Financial markets regulation: political accountability challenged

3.1 High-frequency trading/MiFiDII

When the EU responded to the G-20 2009 agenda on the better regulation of financial markets, HFT was included in the revision of the Markets in Financial Instruments Directive MIFIDI 2004, and MiFiDII adopted in 2014. Technological change had brought about an enormous change as regard the speed and volume of such financial transactions by employing algorithmic trading leading to an increasing number of exchange platforms and alternative trading systems (Bodek and Dolgopolos, 2015; Mattli, 2019a, b).

The legislative aim was to subject market sectors to public oversight which had operated directly between buyers and sellers “in the dark”. These transactions may imply a systemic risk because of the large volume and the speed of orders being placed and removed in the market and the ensuing volatility and uncertainty for market participants (Conac, 2017, p. 472).

The revised MiFIDII legislation including HFT was adopted after an extensive review of the MiFIDI legislation based on a large stakeholder consultation by the EC, an impact assessment and another stakeholder consultation by the European Parliament (EP). After negotiations in the Council of Ministers and several amendments by the EP, the act was adopted in May 2014. In short, political actors, including the EP, played an important role in shaping the HFT regulation contributing to the political salience of the act as one of the most important parts of MiFID II (Karremans and Schoeller, 2020, p. 39).

The objective of the HFT regulation is to increase the transparency of financial markets, a crucial precondition for securing political accountability. It defines the HFT technological infrastructure in terms of system determination, high message intraday rate of orders, quotes and cancellations. HF traders are obliged to apply internal controls according to technical standards defined by the ESMA. They have to pass on information, including their algorithmic strategy, to national authorities and the concerned trading platform and report on executed and deleted orders (Busch, 2018; Gomber and Nassauer, 2014, p. 140; Karremans and Schoeller, 2020, p. 34). These obligations imply high investments for firms for the storing of data, recording trading activities and, if necessary, interfering in them (Karremans and Schoeller, 2020, p. 42).

How well are these new obligations implemented? From the perspective of the governor's dilemma, the intermediators have to apply the technical standards proscribed by ESMA (ESMA/2015/1464; ESMA, 2016/1452). In this step of delegation, the technical standards directly apply in the Member States and contribute to the harmonization of implementation practices (Karremans and Schoeller, 2020, p. 43). Hence regulation through technical standards did not raise the governor's dilemma in that the public intermediator, ESMA, due to superior expertise may not abide by the rules defined by the governor.

By contrast, at the national-level Financial Supervision Authorities (FSAs) allowed for considerable discretion in supervision (Conac, 2017). National authorities with diverging views on how to intervene in financial markets resulted in diverging patterns in supervision. For instance, the UK and Northern member states such as the Netherlands tend to favour financial innovation and loose regulation, while France and Italy pursue a more restrictive approach (Quaglia, 2012). However, two factors tend to reduce these differences: ESMA's forum for national authorities helps obtain a certain convergence of practices and effective market investigation requires trans-border cooperation which reinforces convergence (Karremans and Schoeller, 2020, p. 43ff).

From the perspective of the materiality of technological innovation, the rise of HFT is the obvious consequence of technological innovation based on algorithmic trading. This perspective is closely linked to the rent-seeking theory of the functioning of financial markets regulation because the new technology in principle allows actors to engage in direct transactions without an intermediating actor. In the case of HFT the structural dependency on the intermediating market actors, i.e. investment banks, was reduced and thereby the costs imposed by their institutional rules of accession and participation trading venues (MacKenzie, 2019; Peridis and Héritier, 2021, p. 43). Historically, the Security and Exchange Commission issued new rules prescribing investment banks to allow small firms to access the market and participate in HFT. In return, policing rules for HFT were introduced to prevent predatory and aggressive trading. In short, the introduction of algo-based HFT reduced the rent-seeking and high prices for end-users deriving from the intermediation of private actors (MacKenzie, 2019).

In contrast, the factor market structure makes the working of accountability channels more difficult. Because of the fragmented market structure exchanges and other market service providers see themselves under pressure to offer “… a variety of private incentive programs to firms, such as special order types and privileged data feeds, to attract order flows and volume traders” (Gallagher, 2017; Mattli, 2019a; Seddon and Mattli, 2020, p. 173). The resulting lack of transparency prevents political control.

In short, the case of HFT shows several delegation links. From the political governors EC and EP to the public intermediator ESMA; from ESMA to member state authorities; and from the latter to financial firms. Implementation works well through the direct causal mechanism of technical standards, but less if based on the diverging national administrative practices allowing for more or less political control depending on national administrative stringency. Rent-seeking is possible because of the fragmentation of service markets and the competition between service providers enabled by digital technologies. However, the latter also allows for circumventing private intermediators. What is more, public authorities using RegTech could also reduce rent-seeking by private intermediators and control rule applications in real time.

