Regulatory Arbitrage

Updated on January 31, 2024
Article byGayatri Ailani
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Regulatory Arbitrage?

Regulatory arbitrage refers to the practice of structuring activities or business functions to gain from the differences in regulations or gaps, specifically from cross-country differences in regulations. 

Regulatory Arbitrage

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This practice helps entities reduce regulatory costs and weakens the rule of law by distorting regulatory competition, altering the distribution of regulatory costs, and encouraging a lack of responsibility. The simplest example of the practice is the phenomenon of banks transferring funds to markets with fewer regulations.

Key Takeaways

  • The regulatory arbitrage definition portrays it as the process of designing operations or corporate functions to profit from regulatory gaps or differences, particularly those resulting from cross-border variances in regulations.
  • This strategy affects the law of the land by distorting regulatory competition, altering the distribution of regulatory costs, and creating a lack of accountability while aiding companies in reducing regulatory expenses.
  • Examples include Facebook’s act of modifying its terms and conditions to mitigate the impact of strict European privacy regulations on the user data it collects. Additionally, Facebook established an Irish subsidiary in 2008 to benefit from Ireland’s attractive economic and taxation policies.

Regulatory Arbitrage Explained

Regulatory arbitrage occurs when businesses and consumers frequently take advantage of differences in laws and policies between jurisdictions to avoid strict local laws, regulations, or restrictions. Its proponents portrayed it as an economically efficient process that eventually reduces costs. However, it can harm businesses and social welfare. For example, it affects the businesses faithfully following the rules and regulations set by the government and distorts regulatory competition.

Regulatory arbitrage from a competition standpoint assumes that regulators in different countries compete for relevant transactions or corporations. They wish to adjust regulatory prices to attract more business or to beat the competition. Stakeholders often avoid stringent domestic regulatory practices if another territory provides a more appealing environment for an identical transaction.

Regulatory arbitrage and financial crisis are closely related concepts. When the government implements stringent regulatory measures in many fields to avoid a financial crisis in the future, private entities find ways to overcome the difficulties due to regulations and restrictions, which in turn increases the risk of another crisis.

Another important element is the internet. Once linked, it is difficult for a country to prevent its residents from connecting with the rest of the globe. As a result, having access to the internet makes regulatory arbitrage possible, allowing people to set up their businesses in various circumstances to benefit from other countries’ regulatory frameworks.

Regulatory arbitrage limits a country’s ability to pursue its policies by making some national regulations challenging to apply. Entities using the internet may send and receive confidential communications independent of local laws; censorship and export limits on information become extremely hard to implement, while authorities can still put certain limitations on use. Moreover, when personal data may be held in offshore data havens, the efficacy of data protection rules modeled weakens.

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Let us look at regulatory arbitrage examples to understand the concept better: 

Example #1

Crypto assets are not fairly exposed to global governance or international standards, and varying jurisdictional oversight can cause regulatory arbitrage. There exist a jurisdictional or regulatory gap between regulators. In other words, they can easily operate outside established regulatory frameworks. Based on architecture, some crypto assets may be debatably excluded from the definition of conventional securities and serve primarily as a medium of exchange or payment.

The market may not then regulate cryptocurrency assets that do not meet the criteria for securities or derivatives. Lack of market transparency, clarity about client asset custody, etc., can result in asymmetries that can cause voids, loopholes, redundancies, and contradictions among numerous countries. This regulatory vacuum would be closed if there was a single organization with broad regulatory authority over digital currency.

Example #2

Fintech regulatory arbitrage and the rise of shadow banks: The fintech shadow banks take advantage of regulatory arbitrage. The banks face an ever-increasing regulatory load, more legal attention and monitoring, and higher capital requirements, which have impacted what products they can offer, etc. As a result, banks leave areas with high regulatory costs, particularly when facing stricter capital limitations. But, this void is filled by shadow banks, mostly freed from regulatory expenses and other constraints.

Example #3

Facebook, the world’s largest online social network, wanted to minimize its exposure to GDPR, which permits European regulators to penalize corporations that acquire or use personal data without users’ consent. So Facebook changed its terms and conditions to lessen the impact of tight European privacy rules on the user data it collects. The EU rule may allow fines of up to 4% of global annual turnover for infringement. Minimizing exposure helps eliminates a significant potential liability for Facebook.

Facebook was under scrutiny from regulators and lawmakers worldwide after the personal information of millions of Facebook users ended up in the hands of consultancy Cambridge Analytica, sparking widespread concern about how the company handles user data. Furthermore, Facebook formed an Irish subsidiary in 2008 to take advantage of the country’s low corporate tax rates.

Frequently Asked Questions (FAQs)

What is the meaning of regulatory arbitrage?

It is the process of selecting or setting activities or business functions to reduce the impact of strict regulations set by the government or authorized regulatory bodies. It is a complex and significant component of regulatory competition because it provides regulatory alternatives for enterprises and helps them to maximize their benefits from such competition.

What is the problem of regulatory arbitrage?

Regulatory arbitrage, or the ability of financial organizations to disregard or nullify restrictions, is a well-known problem affecting financial regulation. The goal for which the rules were created is violated when the rules are avoided by unethical means. So every time an institution attempts to circumvent the laws, the likelihood of another crisis grows.

How to prevent regulatory arbitrage?

It is difficult to avoid completely but can reduce its prevalence by identifying the most obvious loopholes and establishing a set of standards that will help reduce its scope.

This article has been a guide to What is Regulatory Arbitrage and its definition. Here, we explain it with examples. You can also go through our recommended articles on corporate finance –

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