consequence of fragmentation is extraterritoriality, which has become increasingly evident in global derivatives markets, under which individual rule-making bodies have created unique frameworks for the clearing, reporting, and trading of over-the-counter (OTC) contracts. According to the IIF report, “Implementation of these reforms is largely complete across markets including the United States, EU, and Japan. In some cases the extraterritorial application of rules, and insufficient deference between home-country and third-country regimes, has resulted in a system which is operationally complex, costly and has caused certain markets to fragment along geographical lines.5

Fragmentation creates risks for fund managers

Recent geopolitical
events have intensified
the risk of wider
regulatory fragmentation
materializing over
the next few years

In addition to adding costs for asset managers, arbitraging regulation can also create risks. The IIF paper highlights that OTC and exchange-traded derivatives reporting to trade repositories, for example, has been “uneven across jurisdictions”. Despite the rules being introduced to help regulators preemptively spot systemic risks in derivatives markets, the IIF concedes that the lack of harmonization around data quality is a concern.6 As OTC and exchange-traded derivative reporting is not fully harmonized, regulators are finding it difficult to measure and benchmark risks based on the information available at the trade repositories.

The IIF report also warns that impediments to cross-border cooperation and information sharing could impact market integrity. A number of countries, including China and India, have strict data localization rules precluding the movement of data by institutions outside of their home markets.7 Such restrictions can be problematic for asset managers with global footprints, as these laws prevent “the internal sharing of data for risk management, cyber-security, and regulatory (e.g., anti-money laundering) purposes.”8 The introduction of more flexibility for cross-border information sharing would help enable institutions to holistically monitor and manage risks across multiple jurisdictions.

Living in a less fragmented world

While global bodies such as the Financial Stability Board (FSB) do seek to minimize regulatory fragmentation, the direction of the current political environment is making it increasingly difficult. Recent geopolitical events have intensified the risk of wider regulatory fragmentation materializing over the next few years. For example, under MiFID II, European investment firms can only trade shares either on EU exchanges or foreign exchanges that have been given the seal of equivalence by the European Commission.9 As United Kingdom exchanges will no longer be equivalent after Brexit, EU investment firms will not be able to trade securities listed in London if they are also listed on a European Economic Area (EEA) stock exchange or venue.10 This risks forcing EU investors to execute certain trades on less liquid EEA exchanges, adding to their costs and exacerbating fragmentation even further in a post-Brexit world.11

Another unintended consequence of fragmentation is extraterritoriality

Calls for change are mounting and greater momentum and awareness is expected in the coming months. In addition to the FSB’s efforts, for example, the G20 Osaka Summit in June 2019 is prioritizing financial market fragmentation as a top agenda item. Shunsuke Shirakawa, vice-commissioner for international affairs at Japan’s Financial Services Agency (FSA), notes the need for pragmatic solutions. “The first stage is the international rule-setting stage. The second is the national rule-making stage and the third one is supervisory cooperation. At each of these stages if we can communicate more closely we can be better in terms of market fragmentation,” he said. 12

Moving towards a more globally integrated approach to regulation is essential to help improve regulatory oversight and supervision while removing inefficiencies for managers.