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The International Lawyer

The International Lawyer, Volume 56, Number 2, 2023

Multilateralizing Deference - A Proposal for Reforming Global Financial Law

Matthias Lehmann and Jonas Schuerger


  • Deference is more important today than ever before. With increasing extraterritoriality of state regulation and supervision, deference is required to maintain the integration of worldwide financial markets.
  • The break-up of formerly integrated trade zones, such as the European single market due to Brexit, also calls for more flexible solutions that avoid ultimately unravelling relations.
  • In addition, deference offers emerging markets a unique opportunity to participate in the international financial system.
  • It helps overcome regulatory barriers, thereby creating a level playing field and promoting a competitive environment.
Multilateralizing Deference - A Proposal for Reforming Global Financial Law
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I. Introduction

Deference is more important today than ever before. With increasing extraterritoriality of state regulation and supervision, deference is required to maintain the integration of worldwide financial markets. The break-up of formerly integrated trade zones, such as the European single market due to Brexit, also calls for more flexible solutions that avoid ultimately unravelling relations. In addition, deference offers emerging markets a unique opportunity to participate in the international financial system. It helps overcome regulatory barriers, thereby creating a level playing field and promoting a competitive environment. These traits are most urgently needed in times of evolving trade wars and growing protectionist tendencies. Therefore, if deference did not already exist, it would have to be invented.

But the current design of deference is far from ideal. While embedded in the laws of many states, an expanded recognition of foreign legal regulatory and supervisory frameworks has not been sufficiently achieved in practice. Deference provisions are widely in force across all major jurisdictions, but they have not been used frequently enough to adequately open up markets. The potential of deference mechanisms has not yet been fully exploited, so market fragmentation and the associated problems remain major challenges. This paper will address the reasons for which deference cannot reach its potential in practice and suggest possible global solutions to this problem.

Part II of this paper discusses deference, its individual manifestations in jurisdictions worldwide, and its advantages. In Part III, the deference’s current design and its shortcomings will be criticized. Part IV sets out why these shortcomings are not coincidental but directly caused by various factors. Part V proposes the multilateralization of deference with the aim of improving upon the concept without diminishing its advantages. Part VI offers final conclusions.

II. Deference and Its Advantages at a Glance

A. Terminology and Importance

Deference has become a fundamental pillar of international financial market regulation over the last decade. Hardly any other concept has been so widely implemented on a global scale. At the 2013 St. Petersburg Summit, the G20 leaders agreed that “jurisdictions and regulators should be able to defer to each other when it is justified by the quality of their respective regulatory and enforcement regimes, based on similar outcomes, in a non-discriminatory way, paying due respect to home country regulation regimes.” Many states followed this call, implementing or expanding deference instruments in their national legal systems. In spite of the broadness of deference, state solutions are quite different in their terminology, conditions, and effects.

Nonetheless, all national solutions that will be presented in this paper—be it equivalence, appropriateness, or substituted compliance—can be classified as deference and subsumed under this generic term because they share a core objective and approach. They seek to promote international trade and minimize market fragmentation, while ensuring a stable financial market that contains the emergence of systemic risks. This is achieved by states foregoing the application of their own regulatory law extraterritorially and withdrawing their own supervisory competences in reliance on the regulatory and supervisory work of other states. The nature of this reliance, however, is not blind trust. Rather, trust (and therefore deference) closely depends on a qualitative analysis of the foreign legal and supervisory system. Only if these meet certain requirements will states be willing to refrain from applying their law extraterritorially. Deference can thus be defined as a state recognizing the regulatory and supervisory framework of another state as being broadly in line with its own and consequently refraining from imposing its domestic rules on financial service providers or products established in that other state.

B. Varieties and Scope

With only a few exceptions, deference is well known and exists in all major jurisdictions. The areas of the financial markets covered by deference, however, vary considerably between jurisdictions. In some states, such as Saudi Arabia, deference provisions are not very detailed. They exist only in the form of general authorizations for supervisory authorities to defer to foreign regulation or supervision.

The European Union (EU) is one of the jurisdictions where deference is most prevalent and subject to elaborate legal provisions. At the beginning of this millennium, the EU introduced the concept of equivalence, a type of deference. Equivalence is based on a decision by which the European Commission determines whether the legal and supervisory system of the third country achieves an equivalent regulatory outcome to those of the EU. Equivalence provisions were first implemented in relation to the supervision of financial conglomerates, the recognition of third-country prospectuses, and in the area of accounting and auditing standards. Following the 2007-2008 global financial crisis, equivalence made a breakthrough. It is now embedded in around forty provisions of EU law and covers a wide range of areas, including derivative transactions, central counterparties (CCPs), credit rating agencies, investment firms, statutory auditors, and benchmarks. Nonetheless, there are still some areas (like market access for credit institutions, direct insurances, or investment services to retail clients) that are not covered by equivalence provisions.

Switzerland has seen deference mechanisms become similarly widespread. Like in the EU, they often manifest as equivalence provisions but can sometimes appear as “appropriateness” regimes. Appropriateness regimes are more liberal than equivalence, as they involve a less detailed comparison with domestic law. With respect to services to retail clients, Switzerland is also more liberal than the EU and has introduced deference mechanisms in this area as well.

Another jurisdiction where deference (again in the form of equivalence) is well advanced is Australia. Australia uses the instrument of deference extensively in derivatives regulation. The Australian Securities and Investments Commission (ASIC) may adopt deference decisions in relation to trade repositories, CCPs, exchange and electronic platforms, and financial service providers.

