Regulatory Arbitrage Made Simple (or Simpler)

The Future of American Power
June 25 2012 5:57 AM

Regulatory Arbitrage Made Simple (or Simpler)

sheep in the city
The City of London - looming over us all?

Photo by Dan Kitwood/Getty Images

My globalpost column for this week:

Michael Moran Michael Moran

Michael Moran is an author and geopolitical analyst.

LONDON — Like many closed societies, the financial industry thrives on jargon and obscure acronyms. Back in 2009, TARP and “Too-Big-To-Fail” (TBTF to insiders) became household concepts, mostly because it was households — the American taxpayer — who had to foot the bailout bill.

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Now, thanks to massive $2 billion in losses racked up by JP Morgan’s London-based chief investment branch, another piece of financial sector jargon has taken center stage: regulatory arbitrage.

This sounds devilishly complicated, but stay with me. It’s really quite simple.

Imagine, for instance, that you’re a 66-year-old living in New Jersey and you’re retiring next year on a pension. You find out that New Jersey—in spite of what Gov. Chris Christie may claim—is going classify your pension as income and tax the bejesus out of it.* All of a sudden, the $1500 a month you thought you had coming to you drops to $1100, and those nights at the casino in Atlantic City, along with that new yellow and white Cadillac had your eye on, are out the window.

What do you do? Like many people in NJ over the past two decades, you apply regulatory arbitrage: move to Pennsylvania, where virtually all pensions are tax free. This is not illegal—in fact, it may be a necessity in the case outlined above. After all, what’s a 66-year-old in Jersey without a Cadillac?

But now, imagine you are an investment bank. Based in New York, you trade in billions regularly, much of it in “Over-the-Counter” (OTC) derivatives.

For decades, OTC trades had been handled over the phone, and later via email, with the brokers involved noting the amounts and reporting them to their supervisors at the end of the day. The banks loved this system. Given that the prices were opaque, they were able to make a mint on derivatives trades without their clients knowing the difference. Also, this informal system was light on red tape.

But it came with its own, sometimes massive problems. It let traders hide huge loses (at least for a while), usually involving even bigger bets placed in a desperate effort to recoup and hide the original loss. Such an attempt at multi-billion dollar ass-covering by a single young trader took down Barings, the world’s oldest investment bank, in 1995.

Correction, June 25, 2012: This blog post originally misidentified New Jersey Gov. Chris Christie as Doug Christie.