A. The Single Rulebook

Some five years on from the Autumn 2008 collapse of Lehmans, the regulatory dust from the Global Financial Crisis has settled. Significant regulatory policy debates are still underway internationally, notably with respect to the treatment of shadow banking.Footnote ¹ But the main contours of the crisis-era regulatory landscape are now clear. Internationally, most major economies, including the EU, have implemented the G20 reform agenda, set out initially in the 2008 Washington Declaration,Footnote ² and covering, inter alia: bank capital, liquidity and leverage; hedge funds; rating agencies; and the over-the-counter (OTC) derivatives markets. That major regulatory change would have followed the financial crisis is not, of course, a surprise.Footnote ³ Observation of responses to major financial crises over the years from the 1929 Crash to the ‘dotcom bubble’ era and beyondFootnote ⁴ makes clear that what Professor Coffee has vividly described as the ‘regulatory sine curve’Footnote ⁵ leads to a regulatory boom after financial market bust.

In the EU, G20-based regulatory reform has additionally been accompanied by a relocation of regulatory control over financial markets.Footnote ⁶ Over the first major reform era, the 1998–2005 Financial Services Action Plan (FSAP) period, liberalization-driven regulatory reform in support of cross-border activity had seen the location of financial market regulation shift to the EU from the Member States. The crisis-era, driven by the financial stability agenda and the need to address the pathologies of liberalization as well as the G20 agenda, has witnessed the almost complete ascendancy of the EU. This has been driven by a host of factors, including political commitment to a ‘single rulebook’ and the removal of regulatory divergence; the G20 agenda and the EU's related concern to shape the international rulebook; institutional reform (notably the establishment of the European Supervisory Authorities (ESAs) as part of the new European System of Financial Supervision (ESFS) in 2011 and which are conferred with a range of quasi-rule-making powers); extensive reliance on administrative rule-making by the Commission, including the new process for adopting ‘Binding Technical Standards’ (BTSs) which are proposed by the ESAs (the European Securities and Markets Authority (ESMA) in the securities markets sphere) but adopted by the Commission;Footnote ⁷ strong institutional backing from the Commission and Parliament for an extension of the perimeter of EU regulation; and considerable political and institutional support for the curbing of speculation and of financial market intensity and innovation, driven in part by the toxic transformation of the financial crisis into a sovereign debt crisis as the costs of bank failures threatened sovereigns’ borrowing capacity, and related concerns as to the role of speculators in the sovereign debt markets. The extent to which rule-making power has moved to the EU is well illustrated by the Commission seizing the initiative when the global interest-rate fixing scandal broke over summer 2012 and producing a related proposal for reform.Footnote ⁸

Some five years on, the EU regulatory landscape, previously shaped by liberalization, has changed almost out of all recognition. Two distinct phases to the construction of the new rulebook can be identified. The first wave of reforms was closely related to the G20 agenda and concerned with financial stability and ensuring a secure regulatory perimeter and the effective regulation of previously unregulated sectors; it was also concerned with the distinct risks to the EU market arising from cross-border risk transmission and, as the sovereign debt crisis took hold, the destructive feedback loop between the fiscal implications of banking failure and the resilience of sovereigns. These reforms focused on strengthening EU banking regulation (most notably through the massive 2013 Capital Requirement Directive reforms which have implemented the Basel III reforms to bank capital, liquidity, and leverage regulationFootnote ⁹ and introduced additional, primarily governance-related reforms, and through the ongoing bank recovery and resolution reformsFootnote ¹⁰); and on reinforcing EU securities market regulation which, hitherto, had not engaged closely with stability, being traditionally more associated with disclosure-related regulation and the efficiency and transparency of markets and with pan-EU market access. The latter reforms are exemplified by two perimeter-changing measures which have captured market actors not previously subject to EU regulation. The Alternative Investment Fund Managers Directive 2011Footnote ¹¹ has extended the asset management regime, which was previously liberalization-driven and focused on the retail-market-oriented ‘UCITS’ collective investment scheme and its management, to include almost all non-UCITS fund managers, including private equity, property, and commodity fund managers, although it has become most associated with hedge fund regulation. The 2012 EMIR (European Market Infrastructure Regulation) has brought radical change to the over-the-counter (OTC) derivatives markets, requiring in-scope derivatives to be cleared through Central Clearing Counterparties (CCPs) and, in effect, imposing major infrastructure reform on a previously lightly-regulated segment of the financial markets. The securities market stability agenda also includes the EU's new rating agency regime, composed of Credit Rating Agency (CRA) Regulations I (2009),Footnote ¹² II (2011)Footnote ¹³ and III (2013)Footnote ¹⁴ and the 2013 CRA DirectiveFootnote ¹⁵ (which together have led to a new regulatory regime for rating agencies, their supervision through ESMA, and a series of reforms to the rating of sovereign debt), and the 2012 Short Selling Regulation, which imposes new restrictions on short selling in a range of financial instruments, including sovereign debt.Footnote ¹⁶ This phase can also be associated with the major institutional reforms which have reshaped EU financial system governance: first, the initial 2011 establishment of the ESFS, composed of national competent authorities, the ESAs (conferred with a range of quasi-regulatory and supervisory tasksFootnote ¹⁷) and the European Systemic Risk Board, charged with macro-prudential system oversight;Footnote ¹⁸ and second, the 2013 agreement on the Single Supervisory Mechanism element of the Euro Area Banking Union,Footnote ¹⁹ which provides for the supervision of Euro Area banks through the European Central Bank.Footnote ²⁰