In the United States, on the other hand, deference failed to gain widespread acceptance in practice. Deference in the United States is largely based on a proposal put forward in 2007 by two Securities and Exchange Commission (SEC) officials, Ethiopis Tafara and Robert J. Peterson, who argued that foreign entities should be able to substitute compliance with U.S. laws for compliance with the laws of their home country. Hence, deference manifests as “substituted compliance.” Such deference requires that the rules of the foreign state are comparable to the corresponding U.S. rules. But the implementation of substituted compliance stalled immediately after the proposal due to the global financial crisis. Only in recent years have the SEC and the Commodity Futures Trading Commission (CFTC) promoted the principle. Nonetheless, it is essentially limited to the derivatives sector, and the concept has neither been as widely disseminated nor gained the same importance as it has in the EU and Switzerland.

C. Prerequisites and Procedure for Granting Deference

The requirements imposed by states in deference regimes are not homogeneous. But at the center of all deference regimes is a comparability assessment. The state compares the foreign regulatory and supervisory system to its domestic one and tries to identify and weigh similarities and differences. This qualitative analysis of foreign law is a defining feature of deference. Therefore, the yardstick and criteria used in this assessment are particularly important.

Many jurisdictions—including the EU, Switzerland, and Australia—require the foreign legal system to be “equivalent” to the domestic one. The term “equivalence” is partly specified as “sufficiently,” “substantially,” or “in effect” equivalent and, therefore, has slightly different meanings, depending on the particular context. Equivalence is determined primarily by the regulatory outcome a legal regime produces as a whole, not by a line-by-line analysis of abstract rules. Thus, it is not that identical rules are required but that a sufficiently similar outcome is achieved, considered from a holistic perspective. In their analyses, almost all states refer to international standards, albeit to varying degrees. Switzerland, for instance, puts international standards at the center of its examination.

There are also other benchmarks for the comparability assessment. The Swiss legal system, for example, contains provisions that require an “appropriate,” rather than an equivalent, foreign regulation. “Appropriateness” is less self-centered and more liberal than “equivalence” because it not only focuses on domestic regulation but also considers other foreign legal systems, as well as applicable international standards. In the latest revision of the European Market Infrastructure Regulation (EMIR), the EU introduced the standard of “comparable compliance” alongside that of equivalence. In the United States, the term “equivalence” is not used at all, but instead a sufficient degree of comparability is demanded as a prerequisite for a substituted compliance decision. Both the SEC and the CFTC agree that comparability does not require identical rules. What matters is not the wording of the provisions but the regulatory outcome to which they lead. This understanding is broadly in line with that of the term “equivalence” in the EU, Switzerland, and Australia. In this paper, the term “comparability assessment” is used as a generic term for all equivalence, appropriateness, and substituted compliance evaluations.

In addition to the comparability assessment, many states impose further requirements before they are willing to defer to foreign regulation. Regarding this, the EU is particularly strict, frequently demanding the existence of cooperation agreements between the supervisory authorities involved, reciprocal treatment of European service providers in the third country, and compliance with its regulatory framework to relevant international standards. In more recent EU equivalence provisions, special attention is also paid to the systemic importance of foreign firms. Other jurisdictions, like the United States, are generally less strict and often have fewer requirements or otherwise place special emphasis on particular requirements. For example, Australia focuses on the existence of cooperation agreements, while Switzerland is more concerned with compliance with international standards.

Additionally, the procedure under which deference is granted varies from one state to another. In most jurisdictions, the comparability assessment is triggered by request from a foreign state. An exception is the EU, where the European Commission usually decides independently whether to initiate an equivalence assessment. In many states, there are no fixed deadlines for the comparability assessment, and the procedure is generally regulated in rather little detail. The authorities enjoy great freedom in this regard and have considerable discretion in making their decisions.

D. Legal Consequences of Deference

The extent to which states are willing to defer to foreign legal orders varies tremendously, even within the same jurisdiction. Most restrictive are regimes that waive only compliance with single requirements but still require financial players to be licensed by the host state and, subsequently, subject them to supervision by the host state’s authorities. Most liberal are mechanisms granting full market access, waiving both the requirement to obtain a license and supervision in the host state. In practice, neither type of regime often occurs in pure form but only with various nuances. Elements of both can, therefore, in principle, be found in all legal systems.

E. Advantages of Deference

Deference is a solution to many of the problems that plague today’s regulation and supervision of financial markets. Above all, deference is a tool for overcoming market fragmentation. By recognizing the legal and supervisory framework of another country, a state opens up its market to providers from this other country, who are permitted to offer their services to residents of the host country.

In economic terms, deference helps level the international playing field by boosting competition and broadening investor choice. Furthermore, it increases funding opportunities for foreign firms, especially from emerging markets. It also contributes to financial stability via more diversified investment portfolios. At the same time, opportunities for regulatory arbitrage are slashed because firms are not permitted to circumvent the laws of the host countries in which they offer their services. In this way, host countries avoid externalities that may otherwise emanate from the service-exporting countries. While the continuous monitoring of the foreign system forestalls a regulatory and supervisory race to the bottom, deference can incentivize states to bring their regulatory systems up to the highest international standards in order to gain extensive market access for domestic financial service providers, which might then trigger a race to the top.