3.2 Central Counterparty Infrastructure regulation: OTC derivatives trade

The central counterparties regulation (CCPs), a part of the Capital Markets Union (CMU) regulatory reform, plays a crucial role in the trading of Over-the-Counter (OTC) derivatives, financial instruments that derive their value from the value of other assets and are not traded on official trading platforms. CCPs are situated between buyers and sellers of derivatives and engage in “central clearing” to increase the transparency of financial transactions, i.e. the traceability and quality of derivative transactions and to reduce the systemic risk (G20, 2009; Lockwood, 2018). Increasing the safety and efficiency of CCPs in the EU allows for smooth cross-border CCP services, builds up supervisory capacity and seeks to establish a level playing field in the supervision of CCP services (EC, 2017; Smolenska and Héritier, 2021). Now the use of central clearing is mandatory when engaged in the trading of OTC derivatives. In 2020 14 CCPs were authorized in the EU. 80% of interest rate derivatives and 55% of credit defaults are currently cleared by CCPs (BIS cited in Smolenska and Héritier, 2021, p. 71).

EMIR regulates the terms of market access of CCPs, such as the level of capital requirements and the rules of governance (Bulfone and Smolenska, 2020, p. 58f). With supervisory competences delegated to ESMA, these rules led to a certain centralization of substantive requirements and allow for political control. However, supervising implementation remained with national authorities. This resulted in a variegated institutional structure: some member states are tasking national supervisory authorities, others central banks with implementation while ESMA is only controlling the functional equivalence of their supervisory qualities over CCPs (Bulfone and Smolenska, 2020, p. 59).

EMIR legislation was evaluated by the EC in 2015. This accountability check of the performance of the public intermediators, i.e. ESMA and the national authorities, was conducted as a public consultation of the industry. In general, it expressed satisfaction with the EMIR regime; in consequence, the EC only proposed more streamlining of the CCP clearing and reporting obligations. But the EC, supported by the EP, used the opportunity of Brexit and the absence of an important political veto player to take a further step of centralization in 2019. ESMA's power, with the support of the EP, was further strengthened, but the formal intra-EU supervision structure remains decentralized (James and Quaglia, 2019).

Through the theoretical lens of the governor's dilemma, the oversight regime of the CCPs presents a complex centralized, as well as decentralized, even fragmented, picture. The EP and the Council delegated to the EC and ESMA and national authorities, and those two to private CCPs, and the CCPs in turn interact with private contracting parties. The first accountability steps are the legislative budgetary process and the political appointment of ESMA members. Another accountability channel consists of ESMA reporting to the EC, the EP and the Council based on both ex ante and ex post control mechanisms, such as member states' rights to revoke any decision made by ESMA. Further political control can be deployed by national governments and parliaments over the national supervisory authorities and through the network of national FSAs participating in the decisions of ESMA (Smolenska and Héritier, 2021, p. 73). Because of this wide, differentiated, and complex oversight structure, the EC and, in particular, the EP sought to centralize accountability by ESMA. However, despite the EMIR 2.2. reform seeking to tame the accountability jungle in CCPs, fragmentation remained a crucial feature of the entire accountability process (Smolenska and Héritier, 2021, p. 83) characterized as “bespoke accountability channels” (Chiu, 2016; Riles, 2018).

To illustrate the information asymmetry between the governor EP and the intermediator ESMA, during the political supervision of the EP, MEPs did not ask questions as regards technical operational procedures on the occasion of the yearly budgetary discharge of ESMA. Rather, in the EP hearings of candidates for the CCP supervisory committee EP substantive questions focused on general salient political issues of the “greening” of finance and gender (EP, 2020; Smolenska and Héritier, 2021, pp. 93/94). The level of expertise required by technical issues constitutes a barrier to intensive political accountability strategies.

Given the variegated structure of political accountability channels, one would expect rent-seeking on the part of the private intermediators, i.e. CCPs. The hearings held by the EC and EP with stakeholders on their experience with clearing houses offer some information in that respect: It appears that the fragmented control structure favours the arbitrage of financial firms choosing CCPs with less strict rules, e.g. regarding margins, capital requirements, etc. This happens, in particular, in third countries outside the EU in which ESMA only assesses the functional equivalence (Smolenska and Héritier, 2021, p. 90ff). The EC consultation of 2017 found that most financial firms and associations considered EU standards stricter than third-country standards (EMIR review of EC, 2017). The rent-seeking behaviour of CCPs was also mentioned on the occasion of the recovery and resolution regulation of CCPs of 2020. In the case of a possible failure of a CCP strict rules of CCP resolution and insolvency are not applied which results in a bail-out by a Member State instead of a bail-in (EC, 2017). This aspect of rent-seeking is closely linked to the fragmented market structure and the fact that financial firms can choose among a variety of CCPs.

