With global businesses operating in increasingly regulated conditions, cross-border transactions are becoming more and more complex as governments strive to protect consumers and stimulate trade while minimising risk. 

In the globalised world of financial services, it is surprising that the media has paid little attention to the location of financial business. While several large companies and banks have publicly threatened to move their businesses, it is notable that few significant shifts have in fact occurred. Businesses now operate in an ever-more tightly regulated environment. The emerging global regulatory architecture is going to be central to decisions as to where business is undertaken.

Regulators are no longer willing to let global businesses roam unrestricted, nor are governments willing to see their taxpayers backstopping liabilities on a pan-global basis. A robust legal system and an independent regulator are factors that become particularly significant when tensions and disputes are on the rise. This is particularly the case when capital is scarce. There is still a countervailing trend for some countries to impose lax regulatory standards with a view to attracting business, but the impact of this is increasingly limited.

US market

The financial services world is increasingly splitting into business done in the US, that done in the EU, and then the rest. The US regulatory system has always been somewhat ringfenced. Many US rules are designed to ensure that US securities and derivatives business is done in the US. Additional requirements as to the US regulatory status of institutions facing US customers have emerged from the Dodd-Frank Wall Street Reform and Consumer Protection Act.

There is no meaningful exemption from US securities regulation for entities that conduct securities business with US retail investors. There is a substantial exemption from broker-dealer registration for non-US broker-dealers that conduct institutional business, but this requires the participation of a US-registered broker-dealer in each transaction, which usually means a US-registered broker-dealer affiliate.

For derivatives transactions, US customers are required to use US-registered entities to satisfy cleared derivatives requirements and certain collateral must be maintained in the US (out of an apparent mistrust of foreign insolvency regimes). In addition, deposit solicitation from US residents for the most part requires a US presence.

European market

The European market is also becoming more ringfenced. In the EU, investment business with European clients already needs to be conducted from an EU-incorporated entity or face the difficulty of becoming regulated separately in each member country. Traditionally, it has been possible to conduct business into the UK from outside Europe without regulation as an 'overseas person', but it seems that this facility will be narrowed as a result of the EU's Markets in Financial Instruments Directive II (MiFID II) proposals.

Under the proposed legislation, the criteria for determining when a non-EU firm is deemed to do business in the EU will be harmonised for the first time. Non-EU firms conducting retail (and possibly other) business in the EU will have to establish a separately capitalised branch in the relevant EU member state.

Under the European Market Infrastructure Regulation, derivatives trades must be cleared through an EU clearing house or one whose home regime and systems are recognised as 'equivalent' in the EU. Asset managers wishing to market hedge funds to European customers will also, in future, be required to do so through an EU-established alternative investment fund manager (or face a significant marketing disadvantage compared with EU managers).

Reciprocal agreements

In some specific cases, it seems likely that UK and many other EU-based institutions will be able to do business with US customers on the basis of the US concept of 'substituted compliance'. Also, it will generally be possible for non-EU entities to do business with EU customers so long as the regulatory framework in the home country is classed as 'equivalent' and often only if the home country regulator provides reciprocal recognition for EU entities.

There are three big stings in such tests. First, the laws have to be truly equivalent, which presents issues given the political choices made in particular countries’ legal systems. Second, they must be properly and effectively enforced, which is likely to be an increasingly hard test to satisfy, as it is unlikely that any measures will be enforced as effectively in a country introducing them only to pass an 'equivalence' test. Finally, there is no timetable for substituted compliance or equivalent determinations to be made, creating huge uncertainty for institutions.

That said, the measures seem likely to be applied so as to permit trans-Atlantic recognition, or at least to fit with a business model operating out of London and New York-based affiliates that can in turn do business in much of the rest of the world. So, while it will remain possible to run a global business from New York or London (subject to obtaining access to Europe or the US, respectively, through equivalence, substituted compliance or other routes), it will be increasingly difficult to have a significant centre of gravity for such a business outside the EU or the US.

The position is exacerbated by various other proposed restrictions for cross-border activity that will make it difficult to cost-effectively sustain businesses operating from outside the traditional hubs. Regulators, driven by taxpayer pressure and national interests, are likely to use the 'living wills' agenda to reduce complexity and enhance the resolvability of institutions. (Banks are required to produce living wills – road maps of how they will be broken up if they fail.) Cross-border activity breeds complexity. Business is much simpler when done with others located in the same hub or, failing that, in environments applying linked regulatory and legal regimes, such as the EU single market.