There are many ways to access foreign markets without deference, but the advantage of deference mechanisms is that they free the service provider from overlapping regulation and supervision. This is especially important in light of the increasingly frequent extraterritorial application of law by states. In particular, following the global financial crisis of 2008, states imposed even more requirements on foreign financial firms that seek market entrance. This has created a web of overlapping duties, which multijurisdictional service providers need to fulfill. Deference drastically reduces this overlap. Where the service provider’s home country’s legal framework is sufficiently comparable to permit substituted compliance or equivalency with the host country, it may enter the latter’s financial market on the former’s terms.

Furthermore, deference not only reduces the cost of market entry for the individual firm but also lightens the overall burden of supervision by permitting an efficient division of labor between the home and the host country. This allows each to focus on certain firms without having to cover all of them. Taxpayer expenses are diminished, resources are freed, and supervisory attention is concentrated. This, in turn, will improve the efficiency and quality of supervision.

Deference also promotes international cooperation. Virtually all deference decisions are preconditioned on the existence of a cooperation agreement between the home and host country. One of the main reasons for the proliferation of such agreements within the last few years is the interest of home states in assisting their financial industry in gaining access to foreign markets. Moreover, deference is not achieved by the mere conclusion of agreements but requires effective cooperation and continuous monitoring. This helps make cooperation real and not only theoretical.

Deference also subtly fosters international standardization. An exporting state whose regulatory and supervisory legal order failed the assessment of another state is strongly incentivized to improve its laws to match the foreign standard. Importing states, on the other hand, learn about other types of financial regulation and supervision through the continuous checking of the comparability and compliance of foreign systems. Importing states may utilize this knowledge to revamp their own system. Through this continuous alternation between controlling and being controlled, a delicate balance is established that relies on certain common standards, such as in the area of anti-money laundering (AML), countering the finance of terrorism (CFT), or tax evasion. Consequently, the importance of these standards will increase.

III. Shortcomings of the Current Setup of Deference Mechanisms

A. Unilateral Perspective

One of the biggest drawbacks of the current system of deference is that it is underpinned by a one-sided view of the state adopting it. Deference is promoted at the international level, but it is implemented at the national level, with the main decisions taken by national authorities. National authorities see deference from their own domestic perspective, which decisively weakens the concept and renders it unsuitable for international financial market regulation.

A comparability assessment in which the domestic law is compared to the foreign legal system lies at the heart of any deference regime. Thus, domestic rules are used as a yardstick to determine comparability. This perspective elevates national law to the gold standard and ignores international developments and efforts to align regulatory law on a global level.

That the final decision on deference is taken by national authorities poses two additional problems. First, it exacerbates what has been termed “legal-cultural imperialism.” This term describes the oversimplified belief of a national authority that the familiar solution developed in its domestic system is superior in comparison with the solution of a foreign state. This national bias obstructs an objective comparative analysis and prevents a consistent system of deference decisions. Second, national authorities tend to favor national interests. Deciding to open domestic markets to service providers and products from a foreign country carries massive political and economic consequences. Foreign service provider market entry, for example, increases competition for domestic firms. National authorities tend to prioritize their own domestic industry's economic interests, as well as the political interests of their home state (home bias). This again makes the comparability assessment less objective, partially arbitrary, and inconsistent. The home bias also undermines the actual goals of financial market regulation: effective investor protection, maintaining the functioning of financial markets, and ensuring systemic stability.

The withdrawal of deference gives rise to similar problems. While states may have a legitimate interest in revoking deference—for example, if the other state deregulates its markets to the point where the comparability of the legal systems is no longer ensured—many withdrawal decisions are not based on such legitimate reasons. Their main motivation often lies in national economic or political interests rather than in an impartial comparison of two legal systems. Additionally, in many jurisdictions, such as the EU, the withdrawal can be pronounced at any time and without a transitional period. Market access via deference becomes unsuitable for many firms because they lack the necessary certainty for planning. This is particularly problematic in the financial markets, which highly depend on trust.

B. Deviating Methods in Relation to the Comparability Assessment

The restraint of domestic powers is conditioned upon an examination of the foreign regulatory and supervisory system. At the heart of every deference regime lies a thorough comparability assessment of the foreign legal framework. This feature defines all deference mechanisms. But this comparability assessment varies from state to state in terms of the material standard applied and the procedural steps followed.

The material standard against which the foreign law must be assessed is gradually tightening from the standard of appropriateness, through comparability, varying degrees of equivalence, up until identity. The spectrum thus ranges from demanding broad compliance with international standards to effectively requiring full compliance with the domestic regulatory system. The use of different standards contributes to diverging market access barriers across the globe. These create an uneven playing field, distorting competition and preventing the emergence of a consistent system of global financial standards.

With regard to the comparability assessment procedure, many differences exist. These are more difficult to identify because a prescribed methodology is rarely laid down. Instead, the process is usually subject to the discretion of the authority carrying out the assessment of the foreign legal system. An analysis of administrative practices in various jurisdictions shows substantial differences with regard to the granularity of the assessment, the methods used, and their procedural implementation. The comparability determinations in the EU, for example, tend to be highly detailed and granular, whereas Switzerland takes a more pragmatic and liberal approach. In terms of methodology, differences arise even within the same jurisdiction. In the United States, the SEC proclaims to follow a holistic approach, whereas the CFTC makes the comparison on a requirement-by-requirement basis. Contrary to the European Securities and Markets Authority (ESMA) and the European Insurance and Occupational Pensions Authority (EIOPA), the European Banking Authority (EBA) in the EU examines only abstract rules and does not look at the outcomes these rules produce in practice.

