Legal Fragmentation, Extraterritoriality, and Uncertainty in Global Financial Regulation

‘Fragmentation is in no one’s economic interest. Nor is it necessary for financial stability. Indeed it can damage it.’ 

- Mark Carney, speech given at Mansion House, 20 June 2017. 

A paradox of our time is the contrast between increasingly integrated global financial markets and different national regulations governing them. The tremendous coordination effort through international fora, such as the G20 or the FSB, has not been able to prevent legal fragmentation. There are two main reasons for this: First, the hard and fast rules are still set at the national or European level, leaving the door open to varying implementation based on technical or political considerations. Second, the fragile international consensus can be suddenly and unilaterally terminated, as seen most dramatically in the election of Donald Trump as US president.

One has a natural tendency to attribute divergences between national regulations to the pursuance of egoistic interests (‘America first!’). In a recent contribution published in the Oxford Journal of Legal Studies, I argue, however, that this explanation is too simplistic. Instead, it is important to acknowledge the possibility of legitimate differences of opinion regarding the standards required to secure global financial stability. These differences of opinion stem from the uncertainty regarding the causes of financial crises and the means to prevent them. Also, one must take account of the diverging attitudes of states towards risks and their fear that a straight-jacket solution to financial regulation could choke off their economy. The trade-off between risk and development is made differently depending on each country’s culture and political priorities.

Nevertheless, one cannot discount the fact that governments may act egoistically. The problem, however, is that it is impossible to disentangle one motive from the other. A government trying to improve its competitive position will regularly shroud its policies in the uncertainty about the exact causes of financial instability. Even the proponents of overtly nationalistic policies take care to depict global regulation as being economically unsound and overly restrictive.

Enter extraterritoriality. I argue that is not necessarily bad if regulation exceeds the borders of the Nation-State. Quite to the contrary, in light of the increasing interdependence of markets and the differences of opinion about the necessities of global stability, extraterritorial regulation is a legitimate means for states to protect themselves from what they perceive as genuine threats to their economy.

What seems justified from the viewpoint of an individual state, though, may be harmful from a global perspective. Using game theory, I show that the combination of different regulatory regimes with their extraterritorial application will result in overregulation and segregated markets. Such fragmentation is in nobody’s economic interest, just as described by Mark Carney in the quote above.

There are various suggestions on how to solve this conundrum. The most promising seems to lie in increased regulatory coordination and cooperation. Dialogue is the only way to overcome differences of opinion and create mutual trust in each other’s rules and their enforcement. Yet coordination and cooperation will not lead to a uniform global regime. And even if they would, one should not wish for such a result, given that some ‘policy space’ and experimentation at the national level is useful to avoid herd behaviour and common shocks. Therefore, regulatory differences not only will remain, but also should remain. The question is how one can prevent that these differences degenerate into segregated markets. This goal can only be achieved if states should show deference to foreign regulation. To this end, they have mechanisms in place, such as ‘equivalence’ or ‘substituted compliance’ assessments. However, there is a risk that states abuse these mechanisms as protectionist shields against foreign firms. As a remedy, I suggest creating multinational assessment panels, quite similar to the WTO dispute settlement mechanism.

My conclusion is that we need more global regulatory coordination and cooperation instead of less. For certain, this is not revolutionary. The point, though, is that this finding holds despite the fact that the remedy to financial instability is unknown and subject to legitimate differences of opinion. The lesson learned from game theory is that the damage resulting from legal fragmentation is more harmful to all states than any gains made by adopting idiosyncratic regulatory rules, never mind their political motive.

Matthias Lehmann is a Professor and the Director of the Institute for International Private and Comparative Law at the University of Bonn, Germany.