Regulators struggling to define what activities are covered by hugely detailed new rules governing financial markets might do better by returning to first principles.

In February 2014, the European Securities and Markets Authority announced that it did not know how to identify a derivative.

This is an exaggeration, of course. But not by much. Europe’s top financial markets regulator wrote to the European Commission asking it to urgently “clarify the definitions” of a derivative for the purposes of the key Markets in Financial Instruments Directive (MiFID II) and European Market Infrastructure Regulation (EMIR). The latter regulation, which requires central clearing and reporting of over-the-counter derivative trades, has already entered into force last month.

The problem, it appears, is that individual national regulators in the EU had never agreed a comprehensive definition of derivative contracts. The UK does not regard foreign exchange forwards and physically settled commodity forwards as derivatives, and has been exempting them from EMIR requirements. But other European countries disagree.

Leaving aside the surprising fact that a regulation that took several years to draft had entered into force without a common understanding of how it actually works, there is a more profound problem facing the new world of post-crisis regulation. Whatever definition the European Commission eventually arrives at for a derivative, there is a high probability that banks will find new ways to replicate a trade with the same economics if it reduces their regulatory burden.

Money flows like water and attempting to nail down financial flows with very detailed rules will have little effect. Principles-based regulation received a bad press in the immediate aftermath of the financial crisis as a synonym for weak regulation, but the rules should not be confused with the willingness of supervisors to enforce them. In the ever-changing world of financial markets, large trading banks can be encouraged to monitor and manage risk appropriately by making these banks easier to resolve, and imposing higher capital charges for counterparty risk on any non-cash trades that are not centrally cleared or well collateralised. Squabbling over what constitutes a derivative will simply encourage banks to move risk into some new instrument with a new name, no doubt resulting in an EMIR II or MiFID III regulation somewhere down the line.

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