The above analysis shows the existence of a basic agreement among states that comparability assessment is needed. Nonetheless, divergences in terminology, methodology, and procedure persist. These differences lead to contradictory results, sometimes within a single legal system, but even more so between different legal systems. This prevents the emergence of a web of coherent decisions that can be conceived of as a consistent system. Inconsistencies in the comparability assessment, in turn, foster the fragmentation of markets and jeopardize systemic stability. They are also difficult to reconcile with the principles of the General Agreement on Trade in Services (GATS) of the World Trade Organization (WTO), which aim at non-discriminatory market access and only allow restrictions for prudential reasons.

C. Political Influences and Unrelated Motives

Deference mechanisms in almost all states are based on discretionary decisions by competent authorities. This discretion can be justified against the background of the unclear factual basis on which such decisions are taken and the prognostic elements inherent in them. However, a wide margin of discretion carries the risk of being exploited.

Such misuse is particularly likely in the EU, where equivalence decisions are increasingly used as a bargaining chip for other policy objectives unrelated to financial stability and investor protection. The European Commission states that it may “factor in wider external policy priorities and concerns in particular with respect to the promotion of common values and shared regulatory objectives at [the] international level.” The European Parliament even admits that equivalence decisions have a “clear political dimension.” This political dimension has been a painful experience for Switzerland. In 2019, the European Commission did not prolong an existing equivalence decision for Swiss stock exchanges because it was dissatisfied with the progress in the negotiations over the Institutional Framework Agreement between the EU and Switzerland ongoing at that time. The equivalence decision was thus not based on the quality of the Swiss regulatory framework, but on the EU’s aim of pressuring Switzerland into concluding the Institutional Framework Agreement.

The politicization of deference comes with significant disadvantages. When decisions no longer depend on the quality of the foreign regulatory system, the most powerful state prevails, not the one with the best regulation. This leads to unfavorable selection, which threatens the goals of ensuring investor protection and maintaining financial stability. Less influential states will feel like “rule-takers” forced to meet a foreign benchmark and will be unwilling to open up their own domestic markets. In relation to emerging markets, this approach can even resemble a policy of new imperialism. Moreover, this approach renders the outcome of the comparability assessments less predictable and even arbitrary. All this reduces the importance of deference and makes the concept more protectionist. This, in turn, increases market fragmentation, which will result in massive welfare losses.

Similar problems arise when deference is negotiated secretly or only semi-officially in the shadow of the law. Although most comparability assessments are constructed as unilateral decisions, in practice such decisions are often preceded by regulatory dialogue. This exchange is necessary for understanding each other’s legal systems and thus for deference, but it risks making the process opaque and turning the unilateral decision into a negotiation susceptible to extraneous and political influences. These tendencies carry similar risks to those inherent in the politicization of deference and contradict the basic idea of a liberal trade order based on the principle of non-discrimination, as also prescribed by the GATS, with regard to financial services.

D. Excessive Costs, Waste of Time and Resources

In addition to its other drawbacks, deference’s current setup is also extremely costly, time-consuming, and resource intensive. The huge costs are caused by the fact that each state currently conducts its own comparability assessment, adopts its own deference decision, and independently monitors and supervises the developments in the other country following a deference decision. To illustrate, the EU alone has taken over 280 equivalence decisions, most of which were preceded by detailed technical ESMA analyses, and all of which were continuously monitored afterward. This approach further ties up a considerable portion of the resources available to the supervisory authorities, which can no longer be used for other important issues. These costs could be drastically reduced by concentrating the assessments and the subsequent ongoing monitoring of the decisions in one organization, as will be proposed later in Section V.

E. Intermediate Conclusion: Unequal Access, Market Fragmentation, and Excessive Costs

This analysis reveals that the current deference setup, in which decisions are made in an uncoordinated manner at the national level and primarily on the exclusive basis of domestic law, does not meet a globalized financial world’s demands. In particular, deference, in its current state, is unable to mitigate the undesirable effects of the increasing extraterritorial application of financial law by all major jurisdictions.

Leaving deference exclusively at the national level leads to varying degrees of market openness, ranging from liberal regimes like that of Switzerland to more protectionist ones like that of the United States. The unequal market access barriers also distort the competitive playing field on which financial firms are active. Further, deference fails to reach its full potential in this form and leads to market fragmentation. In turn, market fragmentation reduces the supply of investment opportunities, hinders economies of scale, and inhibits specialization and concentration of certain types of financial services in hubs. Thus, it causes overall welfare losses.

IV. The Web of Diverging Factors Involved

Before any proposal to improve the current setup of deference can be made, it is imperative to study the relevant factors involved. These factors comprise certain interests, such as investor protection, financial stability, and competition and open markets. But the shape of deference mechanisms is also influenced by legal principles and rules, such as the obligations of “most favoured nation treatment” or of “national treatment” under GATS. Together, these interests, principles, and rules form a complex web into which the deference mechanism is embedded. Any proposal must respect and be compatible with them; otherwise, it will not succeed.

A. Sovereignty

Sovereignty is the most important premise of the deference mechanism. Each state has the right to decide whether foreign firms must comply with its regulation as a precondition to enter its domestic market. This is because the state is the ultimate guarantor of public order and safety. Inadequate regulation or supervision of financial service providers will likely create dangers for the state’s citizens and its economy as a whole. The looming loss of capital may put the livelihoods of depositors and investors in danger, strain the social security system, and result in a lack of liquidity for the real economy.

The final deference decision, therefore, belongs to the nation-state as the ultimate holder of power. Hence, deference is decided at the national level. It is also the reason why comparability assessments are carried out on a unilateral basis and why they can be withdrawn any time without prior warning or consultation.