A second wave of reform has followed and has led to the reform programme extending beyond financial stability and embracing reforms which can be more closely associated with market efficiency (and in particular the effectiveness of markets in supporting long-term savings and growthFootnote ²¹), transparency and integrity, and with consumer protection. The cornerstone of investment firm and trading market regulation, for example, the 2004 Markets in Financial Instruments Directive (MiFID I)Footnote ²² is being overhauled by the MiFID II and Markets in Financial Instruments Regulation (MiFIR) reformsFootnote ²³ which have the effect of capturing a much wider range of firms, markets, and trading practices within the regulatory net. The asset management regime, for example, has been further expanded by discrete regimes for venture capital funds, social entrepreneurship funds, and long-term investment funds, designed to enhance the ability of markets to raise capital.Footnote ²⁴ The consumer protection regime is undergoing major reforms which include the adoption of a new, cross-sector measure designed to address the distribution of packaged investment products and their disclosure regulation, and to close gaps in the current regime (the Packaged Retail Investment Products (PRIPs) reformFootnote ²⁵). Long-standing elements of EU securities market regulation, including the capital-raising regime,Footnote ²⁶ the market abuse regimeFootnote ²⁷ and the UCITS investment fund regimeFootnote ²⁸ have all been reformed.

The recast regulatory regime still has a youthful feel and remains somewhat unstable. Most of the ‘second wave’ measures have yet to be formally adoptedFootnote ²⁹ and the momentum implications of Banking Union for securities markets and for Member States not part of the Euro Area are not clear. But much, including an extensive administrative rulebook, is now in place; the review process is already underway, underlining the state of permanent revolution which EU financial market regulation has been in since October 2008. The 2012 Short Selling Regulation, for example, is under review,Footnote ³⁰ and the 2013–14 ESA review is underway. It is therefore possible to make some preliminary if necessarily tentative observations as to the cumulative impact of the reform programme, particularly with respect to the new and wider perimeter of the crisis-era rulebook.

The perimeter of EU financial market regulation has been cast around a vastly greater set of market participants and actors. In the securities market sphere, for example, a wide array of asset managers (under the AIFMD), proprietary traders and dealers (under MiFID II/MiFIR), previously unregulated OTC markets (under MiFID II/MIFIR and EMIR), and rating agencies (CRA I-III), to identify only a few examples, are now within the EU rulebook. Similarly, EU securities market regulation, which traditionally has been concerned, more or less, with the equity trading markets and with the major public trading markets will address a much wider range of asset classes and a host of trading venues. Under the MiFID II/MiFIR reforms most forms of organized trading in bonds and derivatives will come within the EU rulebook, while the combined effect of MiFID II/MiFIR, the Short Selling Regulation, and EMIR is to impose an entirely new and detailed rulebook on derivatives trading in the EU which, for the most part, had largely been a function of market discipline prior to the crisis. Entities which do not participate in the financial markets professionally but which engage in incidental financial activities are being pulled into the regulatory net; EMIR, for example, has led to the imposition of complex and potentially costly rules on non-financial entities which use derivatives as hedging tools for their commercial business. Market-shaping regulation has always been a feature of EU financial market regulation, most notably in relation to the MiFID I order execution reforms which reallocated the benefits of trading across different trading venues, but it has become pronounced. EMIR and MiFID II/MiFIR, for example, re-engineer the organization of the OTC derivative markets by interposing CCP clearing and by requiring that these derivatives trade on regulated trading venues rather than bilaterally. MiFID II/MiFIR is also designed in part to pull more trading on to regulated venues and away from the lightly regulated OTC markets.

