Challenges of Cross-border Financial Services Regulation

Traditional financial services are rapidly moving online. One can instantly transfer money, open bank accounts, and secure loans from the comfort of one’s home. Consumer behaviour has changed: financial transactions are becoming just as routine as buying clothes on the Internet or paying utility bills online. Innovative online platforms have given access to the cross-border exchange of financial services between agents from different jurisdictions. However, identical financial services are subject to different regulations in different countries, which gives rise to the problem of regulatory arbitrage, that is parties to transactions can try to benefit from the differences in regulatory approach. Rogue suppliers of financial services can escape liability by operating in jurisdictions with less stringent regulatory regimes.

The challenge of cross-border regulation of financial services is becoming particularly acute now that the negative effects of the pandemic have caused job losses and higher demand for alternative earning options.

Problem of coordination

Traditional financial services and banking activities are the least exposed to regulatory arbitrage because of their highly standardised nature and the common international rules many countries rely on when setting their regulatory policies. But regulatory arbitrage often occurs when risky financial instruments are provided online because there is no unified approach to their regulation.

As a result of regulatory arbitrage, individual buyers are offered high-risk financial instruments without prior warning that they may lose all the money invested. Cross-border high-risk services include foreign exchange margin transactions, contracts for difference (CFD), or binary options. Suppliers offer these services online, targeting individual buyers who are not always able to assess the risks of margin transactions. Although in many countries leverage is limited, rogue market participants set ratios of, for example, 1:50, giving buyers an amount 50 times higher than their deposits, and in negative scenarios, the buyers may not only lose all the money invested but also end up owing the broker. In some countries (USA, UK), binary options are prohibited, but where they are not, suppliers actively use unscrupulous selling practices and do not disclose all the risks of the product.

For instance, in June 2020, the Financial Conduct Authority (FCA) cancelled the licences of Cyprus-registered firms that used celebrity endorsements to attract clients—this was the first time since Brexit that the UK used its right to cancel the licences of financial firms registered in EU Member States. The firms posted fake celebrity endorsements on their social media pages and websites to drag customers into the CFD scheme. The FCA estimates that British investors lost hundreds of thousands of pounds sterling. CySEC, the Cypriot regulator, has supported the FCA and prohibited these firms from some or all their activities.

Before that, the regulator in Cyprus sent a circular letter to licensed Cypriot investment companies warning them that they were not allowed to operate in Russia without licences issued by the Bank of Russia. According to Russian law, activities carried out on the securities market without a licence are illegal, and if misconduct is detected, the Bank of Russia shall take supervisory measures pursuant to the IOSCO Multilateral Memorandum of Understanding and bilateral agreements with other countries. If an unlicensed foreign entity sells its services to Russian citizens, the Bank of Russia shall request the foreign regulator which has issued a licence to this entity to restrict the entity’s activities in Russia. The key measures include banning the company from opening and servicing accounts for Russian citizens, blocking the company’s website for Russian citizens, and the removal of information in Russian from the entity’s website.

The lack of accessible information about the risks of cross-border financial services, fraudulent schemes, and means to protect one’s interests (countries publish cases of illegal cross-border activities only on their information platforms, and there is no one to compile a unified set of instances) makes it easier for buyers to make the wrong decisions when choosing suppliers or financial products.

Historically, central banks have laid the foundation for global collective action through mutual cooperation, including coordinating their activities in supranational bodies (for instance, the Bank for International Settlements, or the Financial Stability Board). But free flows of capital and the evolution of cross-border financial services are creating new relations that are not regulated by any supranational body.

Seeking a solution

Back in 2013, the International Organization of Securities Commissions (IOSCO) created a special Task Force, which proposed the following cross-border regulatory tools: national treatment, recognition, and passporting. National treatment refers to a regime under which foreign financial intermediaries (non-residents) are treated in the same manner as domestic entities, including in terms of market access. Recognition involves enhanced regulatory cooperation, including reliance on foreign regulators’ oversight, control, and supervision of the entities registered in the country of the delegating body. The passporting regime is based on a common set of rules which are applicable in the jurisdictions covered by the passporting arrangement. However, the key obstacle to the use of these tools has been lengthy procedures and, often, countries’ inability to reach an agreement.

Currently, the European Union has an equivalence regime, which is similar to recognition: the European Commission can recognise that the regulatory system of a non-EU country is equivalent to the corresponding EU rules, providing for mutual access to financial market sectors. The EU's single jurisdiction lays the foundation for mutual trust among countries.

In response to the IOSCO Task Force, financial market participants have established the Cross-Border Regulation Forum (CBRF), whose report argues that the IOSCO regimes are ineffective. Administrative barriers and protectionist policies in different countries lead to market fragmentation and hinder the development of supranational regulation of cross-border activities. For the markets themselves, fragmentation is harmful because it makes domestic markets and the financial system in general less resilient and hinders liquidity flows to the sectors that need them in hard times. Moreover, fragmentation increases investor costs as a result of ineffective resource allocation and limited risk management capacity.

The Financial Stability Board notes that supervisory practices and regulatory policies most often lead to market fragmentation in cross-border OTC derivatives trading, banks’ cross-border management of capital and liquidity, and the sharing of data and other information internationally. The IOSCO identifies the following drivers of fragmentation:

1) differences in jurisdictions’ implementation of financial sector reforms consistent with international standards;

2) differences in the timing of this implementation;

3) lack of international standards and harmonisation in relatively new sectors, such as crypto-assets or sustainable finance;

4) lack of regulation and prohibition of certain tools in some jurisdictions, resulting in the unwillingness of cross-border companies to enter these markets.

To minimise the potential risks of market fragmentation, the IOSCO suggests the fostering of trust between regulators, the conclusion of memoranda of understanding, and the use of cross-border regulatory regimes.

While countries are looking for an optimal solution, alternative forms of cooperation are becoming increasingly important. One of these is mini-lateralism, which involves a small group of countries working together to tackle specific subjects that are complicated to address at the multilateral level. This approach is, for example, at the heart of G7 and G20 economic cooperation, and it is used by similar regional associations (ASEAN, EAEU), including in finance (for example, the BRICS’ New Development Bank). International organisations such as the UN or WTO unite many countries with varying political interests and economic resources, which significantly delays decision-making on ad-hoc issues. Industry-specific and regional agreements (similar to the EAEU) concluded voluntarily can help countries respond to acute challenges, including those related to cross-border financial regulation, in a less costly and more flexible way.