Many issues regarding financial regulation and supervision have been debated and agreed on at the international level within the last few decades. But deference has been remarkably absent as a topic. The G20 Leaders’ Declaration at the St. Petersburg Summit merely mentions certain conditions under which jurisdictions and regulators should be able to defer to each other, such as the quality and the similarity of outcomes, without going into more detail. In order to improve deference and recognition processes, the Financial Stability Board (FSB) has suggested promoting the mutual understanding of regulatory and supervisory standards, discussing the information that jurisdictions can usefully provide for the comparability assessment, additional information sharing, as well as stronger mechanisms for supervisory cooperation. The International Organization of Securities Commissions (IOSCO) has added some concrete proposals in this regard. In particular, it has suggested identifying good or sound practices regarding deference tools, making greater use of its Regional Committees (i) to discuss cross-border regulatory issues on a regular basis and (ii) as a forum for the exchange of information among its members about each other’s approaches to cross-border regulation. As IOSCO acknowledges, however, none of these suggestions will change the existing legislative requirements or frameworks that authorities have in place.

Thus, there is currently no harmonizing framework for the operation of deference regimes. The reasons for this are palpable: states are reluctant to give away power over this important decision to the international level. They want to keep policymaking power and retain the last say in matters of finance. Any reform of the deference mechanism that fails to respect these wishes will be doomed to fail.

B. Open Markets

A state may have a rational interest in opening up the market. Motives for doing so are the resulting broadening of investor choice and the increase of competition in finance that flows from such a decision. But there are also reasons for closing the domestic market to foreign providers, such as the dangers for investors and the negative impact on the domestic financial industry by the admission of inadequately regulated or supervised foreign service providers.

In weighing these countervailing interests, the law of the WTO (and, in particular, the GATS) plays a vital role. Its rules are important drivers for open financial markets. Specifically, the obligations of most-favoured-nation treatment, market access, and national treatment point towards opening markets and avoiding any discrimination against foreign service providers. Yet these rules are subject to the so-called “prudential carve-out,” which allows signatory states to take measures for prudential reasons, including for the protection of investors and depositors and for guaranteeing the integrity and stability of the financial system. This safe harbor permits states to apply and enforce the same regulatory rules in relation to foreign service providers as they do in relation to the domestic industry. It also allows a certain degree of differentiation to the extent that foreign service providers that are not adequately regulated and supervised in their home country may be subjected to a second layer of obligations by the host country.

Nevertheless, it would be a mistake to interpret the prudential carve-out as a blank cheque for restricting market access. WTO law strongly limits the possible motives for enacting particular regulatory rules. The panel in Argentina–Financial Services held that there must be a “rational relationship of cause and effect between the measure and the prudential reason,” which the panel reviews rigorously. In that case, the measure in question was held not to meet this criterion. States must not use deference as a bargaining chip in bilateral negotiations. In particular, they are not permitted to offer a favorable comparability assessment and market access as a quid pro quo for benefits in other unconnected areas. Such dealings are incompatible with the strict obligations they have undertaken in GATS.

Reciprocity is a particularly sensitive point of contact between WTO law and the concept of deference. As mentioned before, many states require that the law of the home state of the foreign service provider offers opportunities for market access equal to their own. It is doubtful that this requirement is compatible with the rules of GATS. On the one hand, states have an unconditional obligation to treat other nations as a “most favoured” one, implying a prohibition against discrimination between firms based on their country of origin. On the other hand, reciprocity, when applied in general and to all countries, is not discriminatory. It merely demands that the other state also complies with its GATS obligations and offers a comparable chance to meet the deference requirements as the host country does. In other words, it transfers the principle of equal market access to the prudential carve-out and to the assessment of the foreign regulatory and supervisory framework. In that sense, it cannot be considered as being per se incompatible with the fundamental principles underpinning GATS. This conclusion, however, further complicates deference, as it enables a tightening of the conditions for its granting.

C. Competition Policy

A vibrant financial sector is a precondition for a strong economy. New entrants from other countries can act as stimuli for the domestic industry, forcing it to up its game and improve its offers. Allowing foreign competitors also prevents market fragmentation, broadens investor choice, facilitates the diversification of portfolios, and increases liquidity. The admission of foreign financial service providers is, therefore, in the enlightened self-interest of each state.

But the decision to so admit is not so simple. First, not all competition is fair. Other states may utilize a considerably lighter regulatory and supervisory framework. This not only tilts the playing field in their favor but may also lead to regulatory arbitrage, incentivizing firms to migrate to the least regulated country. This outflow may, in turn, cause risks for financial stability. At worst, it may lead to a regulatory race to the bottom, in which the host state mimics the less-stringent regulation to prevent the emigration of its financial companies abroad.

Second, a state may have a legitimate interest in protecting the domestic industry from foreign competition. This may be the case, for instance, where the domestic industry is still in its infancy and made up mainly of start-ups, which may be nipped in the bud by behemoths from other countries. To have a strong domestic financial industry is also in the state’s self-interest. Not only does it provide jobs and tax revenues, but it also protects against liquidity being withdrawn from the domestic economy and secures equitable financing conditions in difficult times. Moreover, a strong domestic financial industry may also help balance trade relations.

Taken together, competition policy arguments cut both ways. They may speak in favor of deference where the entry of foreign competitors leads to a more vibrant financial sector, but they may also be used against deference where the national financial sector is still nascent and a dynamic view of competition is adopted.

