A Response to Pierre-Hugues Verdier by Stavros Gadinis

[Stavros Gadinis, an Assistant Professor of Law at U.C. Berkeley School of Law, responds to Pierre-Hugues Verdier, Mutual Recognition in International Finance]

Pierre Verdier’s piece, “Mutual Recognition in International Finance,” centers on a fundamental question in this area of the law: how can regulators from one state admit inside their borders institutions and products shaped under another state’s regime, without imposing additional requirements to admission? Lifting regulatory barriers is the primary step towards a truly global financial market, because it removes high transaction costs that constrain capital flows. However, opening the regulatory gateways to foreigners is a matter of heated debate, which typically evokes rational objections as well as deep-rooted fears: do these foreign institutions and products provide to investors similar safeguards to those honed after decades of domestic regulation? Will the sudden influx of – perhaps more cost-effective – foreign providers put the domestic industry in a competitive disadvantage? Could the admission of foreigners ultimately undermine the importance of domestic regulators by providing an official back-door channel into a closely guarded domestic market?

To address this debate, Verdier invites us to examine two cases of mutual recognition that have dominated policy agendas in the last decade: the EU’s unfolding progression towards an “ever closer” financial union, and the more recent US-Australia arrangement for the mutual recognition of broker-dealers and exchanges, spearheaded by the SEC and its Australian counterpart, ASIC. While theorists have long struggled with the concept of mutual recognition, as the article shows, we do not have a strong account of how mutual recognition works in practice. Verdier’s suggestion to compare these two mutual recognition efforts is innovative, because their parallels are by no means obvious: the European effort is long, multifaceted, and part of a larger geopolitical project, whereas the US-Australia effort is a response to specific market needs. Verdier brings to light their common goals, and convincingly argues that we have a lot to learn by contrasting them.

The comparison of these two efforts allows Verdier to ask a key question: does mutual recognition need the full institutional machinery of the EU in order to be effective? Or can it work through a simple arrangement between regulators? In other words, which conditions determine the level of institutional intensity necessary to build a successful mutual recognition regime? This is an important contribution of the article: it conceptualizes mutual recognition as a question of institutional intensity.

Verdier argues that an EU-style institutional design is necessary for mutual recognition schemes that involve multiple states, and states with varying levels of regulatory sophistication. In these cases, institutions address coordination problems and limit states’ individual incentives to defect. Instead, in bilateral settings, where both states possess similar levels of regulatory sophistication, heavy institutional machinery is unnecessary; regulators are happy to rely on each other’s work, and address problems as they arise.  These two dimensions (i.e., number of participating states and variation in regulatory sophistication), combined with sufficient private demand for further market integration, will determine the shape of the mutual recognition arrangements. These two dimensions, in effect, show us that different mutual recognition questions present us with different challenges; to understand them, it is important to disentangle them, as this article does in the two thorough case studies.

To sum up, this article touches upon a central topic in international finance, addresses it in a novel way, offers a new conceptualization of the explanatory variable, and proposes a neat set of dimensions to explain it – that does not leave much to complain about. My comments below will focus on what the findings of the paper suggest for future mutual recognition efforts.

The mutual recognition regime that markets are demanding from policymakers is a US-EU arrangement for stock exchanges and, possibly, broker-dealers. Such a regime would offer many benefits to transatlantic exchanges and multinational investment banks. Verdier’s article helps us identify the question that is tormenting US regulators faced with such a challenge: can they treat the EU as a single jurisdictional area, with uniform characteristics across member-states? Can they trust the institutional integration within the EU to eliminate the differences between member states that were so apparent only a few years ago? Will a US-EU regime resemble a bilateral one, or a multilateral one?

As Verdier explains, the US-Australia arrangement was conceived as somewhat of a test case for the SEC: once they had a better sense of how mutual recognition would work in practice, they could appreciate whether a similar arrangement with a wider set of jurisdictions would be feasible. Now that the Australia experiment has all but stalled, with no actual mutual recognition ever granted, where does this test stand? We could interpret this inactivity as a mere change of priorities that does not speak to the effectiveness of the arrangement. Or, we could interpret it along the lines of Verdier’s second case study: if the only mutual recognition regime with actual success is the one relying on institutions, some institutional solution may be better-suited to address the complexities of a US-EU venture. Such a solution does not necessarily involve a new international body, but it could benefit from a mechanism allowing regulators to cooperate more closely.

The lack of progress on the US-Australia effort becomes more puzzling if one considers the broader similarities between the two jurisdictions. Verdier highlights their mutual commitment in vigorous enforcement, with both scoring high in various quantitative measures. Of course, the two states share more than a regulatory philosophy and sophisticated financial laws. A common language allows US regulators to examine closely the regulatory record of any Australian institution; a shared common law tradition helps US lawyers understand better the particularities of the Australian regime; a broader set of cultural similarities help facilitate contact between US and Australian regulators. It is no coincidence perhaps that the other candidate for bilateral mutual recognition, Canada, shares these traits. Whether a bilateral mutual recognition regime could emerge between the US and states outside the Anglo-American tradition, it remains to be seen.

Mutual recognition efforts will face new challenges in the aftermath of the 2007-8 crisis. The widespread collapses of financial institutions underlined the role of the state as the lender of last resort for the financial sector. When a state considers admitting foreign institutions in the context of mutual recognition, can it rely on their home authorities to support them in case of a collapse? Will these authorities have the resources necessary to bail out their firms, and will they expend such resources to safeguard their firms’ foreign operations, which pose little threat to their electorates? These concerns affect all firms currently operating internationally, but are more pronounced in the mutual recognition context, which facilitates cross-border establishment. The solutions to these concerns will also shape future mutual recognition efforts.