Leaving aside the well-worn debate on the relative merits and demerits of harmonization versus competition, and on the risks associated with harmonization on this scale, regulation of this ambition, range, depth and intensity places great pressure on the EU rule-making process. From the very many challenges which arise, two can be highlighted. First, careful calibration of regulation is required given the differential impact which rules of this range and intensity can have on market actors, based on their size, complexity, and business model. The AIFMD, for example, has required careful calibration through administrative rules and ESMA guidance given the wide range of fund managers which come within its scope. Second, unintended consequences, which can include a reduction in market efficiency where regulatory costs prejudice risk management and thereby liquidity, can be significant: the Short Selling Regulation's prohibition of certain short sales in relation to sovereign debt, for example, was untested and imposed with very little empirical evidence; the proposed new MiFID II/MiFIR regime for regulating bond and derivative trading venues similarly has a thin empirical base; and there is considerable uncertainty as to the cumulative impact of the reform programme generally on the availability of the high-quality collateral (or assets) now required to secure a range of different transactions.Footnote ³¹

The vulnerability of the institutionally fragmented and highly politicized EU law-making processes to producing sub-optimum financial system rules has been extensively documented.Footnote ³² It remains to be seen whether the new rulebook will have prejudicial effects, although some indications augur well.Footnote ³³ But it seems clear that the success of the regime is likely to depend on its ability to correct and calibrate. The extensive review clausesFootnote ³⁴ to which all the crisis-era measures are subject (and which were initially used over the FSAP period) provided a means for releasing political tensions during the negotiating process. But they also hold the promise of useful ex-post review. ESMA has significantly enhanced the EU's technical capacity in the securities markets sphere at the administrative rule-making level and has demonstrated its ability to corral complex market data, engage with market stakeholders, liaise with international standard-setters, and to adopt complex rules.Footnote ³⁵ ESMA has also opened a safety value in that it has shown itself capable of providing temporary mitigations where confusion and the risk of prejudice to market efficiency arise.Footnote ³⁶ But correction at the legislative level is likely to remain necessary given the scale of the crisis-era rulebook. Whether or not the law-making process can cope with large-scale refinements and recalibrations remains to be seen. The MiFID I Review, which has led to MiFID II and MiFIR, grappled with the difficulties which MiFID I generated with respect to competition in the trading market sphere, but resolution of these difficulties has proved a politically-charged process and led to old political battles being reopened;Footnote ³⁷ on the other hand, the review has led to a significantly more nuanced approach to trading venue regulation.

The extended perimeter also applies to the international market. By contrast with the FSAP-era, the crisis-era reforms have seen the EU export its regulatory model globally. Access to the EU market has increasingly become conditional on compliance with equivalence criteria which are often broadly designed to apply the EU rulebook. The rating agency regime, for example, requires that rating agencies are either established in the EU and registered and supervised by ESMA or that equivalence criteria are met with respect to ratings used in the EU produced by a non-EU rating agency. The AIFMD's highly contested and complex third-country access provisions similarly make market access conditional on equivalence criteria. EMIR makes market access by third country CCPs and the trade repositories which hold OTC derivative market data subject to ESMA registration and compliance with an equivalence assessment. Equivalence assessments are typically linked to regulatory and supervisory assessments and so represent a potentially intensive assessment of third country regimes. Access aside, the extraterritorial impact of EU regulation is strengthening. EMIR's requirements, for example, apply even where both counterparties to the OTC derivative transaction are established outside the EU. The Short Selling Regulation similarly applies to non-EU parties, as long as the financial instrument comes within the scope of the Regulation. Although mitigants apply in each case, in principle the two regimes have significant extraterritorial impact.

The extended international perimeter of the EU rulebook may strengthen the EU's capacity as an international actor and enhance its ability to achieve access by EU actors to third country markets and obtain concessions on the application of third country rules. But it may also create a new location for conflict between the EU and its Member States as to control over the rulebook. Equivalence assessments are increasingly becoming centralized. In the case of the CRA, AIFMD and EMIR regimes, for example, the equivalence assessment is made by the Commission on ESMA's advice. Member States have proved reluctant to lose control over market access in more long-standing areas of market regulation; while the MiFID II/MiFIR regime is likely to lead to greater harmonization of the conditions under which third country firms may establish branches in the EU, the access/equivalence decision is likely to remain with the Member States.