D. Investor Protection

One main argument against allowing market entry for foreign firms is the protection of investors. Inadequately regulated or supervised firms may pose great dangers for unsuspecting domestic investors. Investments or deposits could be lost, which would shake investor confidence in the whole financial system and cause social unrest and turmoil. At the very least, the admission of less regulated or less supervised foreign firms on the national market may distort competition and lead to inefficient allocation of capital.

Yet it would be too one dimensional to consider foreign firms solely as a threat to investors. Permitting foreign competitors to offer their services on a national domestic market may significantly increase investor choice and allow for better returns. It may also contribute to more diversified investment portfolios, less susceptible to shocks. This, in turn, fosters financial stability not only in the domestic market but also worldwide.

As with financial stability, investor protection thus also cuts both ways with regard to the question of market access by foreign firms. The answer to this question not only depends on the state’s assessment of the firm’s home state system, but also on the extent of the assessor state’s paternalism. Some states, like Switzerland, start from the assumption of a well-informed investor who is able to seek high returns abroad in full cognizance of the risk. Other states, like the United States, are warier of foreign services and products. The SEC, in particular, subjects any offering of securities to U.S. investors by foreign firms to strict scrutiny. This difference in attitude is thus a very important parameter for the deference decision. Remarkably, it has little connection to the quality of the foreign legal framework but merely depends on the characteristics of those that decide over deference.

E. Financial Stability

A state exporting financial services without subjecting them to proper scrutiny may create externalities for other countries. By allowing foreign competitors into the domestic market, a state may thus import risks for the stability of its financial system.

One important function of the comparability assessment is to avoid this danger. States analyze the legal frameworks of others to determine whether they sufficiently protect against stability risks. This function has especially been emphasized since the global financial crisis of 2008, which has vividly illustrated the potential of financial turmoil to cross borders. The comparability assessment acts as a firewall to prevent crises from spilling over to other countries, which is why it must be carried out to an exacting degree.

An exaggerated focus on financial stability, however, may cloud perceptions on other issues, such as the benefits of open markets and vibrant competition in the financial sector. Although stability concerns must be taken extremely seriously, they should not result in systematically closing the doors to foreign service providers. A “safety-first” approach, when carried out to the extreme, risks the reterritorialization of finance and the unwinding of the benefits of globalization. Ultimately, it may prove not only costly but also counterproductive in terms of stability if investors and the real economy depend exclusively on the domestic financial sector.

On the other hand, there are systemically important financial service providers, such as banks or financial market infrastructures, the demise of which may put the national financial system in danger. It is, therefore, reasonable to demand control over these players in return for granting them market access. An illustration is the EU’s recent change of the EMIR equivalence mechanism for the clearing of over-the-counter (OTC) derivatives.

To strike the appropriate balance between these countervailing concerns is not easy. The issue is all the more difficult as stability risks are hard to identify. There is a lurking danger that regulators will hide behind the concern of financial stability for other motives, such as the protection of incumbents. But it would be equally dangerous if states carried out their comparability assessments negligently, thereby permitting the proliferation of financial risks across the globe.

F. Political Economy

Each state deciding whether foreign firms are allowed access to its markets must weigh the often contradictory arguments in favor of opening or closing markets. When deciding between these competing factors, the personal characteristics and interests of the decision-maker may prove influential. This phenomenon has been termed “regulatory capture” and occurs when regulators and supervisors identify with the regulated and supervised. Since the focus of regulation and supervision is on the domestic industry, regulatory capture often results in a strong preference for domestic players (home bias) and market closure for foreign competitors. This home bias is further reinforced by the personal influences of politicians, which are likely to emphasize the benefits of a viable local financial industry for a high level of employment and tax revenues. These political preferences will weigh heavily on the regulator and supervisor, which are often a part of a hierarchically organized executive branch.

Politicians and regulators, even if completely neutral, might well have a strong rational tendency towards denying market access. This is because granting deference usually involves very high risks in the form of lost deposits and investments, as well as financial turmoil and social unrest. This contrasts with the comparatively few dangers resulting from an (unjust) denial of deference, such as stifling competition and limiting investor choice. It must also be borne in mind that, from the point of view of the political and regulatory elite, granting deference involves an abdication of control and influence. The odds are thus further stacked against deference by the skewed incentives of the national decision-makers.

G. Conclusion

The web of factors thus sketched out provides a glimpse into the intricacy of interests, principles, and rules involved in the design of deference mechanisms. Many of the issues may cut both ways as arguments in favor and against granting market access, as was illustrated in the context of competition policy or financial stability. They are also highly dependent on the situation and country concerned, such as whether a country principally exports or imports financial services.

This explains, in part, the confusing variety of deference mechanisms and the abundance of decisions to recognize or refuse foreign legal systems. When looking at the national regimes and the outcomes they produce, the picture blurs. The motives can hardly be identified. One cannot assume that a national decision to refuse deference is based on investor protection and financial stability, and not on a protectionist impulse in favor of the domestic industry.

Therefore, it seems time to reform the current setup. In the following part, a better and more transparent way of complying with the competing interests, principles, and rules will be suggested.

V. An Alternative Suggestion: Multilateral Deference

A. The Proposal at a Glance

The preceding analysis has identified the main deficiency from which deference suffers: an uncoordinated and inconsistent approach taking place exclusively at the national level. This focus on the national level has numerous disadvantages, which have been described in detail above. Ultimately, these disadvantages lead to fragmented markets, cause massive welfare losses, and undermine the further globalization of financial markets. A multilateralization of deference is urgently needed.

