In 1997, Robin Potts QC was asked by ISDA, the International Swaps and Derivatives Association, to review the new market in credit default swaps. Mr Potts drew attention to the famous case of Carlill v. Carbolic Smoke Ball Company  A century earlier a  race-going judge, Sir Henry Hawkins, had defined a wager as  ‘ a contract by which two persons, professing to hold opposite views touching the issue of a future uncertain event, mutually agree that dependent on the determination of that event one shall win from the other’. 

       Insurance  is (in Mr Potts’ less felicitous words) ‘a contract to indemnify the insured in respect of some interest which he has against the perils which he contemplates he will be liable to’.  Mr Potts delivered the answer ISDA hoped and expected:  credit default swaps were neither insurance (in which case they would have been taxed and regulated as insurance policies) nor wagers (in which case they would have been taxed and regulated as bets).         Mr Potts deftly avoided a difficult issue ; if credit default swaps were neither wagers nor insurance contracts, what were they? What was the purpose of the transaction?

  In 1997 there was an answer to this question, although not one on which Mr Potts chose to dwell.  Much of the complexity of modern finance is the result of regulatory arbitrage – avoiding or minimising regulatory restriction by engaging in a transaction with more or less identical commercial effect but more favourable regulatory treatment.

       The initial purpose of the credit default swap was to exploit differential regulation of banks and insurance companies.  Banks were required to hold reserves against loans  calculated as a proportion of the amount of the loan.  Insurance companies were required to hold reserves calculated as a proportion of the expected losses on the policies.  Exxon Mobil was a corporate borrower – and loans to companies carried a high risk weight in computing the reserves of banks.  But Exxon Mobil was an extremely safe credit, so that the expected loss on the loan was negligible.  Hence there was scope for profitable trade between bank and insurance company.

  Even after Mr Potts opinion some doubt remained as to the legality of such transactions by US residents, but this was settled by the Commodity Futures Modernization Act of 2000, promoted by Fed Chairman Alan Greenspan and Treasury secretary Larry Summers, The explosive growth of the markets in credit default swaps which were at the centre of the financial crisis followed. Credit default swaps extended far beyond loans to Exxon Mobil. When  in 2006 Goldman Sachs sold securities linked to sub-prime mortgages which hedge fund manager John Paulson expected to fail, all parties in the transaction were engaged in what Sir Henry Hawkins had described as ‘a wager’.    

   The usual response to regulatory arbitrage is to elaborate the regulation.  Thus begins a game of cat and mouse, in which the financial companies are generally one or more steps ahead of the regulator.  The familiar  outcome is regulation which becomes progressively more complex but less effective in achieving its intended purpose.  

        From the perspective of the non-financial economy, resources devoted to arbitrage are a dispiriting waste.  Some of the cleverest minds in the country are devoted to activities which are actively damaging to the goals of effective regulation and honest and transparent accounting. Arbitrage is  a significant contributor to the trading profits of financial institutions. 

      Regulatory arbitrage is an inevitable outcome of the detailed prescriptive regulation of financial services.  The only means of avoiding it is to ensure that transactions with similar economic effect are always treated in the same way.  This is a generally accepted objective, but not realistically achievable in the context of the complexity of the financial and regulatory system we have today.  

Many regulators still cling to the hope that regulatory arbitrage could be eliminated if only regulatory rules were sufficiently extensive and sufficiently carefully prescribed. But this is an illusion.  One remedy for regulatory arbitrage is to allow regulators more discretion, so that they feel confident in implementing the spirit rather than the letter of the rules.  But this would require a dramatic and permanent shift in both the calibre of regulatory staff and the balance of political influence between regulators and those who engage in regulated activities.  The better response is to find simpler and  more robust principles of regulation.