Opponents of a Canadian national securities regulatory body emphasize the virtues of the European-style “passport system” that provincial securities regulators have adopted. However, a close look at the experience in the European Union (EU) suggests that it has not worked as well as might have been expected and that centralizing administrative forces are necessary in resolving the most contentious issues in capital markets.
The EU’s passport system is a response to the failure of the Member States to agree on harmonized securities regulation. While the Treaty of Rome, 1957 called for the establishment of a “common market” across the European Community, the call rang hollow because individual countries did not adopt common regimes to implement the intended free movement of goods, services, capital and labour. This reluctance was aggravated by the absence of political machinery at the EU level to achieve consensus among the Member States in an expeditious way. Despite the Treaty, each country was able to protect its local markets, including those in financial services, from foreign competitors.
The Single European Act, 1986 was the EU’s response to this failure. It committed the Member States to the completion by 1992 of the “internal market” that would include common economic and monetary policies. Most importantly, it established majority-voting in the Council of the European Union, the key decision-making body in the EU.
The first EU legislation to deal with investment services was the 2nd Banking Directive, 1989 that allowed banks to operate across the Community under “home-country” rules (the “passport system”). Since many European banks were universal banks that conducted both banking and securities businesses, the securities activities of those banks benefited from the liberalized regime.
However, independent investment firms were not allowed the passport and were required to follow the regulatory regime in each country in which they operated. Moreover, the passport system did not deal with certain prudential and investor-protection (“conduct of business”) matters. The result was that, once again, significant differences emerged among the Member States.
In 1993, the Investment Services Directive permitted independent investment firms to operate by passport, enabling them to operate throughout the Community directly or by establishing branches. In both cases, the home-country regulator had the primary regulatory responsibilities including enforcement and supervision. In this regime, a U.K. stock brokerage could do business in France subject to U.K. rather than French securities rules. It would do so if U.K. rules were less costly and intrusive than French regime. France might then change its rules to level the playing field for its domestic firms but it was not required to do so.
In this way, the passport system encouraged “regulatory competition” among the EU’s Member States. The goal was voluntary harmonization of regulations that could not be achieved through direct negotiation among the Member States at the EU level.
However innovative the passport system was in concept, achieving its ultimate goal proved illusive. The Investment Services Directive allowed free location by investment firms, but only in respect of those “core” services specifically identified in annexes to the Directive. Moreover, it did not deal comprehensively with crucial conduct-of-business matters and, perhaps not surprisingly, differences in interpreting the Directive emerged among the Member States that allowed local barriers to continue.
The treatment of “regulated markets” under the Directive was notably incomplete. Stock exchanges in the U.K. and Netherlands were quote-driven, “dealer markets” characterized by lack of transparency and fragmented markets. However, French and Italian exchanges were order-driven, “auction markets” in which local regulators required consolidation of order flow to the central exchange. These consolidation rules limited access to alternative trading systems in order to promote transparency.
It became clear that eliminating such differences across the EU required significantly greater political will. In 2000, the EU Council of Economic and Finance Ministers empanelled the Committee of Wise Men on the Regulation of European Securities Markets to make proposals to further develop the internal market while respecting the balance between the Treaty of Rome and the various national regulatory bodies. Under the chairmanship of Alexandre Lamfalussy, the Committee concluded:
“The Committee notes that an almost universal consensual view has emerged that the European Union’s current regulatory framework is too slow, too rigid, complex and ill-adapted to the pace of global financial market change. Moreover, almost everyone agrees that existing rules and regulations are implemented differently and that therefore inconsistencies occur in the treatment of the same type of business, which threatens to violate the prerequisite of the competitive neutrality of supervision.”
The Committee made radical proposals to reform EU decision-making. It proposed a new process including the Committee of European Securities Regulators and the new European Securities Committee. Henceforth, any legislative proposals that required approval of the European Parliament or the Council would be limited to essential principles while the European Commission would be authorized to produce implementing measures.
Judging from the EU’s experience, passport systems are inevitably complex, incomplete and hard to administer. Certainly, they do not resolve the most contentious regulatory issues. A national body with significant input from the regions is likely to serve Canada better than the status quo.
Lawrence P. Schwartz, Ph.D. is an economist specializing in financial-sector policy and regulatory issues. A past Member of Canada’s Competition Tribunal, he authored a paper on performance measurement for the Expert Panel on Securities Regulation.