University of Houston Finance Professor Craig Pirrong discussed the potential impact of "Brexit" on the global financial markets. In a blog post, he noted that the results of the "Brexit" vote substantially increased the odds of the European Union "falling apart," and of regulatory and legal fragmentation, with the biggest potential disruptions and inefficiencies occurring in the financial sector. He questioned how the London Clearing House would fit into the "fragmented regulatory landscape," and recalled past "torturous negotiations between the US and EU over recognizing each other's [Central Counterparties]."
Professor Pirrong argued that "Brexit" will create opportunities by allowing the UK to compete with the European Union, which in turn will influence policy more effectively and in a positive manner:
This is all very complicated, and will be played out in the context of a larger game between Britain and the EU (and between the EU and individual EU countries). Hence the outcome is wholly unpredictable. But having Britain as an independent player will change dramatically the regulatory game. The greater competition is likely to result in less regulation, and crucially less stupid regulation.
Commentary
In regulators' parlance, harmonization is a virtue and arbitrage, a sin. However, Brexit calls these assumptions into question, since the flip side of regulatory harmonization often is a form of collusion among regulators who wish to achieve higher, more cumbersome and more costly levels of regulation, while regulatory arbitrage can be utilized as a way to correct for these shortcomings.
Normally, regulatory arbitrage involves the practice of taking advantage of differences in regulatory systems in order to circumvent unfavorable regulation; e.g., moving one's IPO business from the U.S. to London to escape the burdens of Sarbanes-Oxley, or moving one's business to Ireland to take advantage of lower tax rates, or moving one's swap business abroad to escape Dodd-Frank. See Wolf-Georg Ringe, "Regulatory Competition in Global Financial Markets: The Case for a Special Resolution Regime," Oxford Legal Studies Research Paper No. 49/2015 (January 15, 2016) (observing that "arbitrage can trigger regulatory competition between jurisdictions that may respond to the relocation of financial services (or threats to relocate) by moderating their regulatory standards").
Regulators publicly oppose this practice, and work with each other to prevent it under the guise of achieving "regulatory harmony," or avoiding a "race to the bottom." But such harmony does not always act as a positive force, while the race among jurisdictions more often is not to the "bottom," but rather to a competitive equilibrium. See Graciela Chichilnisky, Limited Arbitrage Is Necessary and Sufficient for the Existence of an Equilibrium (1997).
According to Yale Law Professor Roberta Romano, regulatory competition is beneficial because it "provides an incentive for regulators to improve their regimes," and "more quickly corrects for policy mistakes than a single regulator can." See Roberta Romano, "The Need for Competition in International Securities Regulation," John M. Olin Center for Studies in Law, Economics, and Public Policy Working Papers, Paper 258 (2001), at pp. 5-7.
Likewise, having Britain as an independent player may provide competitive force not only for less regulation in the financial markets, but also for "crucially less stupid regulation," as Professor Pirrong colorfully puts it.
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