Finally, the extended perimeter may have destabilizing effects on the single/internal financial market which has, from the outset, been the driver for the regulatory programme and remains pivotal, and on which the EU's competence to regulate in this field is dependent. The wider the regulatory perimeter, the greater the risk that EU rules have asymmetric impact across the Member States, given the tendency for financial market segments to concentrate in particular markets. This is particularly the case where EU rules address the wholesale markets, which are largely concentrated in particular Member States, most notably the UK. The construction of the internal market in financial services has long been attended by competing national interests and tensions as to the nature of financial market regulation, which, drawing on the influential Varieties of Capitalism analysis,Footnote ³⁸ can be associated with the contrasting Liberal Market Economies, typically associated with market-based financing and a more facilitative regulatory model, and Co-ordinated Market Economies, typically associated with bank-based financing and more intrusive regulation, which obtain in the EU.Footnote ³⁹ Prior to the financial crisis, these tensions were, broadly, contained; the regulatory programme was generally facilitative and regulatory costs could be offset by market access benefits. But the crisis-era programme is significantly more regulatory in orientation and has a very wide reach, deep into the wholesale markets in particular, and can more easily be associated with prejudicial regulatory costs and with the differential imposition of regulatory burdens. The uniformity of the rulebook may accordingly come under threat, reviving the costs which the internal market is designed to eliminate. The rule-making process may also come under threat where Member States perceive that internal market rules have a discriminatory impact.

The highly contested Financial Transaction Tax (FTT) Proposal provides a useful example. The cacophony of protest which the Commission's 2011 FTT Proposal,Footnote ⁴⁰ widely regarded as an anti-speculation measure, prompted in some markets, and the prospect of a veto from a number of Member States, including the UK, led to its being recast in 2013 as a measure for a smaller group of Member States under the Enhanced Co-operation mechanism.Footnote ⁴¹ But the spillover effects of the FTT outside the ‘FTT-zone’ and on the internal market more generally are considerable and have led to the UK challenging the FTT proposal before the European Court of Justice.Footnote ⁴² Internal market tensions can also be identified in the reforms to the regulation of trading markets under MiFID II/MiFIR; the UK successfully negotiated a recital statement that no action taken by a national competent authority or ESMA in the performance of their duties should directly or indirectly discriminate against any Member State or group of Member States as a venue for the provision of investment services and activities in any currency. Similarly, the UK's 2012 challenge to ESMA's powers to impose directly controls on short selling in national markets,Footnote ⁴³ while based on the limits imposed on agency powers, can also be associated with a concern to shield the UK from perceived over- and costly supervision, and with the likely differential impact of such powers on the UK market, given the scale of its wholesale market. But it is the construction of a new, centralized governance model for the Euro Area financial system under Banking Union which may ultimately pose the greatest threat to the internal market; the likelihood of the ‘Euro Area 17’ acting as a block when it comes to rule-making for the ‘internal market 28’ is real and poses a potentially existential challenge to internal market harmonization. The risks are all the greater as the momentum dynamics which strongly characterize institutional reform in the EU caution against predictions that Banking Union will remain contained within the banking sector, despite its distinct fiscal and political drivers.

B. Supervision and Enforcement: A New Governance Model?

One of the more striking features of the crisis-era reform programme internationally has been the extent to which it has engaged with the achievement of outcomes.Footnote ⁴⁴ This can be observed in the host of institutional design innovations to the structure of regulators—domestically, regionally, and internationally.Footnote ⁴⁵ It can also traced in the much closer focus on the operational supervisory process through which the outcomes which rules seek are pursued through a range of different strategies: risk- and judgment-based supervision, in particular, has acquired a particular prominence.Footnote ⁴⁶ In the EU, this new concern with the achievement of outcomes can also be observed; but, as with the crisis-era rulebook, it can also be associated with a shift in the location of control.

Banking Union will lead to a transfer of supervisory competence to the Single Supervisory Mechanism in the Euro Area. But, for the present, in the securities markets national competent authorities remain the primary supervisors, and national supervision is a key element of the ESFS (composed of the national authorities, ESMA and the ESRB). The supervisory powers required of national authorities have not previously been subject to detailed harmonization. But the crisis-era reform programme has led to the adoption of sector-specific harmonized powers with respect to, for example, product intervention and prohibition (likely under MiFID II/MiFIR), the imposition of position limits on derivatives trading (likely under MiFID II/MiFIR), the introduction of fund management leverage limits (the AIFMD), and the prohibition of short selling (Short Selling Regulation). Sanctions, previously the preserve of the Member States and typically subject only to the requirement that they be adequate and sufficiently dissuasive, are being subject to harmonization; the type of sanctions which Member States must have available, including pecuniary sanctions, are being prescribed as is the process through which sanctions are imposed;Footnote ⁴⁷ a requirement for criminal sanctions has also made its first appearance, under the market abuse reforms. New whistle-blowing requirements are also being adopted. The new focus on outcomes can also be seen in the emerging, if still tentative, concern to deploy private enforcement mechanisms; previously EU-mandated enforcement requirements have been almost entirely directed towards public supervision, reflecting the very significant sensitivities and complexities associated with any harmonization of private enforcement through national courts. The 2013 CRA Regulation III, however, has introduced a harmonized civil liability regime in respect of rating agency ratings. While it is sui generis for a range of reasons,Footnote ⁴⁸ it remains an important departure for EU financial system governance.