Multilateral deference includes international organizations in the deference decision-making process without completely leaving nation-states out of the game. Accordingly, we suggest that the comparability assessment undertaken prior to each deference decision is transferred to the international level. The comparative analysis at the international level should be divided into two phases. The first step is to determine whether a particular national legal system has implemented the applicable international standards in a given area. The second step is to compare the national legal systems with each other. The analysis ends with a non-binding recommendation for one state to recognize the system of another state as comparable or not.

Based on the comparative analysis findings, nation-states can then continue to decide autonomously whether to issue a deference decision on equivalence, appropriateness, comparability, or substituted compliance. It is within their sovereign right to deviate from the recommendations made by the international organization in charge of the comparability assessment. This does not render the analysis at the international level inconsequential: It will, at least, put states under political pressure to justify their deviation from the assessment. Moreover, the international assessment findings may be useful to domestic courts and the WTO’s dispute settlement system, both of which may review the legality of a market access denial.

B. Procedure

Deference decisions can be divided into two phases, which currently both take place at the national level. The first step consists of a preparatory technical analysis of the foreign regulatory and supervisory framework. This analysis forms the basis for the subsequent second step, which is issuance of the deference decision itself. This two-step approach is particularly evident in the EU. At the first step, the European Supervisory Authorities undertake technical analyses, which sometimes run hundreds of pages. On the basis of these, the European Commission then decides whether to adopt an equivalence decision or not.

1. Step 1: Technical Comparison and Recommendation by International Organizations

At the beginning of any deference decision is a very extensive, in-depth, and time-consuming comparison of two legal systems. Depending on the jurisdictions and the market in question, this comparison has very different dimensions. As explained, terminology, methodology, and procedure differ considerably between the various states, resulting in an opaque and inconsistent web of decisions. This can be avoided through a harmonization at the international level.

Multilateral deference should not start at the national level but with international organizations. These organizations should be responsible for the technical comparison of legal systems. In the beginning, these organizations must draw up a questionnaire restricted to a specific subject area, such as the regulation of benchmarks, which they then put on their website and send to the national supervisory authorities. This questionnaire would be divided into two parts. The first part would ask to what extent the regulation of the respective state implements international standards in the given area, if such standards exist. Such evaluations on the implementation of international standards are already partly carried out by organizations such as IOSCO, including through the sending of questionnaires.

The second part of the questionnaire would turn away from international standards and ask more specifically how a state solves a particular regulatory problem in national law. It is important that the questions are not conceived from the perspective of a specific legal system or with such a system in mind but that they address the problem functionally. For example, one can ask whether and how a state ensures the independence of credit rating agencies, but not whether the legal system of a state contains a regulation that requires the mandatory rotation of rating agencies to ensure independence.

Entrusting an international organization with the preparatory technical analysis has distinct advantages. First, concentrating the comparability assessment in one actor will harmonize the terminology, methodology, and procedure applied. Greater harmonization is a prerequisite for more consistent and coherent deference decisions, which will, in turn, (i) foster regulatory competition in the form of a race to the top, (ii) avoid discriminatory behavior, (iii) open up markets, (iv) promote investor protection, and (v) enhance financial stability. Second, a neutral analysis at the international level contributes to the international exchange of knowledge and experience. States, especially those with emerging markets, get the opportunity to gain knowledge about other legal systems and can draw conclusions on how to improve their own domestic legal system without feeling like “rule-takers” pressured into changing their law. Third, shifting responsibility for the technical analysis to the international level leads to a depoliticization of deference and improves the overall quality of the assessment. Political influence on the technical comparison is reduced when the analysis is carried out by independent experts who are, although still linked to the states, further away from the day-to-day political business than national authorities are. In the long run, these independent experts will be more experienced and specialized than the general staff of the national supervisory authorities are, which will enhance the quality of the analyses. Fourth, a comprehensive technical analysis of the legal systems of all major jurisdictions at the international level will help identify systemic risks and thus ensure global stability. Finally, there are massive cost benefits and savings in supervisory resources associated with the concentration of the assessment, as states no longer have to compare their laws with every other legal system in the world. Supervisory resources that are consequently freed up can then be used to address other important concerns.

The use of a questionnaire as a basis for comparative analysis also has important merits. The most obvious is that the international organizations involved would save considerable time and resources when national authorities do the preparatory work. If the order in which the international organizations conduct the comparability assessments depends on the timing and depth of the national authorities’ responses, then there is a strong incentive for states to collaborate and to report on their legal systems early and in great detail. Another advantage is that state officials are best positioned to explain their domestic legal system, as they have superior knowledge of it. The answers must, of course, subsequently be checked by the international organization, which will develop sufficient expertise to verify the responses over time.

2. Step 2: Adoption of Deference Decision at National Level

According to our proposal, the legally binding decision on deference will then be taken at the national level as a second step. This directly follows from the principle of sovereignty and the role of government as the ultimate guardian of order and security in its country. One objection to national decision-making could be that the benefits of multilateralization outlined above—greater harmonization and the creation of a consistent and coherent web of deference decisions—would be realized to an even greater extent if the final deference decision were taken directly by the international organization or if its technical analyses were at least binding on states. While it is true that deference decisions on the international level would lead to even further harmonization, such a complete shift of competences to intergovernmental bodies seems neither realistic nor politically wise. It seems unrealistic because states are unlikely to give up their sovereign right to decide on market access rights of foreign firms and products, especially in an area such as financial law, which has a massive impact on the real economy and the financial situation of the population. It is also not a politically smart strategy. Representatives of international organizations are not directly elected by the people, and, therefore, their democratic legitimacy is weaker than that of states. They also lack political and legal accountability. If deference decisions carry grave consequences, such as the importation of systemic risks by firms from weakly regulated jurisdictions that result in financial crises, citizens must have the option of holding the politically responsible person to account, for example, by voting them out of office. This option exists only to a very limited extent in the case of international organizations. Moreover, the possibilities for seeking legal protection against the deference decisions of international organizations would be very limited, which is problematic from the point of view of the principles of the separation of powers and the rule of law. All in all, international organizations should not be the final decision-makers over deference.