As to the materiality of technology employed in OTC derivatives trading, and the complexity of the technical issues involved in central clearing, the accessibility threshold for political control is high. The above-mentioned absence of substantive detailed technical scrutiny of MEPs shows that intermediators, public and private, with their expertise, and competences can develop a certain power vis-à-vis the political governors and eschew control.

3.3 A private transnational regulator: the International Swaps and Derivatives Association (ISDA)

OTC derivatives deriving their value from other assets were largely unregulated until 2000 (Awrey, 2010, p. 162). The underlying contracts represent the right or obligation to buy or sell certain security, commodity, currency or another financial instrument at some future point in time at a defined settlement rate (Karremans and Héritier, 2020, p. 139; Biggins and Scott, 2012, p. 312). They are not traded on exchanges, but “over-the-counter”, directly between buyers and sellers, hence are not centrally cleared in CCPs (Karremans and Héritier, 2020, p. 139). As bespoke agreements between buyers and sellers, they are considered useful investment and risk strategies, but – not being cleared – are also considered to be riskier at a micro and macro level (Biggins and Scott, 2012, p. 316).

The internationalization of financial markets and the increase in new digital technologies gave OTC derivatives a new importance (Schinasi et al., 2000). “In this transformation, OTC derivatives became increasingly complex instruments involving multiple payment exchanges, with credit exposures being increasingly associated with time-varying derivatives” (Schinasi et al., 2000, pp. 3, 16 cited in Karremans and Hé ritier, 2020, p. 140). In their complexity, they became difficult to understand and predict. Based on new digital technologies, the volume and speed of these instruments increased very quickly (Schinasi et al., 2000) and became the world's biggest, not publicly-regulated market (Helleiner et al., 2018). The reason is, for one, the complexity of the market and that ISDA, the association, became the world's private regulator of this market (Karremans and Héritier, 2020, p. 140).

ISDA as a private self-regulating organization established itself to ensure stability and predictability in the trading of derivatives, especially OTC derivatives in the 1980s. It developed contractual standard practices of derivative trading to reduce transaction costs of trading. The most important one is the Master Agreement which became a global standard, defining contract standards to trade derivatives (Rauterberg and Verstein, 2013). In the course of this development, ISDA became a crucial authority in dealing with public regulators. It was considered to guarantee system stability and reliability in the settling of obligations in derivatives contracts (Karremans and Héritier, 2020, p. 140). Inversely, private self-regulatory actors of financial transactions depend on the enforcement of private law by public authorities and, in the case of a liquidity crisis, on the guarantee of a central public authority (Pistor, 2019).

ISDA started with 11 financial institutions and comprises over 900 today, such as the world's largest banks, financial operators and large corporations. Banks are primary members, service providers with a key role are associate members [2] and end-users are subscribers [3]. Only primary members develop ISDA's self-regulatory policy and decide on which policies to support (Karremans and Héritier, 2020, p. 141; Morgan, 2008, 2009).

In its early phase, ISDA sought to ensure that the legislation of states, particularly in the field of insolvency and bankruptcy, was congruent with the standards of the Master Agreement. It particularly sought to ensure that OTC derivative transactions remained outside the realm of bankruptcy and gambling legislation (Biggins and Scott, 2012), i.e. that the parties to derivative exchanges would be able to net out their balances in the case of bankruptcy of one of the parties without going through the legal procedures associated with national bankruptcy legislation (Morgan, 2008, pp. 647–651; Karremans and Héritier, 2020, pp. 142/143).

Through the governor's dilemma lenses ISDA, the private intermediator and the governor/legislator have a common interest in the stability of the financial system. Legislators trust the expert advice of ISDA, and the intermediator/self-regulator in return depends on legislation to harmonize legislation across different jurisdictions to facilitate transactions and to rely on private law for the enforceability of contracts (Pistor, 2019).

After the financial crisis and the G20 decisions, public regulators stepped up international and European regulation. In shaping EMIR ISDA was an important interlocutor of public authorities, i.e. ESMA, when defining technical standards which OTC derivatives have to comply with. New reporting and clearing obligations were introduced to authorize trade repositories and CCPs (Karremans and Héritier, 2020, p. 145). In this process, ISDA fully cooperated with ESMA and did not oppose these measures (Karremans and Héritier, 2020, p. 145). At the same time, it also sought to secure that certain market sections would be exempt from the new regulations, arguing that some central clearing obligations do not suit certain derivatives and that defining the eligibility criteria required detailed financial technological expertise (Biggins and Scott, 2012, p. 340). It insisted on “… uniform criteria across jurisdictions, but against using uniform criteria in applying the new rules across the whole market …” (Karremans and Héritier, 2000, pp. 147/48).