It seems that many institutions will be required to turn various businesses into subsidiaries. This is not required in the US or the EU single market, but can be an issue for businesses on both sides of the Atlantic. It is potentially a very expensive constraint for businesses in their operations outside the US and EU. The UK Financial Services Authority recently drew attention to the implications of US depositor protection rules and is proposing to prevent institutions that prefer US over UK investors from doing business with UK customers. This will drive US banks to operate out of a UK subsidiary on a US-UK affiliate model.

Local protection

Countries are now increasingly protecting local customers, including wholesale counterparties, on the basis that even seemingly sophisticated buyers need to be protected. So the more that can be done in a financial centre and from there across the US or EU markets, so as to reduce the application of local restrictions (which the single market generally removes), the lower the friction. Even in the single market there is a regulatory requirement for a regulated entity to have its principal place of business in its own country.

The legal and regulatory frameworks also play a part in determining comfort levels of regulators and market participants. The US and UK systems are sophisticated, developed and generally reliable. There have been issues in each country, for instance the recent failures of Lehman and AIG, and the Libor scandal (which brought into sharp focus yet one more gap in the scope of regulation). However, these have at least been openly and critically discussed without restriction. US and UK courts hear and will be hearing cases on these matters without favour or hint of protectionism or nationalism, regardless of the litigant.

Depth of knowledge

US and UK regulators are generally seen as sophisticated, with a wealth of local and international experience from varied backgrounds. This local depth is particularly important as regulation is ultimately applied at the local level.

Supervision needs to be undertaken systematically and using meaningful staff numbers in order properly to oversee complex financial institutions. The UK’s move back towards more judgment-based regulation, with modern legal underpinnings and rights, needs a number of different disciplines and skills. This cannot be undertaken by a handful of people, no matter how talented, and it will be important that this reputation is not lost during current reforms to the UK’s regulatory architecture.

Furthermore, a financial regulatory framework needs to be wrapped in legal process and overseen by sophisticated and independent courts. Oversight must be seen to be impartial and reviewable by independent parties applying legal techniques of reasoning and fact-finding.

Outsourcing increase?

The move towards ringfencing of local markets means that the threat to relocate out of London to the US, or out of the US to London, or from New York or London to Hong Kong, Switzerland, Singapore or elsewhere, is limited in its commercial impact. Some flight of hedge funds in response to regulation and taxes has taken place. Lower-value work is now often undertaken by major outsourcing centres such as India.

Nonetheless, European customer business cannot readily be conducted from the US or Asia. Nor can US business be easily conducted from outside the US. Regulators are increasingly uncomfortable with significant functions being outsourced to countries far removed from the principal place of business, layering on local regimes and the risk of legal and regulatory mismatches. Access to the major markets is practicable only to those within them, or, in the case of Europe, from a legal and regulatory system that is deemed equivalent in a meaningful sense, yet to be determined.

Moreover, there is no equivalent to either the EU or the US elsewhere in the world. Although China and India have huge populations, there is no pan-Asian block to which access can be achieved with a single regulator. Nor is there yet one for South America, although this might eventually be developed. As a result, business in other major centres depends on the goodwill of regulators in allowing crossborder business to take place unhindered, to avoid the deadlock of institutions located in a particular country being able to trade only in that jurisdiction.

Thus, if a country outside the US and the EU imposed barriers to transnational trade because of local systemic risk concerns, those who rely on informal arrangements to access that market could find themselves shut out. It may therefore prove difficult to run a global business from outside the US or the EU. Access to those markets is likely to be difficult to obtain and, if granted, could just as easily be removed.

European modification

The European framework will be modified in the likely event that the European Central Bank (ECB) becomes the direct regulator of eurozone banks. However, in so doing, the ECB will be applying pan-European standards equivalent to those applied in Europe outside the eurozone. The positioning of financial centres is dependent upon many factors, but the sophistication and depth of the main centres are notable. Intellectual leadership and independence at the centre of the system are ultimately critical for businesses, despite concerns about the increase in regulation.

Furthermore, the direction of travel of regulation is against business being permitted to be undertaken merely where this results in the least friction, oversight and tax. Users themselves have, in current conditions, been choosing sophisticated and fair systems over all others. Independent and transparent systems translate ultimately into reduced risk and stronger businesses, whereas the right to object, argue and criticise are not universally upheld or respected. When times are good, these values are somewhat diluted in their importance. For the foreseeable future, they are core.

Barnabas Reynolds is partner and head of the financial institutions advisory and financial regulatory group at Shearman & Sterling

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