US, UK and European regulation chiefs pledging to crackdown on risk management within derivatives trading and tighter cross-border trading regulations in order to prevent a repeat of JP Morgan's major "London Whale" event loss could inadvertently cause regulatory arbitrage.

According to lawyers that spoke exclusively to the IBTimes UK, the plans to tighten derivatives trading through cross-border regulation could in fact cause businesses to flee to Asia, in a bid to overcome increased capital requirements, tighter supervision and regulatory uncertainty stemming from a battle between all three regions for better regulation of the banking sector.

"We are in a three way tug-of-war involving bank regulator in the EC, the US and the UK," says Scott Cameron, Partner at global law firm Reed Smith. "The outcome of this on the regulation of European and U.S. banks, when combined with increased capital requirements, may see financial institutions moving operations to Asia to the extent possible."

Other lawyers add that while this is possible, there is a large logistical obstacle to overcome.

"Regulatory arbitrage is certainly possible in theory - and people point to Hong Kong and Singapore as possible destinations for banks wishing to flee US or EU regulation," says Owen Watkins, barrister for Lewis Silkin. "But in practice the obstacles to such a change remain large. One suspects that banks use the threat of moving jurisdiction in order to bring pressure to bear on regulators to water down their regulatory proposals."

London Whale Highlights Policing Issue

In May this year, JP Morgan confirmed that the bank has lost billions of dollars, after an employee at its Chief Investment Office (CIO) made a series of enormous bad hedging bets.

In one of the largest legal losses for a bank in recent history, Bruno Iksil, who reportedly deals in huge volumes, earned himself the nickname "the London whale" - which echoes gambling terminology that refers to a "whale" being a leviathan gambler who frequently bets monumental amounts of money.

In the aftermath, the bank's CEO, Jamie Dimon said that the CIO has $7bn in unrealised gains that may be used to offset the damage testified in front of the US Senate Banking Committee in order to defend the banks practices. The bank's supervising body Office of the Comptroller of the Currency (OCC) Thomas Curry agreed that the amount lost in the 'London Whale' event will not create a solvency issue for the investment bank or threaten the broader financial system.

While this recent loss seems to be contained within JP Morgan, the event reignited the argument about the loopholes or lax supervision in cross-border regulation.

"US banks, such as JP Morgan, operate in the UK by way of a branch, not a separate subsidiary," says Watkins. "That means that, as Hector Sants, the FSA's CEO has noted, the FSA has very little prudential oversight of these banks' UK operations. The irony therefore is that although Gensler of the CFTC is right to point out that the recent JP Morgan loss was 'made in London', it was a loss made under American supervision of the OCC."

Commodity Futures Trading Commission (CFTC) chairman Gary Gensler called for new derivatives rules to extend outside US jurisdiction and into other territories, such as the UK and Europe, which would mean that UK and European regulators would need to work with the US to tighten its own regulations and move towards a more globalised regulatory environment.

Gensler argued that risk from financial companies' overseas branches and affiliates "inevitably flows back to the United States."

"Recent events at JP Morgan are a stark reminder of how swaps traded overseas can quickly reverberate, with losses coming back into the United States," said Gensler. "AIG's subsidiary, AIG Financial Products, brought down the company and nearly toppled the US economy. How was it organized? It was run out of London--actually as a branch of a French-registered bank--though technically organized in the US."

Tightening regulation pushing companies abroad

Regulators in the US, UK and Europe are working towards tightening supervision and rules for derivatives, while also trying to coordinate with each other to produce a more globalised and seamless cross-border regulatory environment.

"The US congress is struggling to come to terms with the application of the Volcker Rule prohibiting proprietary trading to foreign units of US banks, particular in light of the recent trading losses incurred by a major US bank via its UK based investment operations," says Cameron. "It now seems more likely that Volcker will be extended to the foreign branches of US banks regardless of the effect on their competitiveness. Similarly, the UK government's proposals for ring fencing UK based banks as contemplated by the Vickers Report, may limit the ability of UK banks to conduct principal trading and other prohibited activities through branches located outside the EEA."

The CFTC is currently working on a draft rule to apply new derivatives regulations to all deals involving a US firm, even if the trade is executed by a foreign subsidiary or an offshore branch.

While major banks oppose the rules, Gensler pointed that the role of international subsidiaries of US banks during the 2008 financial crisis, as well as the 'London Whale' event supports his argument for the new regulation and that the new regime must reach overseas.

The US, under the Dodd-Frank Wall Street Reform and Consumer Protection Act, is also forcing standardised derivatives to be traded on exchanges or swap execution facilities, while over-the-counter (OTC) derivatives also have to be cleared through a central counterparty (CCP).

Meanwhile in the EC "there seems to be moves in the Eurozone countries (arising out of the Euro crisis) to move towards a single banking regulator, with the consequence that any tightening of regulation on Eurozone banks could be more easily imposed than at present," says Watkins.

Increased capital requirements under the UK's Vickers Report and Europe's Basel III rules also puts even more pressure on banks and the cost burden could push more banks and businesses to Asia as rules are less onerous.

In the most recent Institute of International Finance (IIF) study, titled 'The cumulative impact on the global economy of change in the financial regulatory framework', it estimated that banks in the leading industrial economies will need an additional $1.3tn in capital by 2015.

Learning from the past

The notion of regulatory arbitrage is not necessarily a new one, say lawyers but businesses moving to Asia can be seen mirroring the past.

In the aftermath of the Enron and WorldCom, the US enacted Sarbanes-Oxley in 2002, as people felt that better corporate accountability and financial transparency was needed, says Cameron.

"However, the overriding consequences for those outside the US, was a shift to European capital markets and in particular London," added Cameron. "Many non-US companies deregistered with the SEC and subsequently, European markets grew to such an extent that by 2005 London was widely seen as taking over as the number one global financial centre from New York City."

Both Watkins and Cameron can see the possibility of this happening with Asia, if impending regulations crackdown too hard on banks.

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