Europe and the United States are locked in competition to see who can pass the strictest new financial regulations first. Each believes that if it is first, the other will have to harmonize their rules behind it. Both could be wrong about that, but it looks like Europe will win the blue ribbon for first place in the regulation race.
Angela Merkel and Nicolas Sarkozy are throwing their weight behind the European Commission's hedge fund regulation known as the Alternative Investment Fund Managers directive. The AIFM is causing consternation from the US and other non-resident hedge funds which, if it passes, may not be allowed to do business in Europe. Many EU leaders actually believe that hedge funds are the reason their countries have become destabilized. And it looks like AIFM will pass on Tuesday, leaving US hedge funds to swing in the wind.
Meanwhile, the US Senate is debating the finer points of (read: pretending to understand) Chris Dodd's financial regulation bill. It rejected Ben Bernanke's and Wall Street's pleas to loosen derivatives trading rules, including keeping in there Sen. Blanche Lincoln's proposal to hive off swaps and derivatives from banks altogether.
And Paul Volcker is running around Europe touting the virtues of his prop trading rule, which he is absolutely convinced will pass. (I agree that the odds for the Volcker Rule passing are pretty good. The Volcker Rule makes its presence known in almost every discussion on how to regulate the TBTF banks. His reasoning is solid, saying that when commercial banks venture into capital markets functions their risks grow too high.)
So we have a regulatory first-mover stand-off, but the focus of these regulations makes me wonder if they are missing something. None of the immediately visible rules - regulating hedge funds, separating derivatives or prop trading from banking, clearing derivatives, smacking down credit ratings agencies - will do the first thing to prevent another market structure bump like the one on May 6th.
The US market has become so terribly fragmented that no one seems to know who is doing what and where, and under which rules. Regulators are running around like lunatics trying to figure out what happened on May 6th, while exchanges are tearing up their databases trying to see who did what and when. What is lacking is market-wide oversight, monitoring and - most importantly - transparency. I hope that some of the new rules and regulations we are about to have will help to pave the way toward this. The good news is that US exchanges, ECNs and regulators are experienced at cooperation.
These are still untested waters in Europe, which can barely deal with common currency issues. Fragmentation in European exchanges, ECNs, clearing houses, and regulators is becoming a major concern. I fear a flash crash in European markets is the next shoe to drop, and it will be faster and more severe than anything we have seen in the US to date.