In short, from the analytical view of the governor's dilemma, ISDA, initially established itself as a private regulator with large expertise advantages compared to the public regulator. After the financial crisis, public actors increasingly issued regulations at the international and European levels to reduce the micro and macro risks of derivatives trading under the roof of ISDA. But the governor quickly faced the classical competence/control conflict. ISDA played an active lobbying role in shaping these public regulations. Through the materiality of the technology lens, this is not surprising given the complexity of OTC derivatives trading. This influence was even more pronounced during the implementation of the public regulations: advocating a myriad of detailed specifications based on ISDA's expert knowledge, the association was able to claw back power to the benefit of its clientele. As a private intermediator, it sought to secure rents for a selected clientele to be exempt from public regulations. The fact that ISDA was able to do so depended also to a large extent on the materiality of the technologies used in derivatives OTC trade with its high speed and highly complex interconnections.

The materiality of the used technologies and the internationalization of financial markets led to a fragmentation of OTC derivatives markets difficult to subject to regulatory control. The standard contract of ISDA, then step-by-step subject to public regulation which was deployed in co-regulation with ISDA. This type of cooperation with the financial industry association implies clear limits to political accountability.

3.4 Fintech

Fintech defined as digitized financial product innovation and new business models challenges regulators because they do not comprehend the new disruptive digitized technologies and the micro and macro risks they imply for users.

This substantive uncertainty as regard the nature and application of new financial products and services induced regulators to cooperate with Fintechs, i.e. individual Fintech firms, and to jointly develop regulatory solutions to the new product or service in a process called “sandboxing”. This type of regulatory reaction led to a fragmentation of the Fintech market, albeit to competitive, regulatory activities that, in a second instance, are now sought to be overcome by steps of harmonization at the European level by MiFIDII (Smolenska et al., 2020, p. 167). Many member states established “facilitator programmes” that engage in public–private interaction and information sharing such as innovation hubs or sandboxes. The UK's FCA has been a pace-setter in this process, introducing an innovation hub and sandboxes. It organized roundtables with Fintech firms in 2014 to support innovations by small and large businesses that can benefit consumers in financial services markets (FCA, 2014, p. 5) (Smolenska et al., 2020, pp. 168/69). They support them when dealing with regulators and also after the authorization of a business (FCA, 2014, pp. 7–9). FCA also clearly states the objective to keep a competitive edge in the European Fintech market (Smolenska et al., 2020, p. 168). At the same time, however, FCA also developed an international network of regulatory sandboxing (“Global Financial Innovation”) with bilateral Fintech bridges (Smolenska et al., 2020, p. 169). Sandboxes offers Fintechs the possibility to jointly with regulators, “… conduct limited tests of their innovations with fewer regulatory constraints, real costumers, less risk of enforcement action, and ongoing guidance with regulators” (Allen, 2019, p. 580, in Smolenska et al., 2020, p. 169). Since then a global race took off for establishing sandboxing as regulatory experiments in Europe, e.g. in France, Switzerland and worldwide. At the same time, cross-border regulatory cooperation in securities regulation – beyond bilateral agreements – in international regulatory networks sponsored by the International Organization of Securities Commissions (IOSCO) is extended (Bromberg, 2017).

In terms of political accountability of its activities the FCA, the pioneer regulatory actor, a non-profit limited company is entirely funded by the firms it regulates. It is officially functionally independent of the UK government but reports annually to the Treasury and bi-annually to Parliament, to evaluate its performance (Smolenska et al., 2020, p. 167).

At the European level, before the national facilitator programmes, since 2013/14, ESMA and EBA have been engaged in monitoring and advising Fintechs, such as in areas of crowd-funding and cryptocurrencies. In 2019, the EC published a Fintech Action Plan “… mapping the private and regulatory landscape establishing guidelines and best practices, and reviewing the impact of related regulatory frameworks such as the General Data Protection Regulation (GDPR) and Digital Single Market strategy in the context of Fintech” (EC, 2018, p. 4).

The latter from the view of political accountability or the governor's dilemma is of interest because as part of a large European legislative programme, it only decides broad guidelines and subsequently hands over the decision on the specific technical details to standardization bodies creating what was called “the hidden underground” of the regulation (Helberger et al., 2021). In these standardization processes, however, political control by national parliaments and the EP only play a marginal role.

Through the lens of the governor's dilemma, Fintech is the very area in which the governor is dependent on the expertise of the new firms and, in consequence, chooses to cooperate with the industry in the development of the appropriate regulations of these new firms. To protect the public interest in their financial trading activities and to prevent rent-seeking by private intermediators public authorities engage in this cooperation. The materiality of the technologies used in trading challenges the understanding and control capacity of regulators including the micro and system risks they involve. What is more, the fragmented and very competitive area of Fintech markets renders political and administrative control difficult.