Regulating capital markets: competition, harmonization and cooperation - a theoretical inquiry.

• Author: Steinwinder, James M.

INTRODUCTION

International financial transactions have increased dramatically over the last twenty years. (1) Cross-border activities among G7 nations, in the bond and equity markets alone, rose from less than 10 percent of gross domestic product in 1980 to over 140% in 1995, according to the International Monetary Fund's (IMF) most recent investment survey. (2) By the end of 1997, portfolio holdings in equity and long-term debt securities reached $5.2 trillion, according to the IMF, and securities firms exceeded $130 trillion. The Bank of International Settlements (BIS) Triennial Survey of Foreign Exchange and Derivative Market Activity (3) revealed $1.9 trillion daily turnover in foreign exchange markets in the year 2004--up 57% from 2001. (4) The survey evidenced a 74% increase to $2.4 trillion daily global turnover in the derivatives market for the same period. (5) Most revealing, however, is that gross market values more than doubled from $3 trillion to $6.4 trillion during the survey period. (6) Developing nations and nations in transition also saw capital flow increases from $57 billion in 1990 to over $286 billion in 1997. (7) By the end of the second quarter of 2005, total external financing (bonds, equities and loans) to these nations exceeded $150 billion.(8) Not surprisingly, however, the BIS survey indicated 50% of all international foreign exchange financial activity occurred in the United Kingdom (31%) and the United States (19%). (9) Market analysts suggest that the staggering increases in global activity were attributable to substantial increases in hedge fund activity, commodity trading advisers and the robust growth of trading by asset managers. (10)

The international investment statistics mentioned above indicate that capital markets and new financial products have developed and expanded exponentially over the past fifteen to twenty years, and such growth is not likely to contract over the long term. Increased financial liberalization means increased competition for all actors on the global stage. Today, national regulators are faced with overseeing complex, speedy international transactions involving many contracts and multiple jurisdictions because of the maze of networks and affiliates through which these transactions pass. Financial products, investment strategies and reporting standards, among other critical factors, differ across jurisdictions. Obvious transparency concerns arise and opportunities for illicit transactions surface in the milieu. Certainly, a national regulator's territorial jurisdiction and ability to unilaterally supervise and regulate such activities is hindered, if not compromised, by these global realities. Should a national regulator implement rules to levy costs on these transactions, thus possibly driving capital to less regulated jurisdictions? If so, could the regulator properly supervise, monitor and enforce penalties against rule breakers? Competitive pressures among national regulators suggest the answer to both of these questions is a resounding NO! Thus, it appears globally mobile capital leads to a globally under-regulated market as national regulators compete for business while protecting domestic entities.

Such competitive downward pressures raise even further questions. Should regulation be aimed at the supply side of rule givers or the demand side of capital suppliers, or both? If the answer to any one of these outcomes is yes, how would the choice of law considerations be determined in order to implement the new paradigm, and who would enforce breaches? Would it be a single public global regulator, not unlike a World Trade Organization (WTO) for capital markets or would it be private enforcement through stock exchanges via contract? If it is a single global regulator, would it reduce risk and transactions costs while increasing certainty through the respect of voluntary transfer of property rights by private contract under the rule of law? Or, would it be a vehicle for dispute settlement via analogues found in civil and common law traditions? If global private sector stock exchanges provide regulatory authority while enhancing economic efficiency considerations and enforcing the rule of law, who monitors the governing global exchange? National regulators are under increasing pressures because of stock exchange mobility brought about by demutualization and the resulting stock exchange mergers, alliances and takeovers. (11)

In the brave new world of not only mobile capital, but also mobile publicly held exchanges, it appears capital market regulation issues begin to more resemble multinational corporate regulatory issues than financial issues. In July 2000, the London Stock Exchange became a quoted company, and listed itself on its exchange and planned on a shareholder vote to merge with the German Deutsche Boerse. (12) Almost immediately, OM Gruppen announced a hostile takeover bid. White knights from around the globe attempted to intervene in what became an American-style corporate raider takeover drama. (13) In the end, OM Gruppen's hostile bid failed. (14) Because stock exchanges are now publicly traded entities, they are functionally multinational corporations that can be bought, sold and reorganized according to the desires of private actors. Thus, private regulation of global markets appears to provide incentives at the very least for uncertainty, for increased risk and for unstable long-term transactions costs--the very factors privatization devotees claim arise from public sector regulation of any industry. (15)

Because the capital market governance alternatives mentioned above appear to provoke a race to the bottom, or to ineffectively regulate global markets that yield unwieldy competitive downward pressures, many scholars from economics, law and financial regulatory institutions have written extensively on the proper regulatory structure for today's globalized capital markets. Most scholars approach the topic from regulatory competition versus regulatory harmonization contexts, while others proffer cooperation among regulators, or some amalgam of the three regulatory approaches. (16) One thing is for certain; any regulatory theory considered for global application must appreciate the diverse, complex and pluralistic world in which we live, as well as the quickness in which international financial transactions are conducted. Additionally, the theory must acknowledge that market systems that exist without sufficient legal foundations for investor protection, insider trading, self-dealing and transparency considerations provide incentives for one-sided deals and eventually evaporate equity capital investment in those markets. (17) Alternatively, insufficient legal protections could transform rational market actors into block holders because of the legal incentives created by systemic externalities arising from an imperfect regulatory structure. (18) Accordingly, any public or private regulatory regime designed for modern globalized capital markets should promote the "law matters" ethos because deep liquid markets with dispersed ownership have historically only developed in jurisdictions where laws provide proper investor and market protections. Incentives matter, law matters and history matters when approaching the question of what a proper regulatory structure for global capital markets should resemble.

The preceding discussion evince facts and real world occurrences within the current regulatory framework and outlines some of the modern dilemmas facing territorially bound, national regulators operating in global capital markets. It is a proper preface to introduce an analysis of the competing scholarly visions for capital market regulation. As such, this paper will analyze the leading current theoretical arguments for competition, harmonization and cooperation as paradigms for global capital market regulation and proffer a hybrid proposal that reflects the theoretical application to the real world regulatory environment.

Theories of regulatory competition, as embodied by issuer choice proponents, regulatory harmonization and regulatory cooperation proposals will be analyzed in order to provide a theoretical framework for global regulation of modern capital markets. Part one will examine arguments regarding the issuer choice form of regulatory competition advanced by leading U.S. scholars Romano, Fox, Choi and Guzman, and Tung. Part two will discuss both harmonization and cooperation theories of regulation. Part three will outline a theoretical structure for global capital market regulation based upon the analysis of parts one and two.

PART ONE

1. ISSUER CHOICE, PORTABLE RECIPROCITY AND REGULATORY PRICE DISCRIMINATION

   1. Issuer Choice

      Romano (19) asserts that the U.S. experience with state corporate charter competition provides, on balance, a proper framework for advancing issuer choice proposals for international securities regulation. (20) Because no international harmonization standards exist for such regulation, issuer choice would provide added competition within the current global framework. Romano would allow each of the fifty U.S. states to compete with the federal government and the federal government to compete with foreign regulators under a statutory securities domicile regime. (21) Underscoring this reasoning, Romano asserts issuer choice would not harm individual investors because institutional investors would select issuer choice regimes that lower the cost of capital while enhancing disclosure standards. (22) Investor's disclosure needs are met by the market mechanism of cost benefit analysis and are reflected by the flow of capital to those regimes providing cost effective disclosure rules. (23) Thus, regulators have market based dynamic incentives provided by rational market actors that reflect optimum disclosure levels, not disclosure levels devised by harmonized regulatory cartels comprised of unelected...