These rulebook reforms are intensifying the EU's ability to shape national supervisory and enforcement strategies. But the more radical shift in the location of supervisory power is being driven by the ESAs. In the securities markets sphere, ESMA wields a host of powers under the ESMA RegulationFootnote ⁴⁹ which are designed to drive stronger convergence in the application of supervisory powers and best practices by national authorities, and which include peer review and guideline-setting powers. ESMA's coercive capacity with respect to the promotion of convergence is considerable; ESMA guidelines, for example, are subject to a ‘comply or explain’ mechanism which requires that competent authorities explain their non-compliance (ESMA Regulation, Article 16). ESMA's exclusive and direct supervisory powers over rating agencies (CRA Regulation I-III) and trade repositories (EMIR) can be expected to strengthen its ability to shape national supervisory practices more generally as it builds its own supervisory capacity. As has been extensively examined,Footnote ⁵⁰ ESMA also wields a number of direct supervisory powers which allow it to direct national competent authorities and national market participants in cases of breach of EU law (ESMA Regulation Article 17), emergency situations (Article 18) and where it undertakes binding mediation between competent authorities (Article 19); ESMA can also take direct action with respect to short selling (Short Selling Regulation) and will most likely be conferred with direct product intervention powers (MiFID II/MiFIR). The generally strict conditionality attached to these powers, their constitutional instability given the restrictions on transferring discretionary powers to agencies, and their political sensitivity makes it unlikely that they will be regularly wielded (they have not been used to date). But they have injected a hierarchical dynamic into the relationship between ESMA and its constituent national competent authorities and serve to strengthen further ESMA's capacity to influence local supervisory decision-making.

The supervision of securities markets is likely to be most efficiently located at national level, absent compelling reasons. The fiscal risks and related sovereign debt feedback loop associated with the banking collapse, and which have driven Banking Union, are much less apparent in the securities market field, although certain securities market infrastructures, chief among them CCPs, have the capacity to generate massive systemic risk and fiscal costs.Footnote ⁵¹ The momentum effects of Banking Union should not be underestimated given the dynamism of institutional evolution in EU financial system governance. But assuming those momentum effects are, for the short term at least, relatively weak, the transfer of direct supervisory powers to ESMA is likely to be slow and incremental. Although ESMA may seem to have rapidly acquired supervisory powers, and the European Parliament has emerged as the standard-bearer for allocating more extensive powers to ESMA, these powers have been limited to emergency powers of varying hue which are subject to strict conditionality and to the supervision of discrete market actors which do not pose fiscal risks and which operate on a pan-EU basis. Further transfers will depend on the extent to which the Meroni rulingFootnote ⁵² constraint, which prohibits the delegation of discretionary powers to agencies, can be met, and on the identification of powers which will not lead to the imposition of fiscal responsibility on Member States following an ESMA decision (the political sensitivities associated with the allocation of fiscal responsibility are evident in the ESMA Regulation Article 38 mechanism which allows a Member State to challenge an ESMA decision which it claims generates fiscal risks for the Member State). The upcoming ruling from the European Court on the Treaty validity of ESMA's direct powers to prohibit short selling in any market under the Short Selling Regulation should bring greater certainty to the extent to which supervisory powers can be transferred to ESMA.Footnote ⁵³ But the fiscal constraint remains real and is well reflected in the location of supervision over CCPs at national level under EMIR, albeit that supervision is coordinated through colleges of supervisors given the potential CCPs have for massive and destabilizing cross-border systemic risk.

The range of channels through which ESMA can influence national supervisory decisions remains, however, significant. It may accordingly be that it is in this more humdrum sphere that changes in the location of supervisory control are most likely to occur over time and where ESMA's influence may be felt most strongly.

The global financial crisis has reordered the location of regulatory and supervisory control over EU financial markets in favour of the EU. The implications of this reordering for financial market efficiency and stability are still unknown. But it is relatively clear that significant new lines of tensions between the EU and its Member States have been exposed, including with respect to the international market, the integrity of the internal market, and the location of direct supervisory powers. As the crisis-era recedes, whether these tensions increase and how they are managed is likely to have a material impact on the post-crisis development of EU financial market regulation.