But what are the advantages of the proposal then, if every state can do whatever it pleases with the recommendation of the international organization? In fact, most of the above-mentioned advantages remain valid even when nation-states make the final decision. For example, the cost savings and conservation of supervisory resources remain when extensive technical assessments are carried out by international organizations. Moreover, it is preferable in terms of consistency and coherence of deference if national decisions are at least based on a uniform basis and not, as is currently the case, on very diverse national starting points. Most importantly, the numerous pitfalls associated with the politicization of deference described above are diminished. If states open up their markets on the basis of international recommendations, they will at least demand an explanation from states that do not follow the recommendations. Accordingly, states deviating from the recommendations are put under increased pressure to explain and legitimize their decisions, which, in practice, comes close to a “comply-or-explain” approach. This increased burden of justification also enhances the transparency of the decision-making process by disclosing political arguments that would otherwise often remain secret in a purely national process. Additionally, both the technical analysis of the respective international organization and the national explanation justifying the deviation can be used by national courts and the WTO dispute settlement body through judicial review of national decisions denying market access.

C. Standards

One of the main advantages of multilateralizing deference is that international organizations are best placed to achieve a far-reaching harmonization of the currently scattered deference approaches. Only international organizations can establish a uniform standard, a uniform methodology, and a uniform procedure. Moreover, international organizations are above national law and, therefore, have a different perspective on it. This distinct viewpoint allows for a more neutral and unbiased analysis of national legal systems. As described above, the comparability assessment would be divided into two parts: first, the compatibility with international standards is examined. Only at step two will the legal orders be compared.

1. Compatibility With International Standards

The comparability assessment of the respective international organization begins with a review of whether the national legal system in question has implemented the relevant international standards in a given area of financial law. Such analyses are already carried out by some organizations, including IOSCO and the FSB. This preliminary exercise is necessary for several reasons. In some jurisdictions, it is already sufficient for a deference decision that the foreign jurisdiction has implemented the relevant international standards. In Switzerland, for example, a foreign CCP is recognized by the Swiss Financial Market Supervisory Authority (FINMA) and can subsequently grant supervised Swiss participants direct access to its facilities, as well as provide clearing services for Swiss financial market infrastructures if the foreign CCP is subject to “appropriate regulation and supervision.” The assessment by FINMA of whether the foreign law is appropriate depends primarily on the implementation of the Principles for Financial Market Infrastructures (PFMI), and not on a qualitative equivalence with Swiss law. Compatibility with international standards is thus the decisive criterion for deference.

The analysis undertaken as part of step one can also often be used as the basis for the assessment carried out in step two because most legal systems are built on international standards. Commencing the comparative analysis with international standards further highlights the fact that national legal orders are not the gold standard in a globalized financial world. Rather, the agreed-upon and shared starting point among states is the regulatory objective and idea, as expressed in international standards.

2. Compatibility of National Legal Systems Inter Se

International standards do not yet exist in all areas of financial markets law, and the implementation of these standards is insufficient for many states to adopt a positive decision on deference. Such a decision also requires a qualitative analysis of their own domestic legal systems compared with those of foreign countries. Therefore, it is inevitable that the international organization in question directly compares the legal systems of two states at the second step.

As seen, there are different standards at the national level for this comparison, such as equivalence, comparability, appropriateness, and substituted compliance. At the international level, on the other hand, there can only be one uniform standard. This standard of review must have the important characteristic that it can be equally applied by all states despite their different domestic standards; otherwise, recommendations at the international level would remain without practical consequences. A graduated standard of review, as practiced by EBA and EIOPA, is most suitable for this purpose. The graduated scale could look roughly as follows:


These standards of incomparable, broadly comparable, in effect comparable, and identity can be translated into national terminology by each state. Each state can, therefore, draw its own conclusions regarding the adoption of deference decisions from the analyses at the international level. For example, the EU will issue an equivalence decision if the foreign legal system is “in effect comparable,” which translates as “equivalent.”

One of the main differences between a comparative analysis done by an international organization and those carried out by national authorities is perspective. An international organization does not look at national legal systems from within but from an external viewpoint. To a certain extent, this allows a shift away from a strict country-specific analysis to a more subject-specific and topical analysis. Given that the international organization is not only comparing one foreign legal system with another one, but also conducting comparisons between many legal systems, it can focus more on general characteristics rather than on peculiarities. This focus on the content of a rule detached from the state of origin promotes a more uniform and less biased assessment.

Such analysis is also vital for the future development of international standards. Today, international standards frequently continue to be drafted more or less from scratch. In the future, the creation of international standards could rely to a greater extent on a comparative analysis of different national legal orders. In areas where such standards do not yet exist, they can be formulated step-by-step and issue-by-issue with the help of these comparability assessments. In the distant future, a uniform global standard of financial regulation and supervision may evolve, composed of the best practices of national legal systems.

D. Competent Body

So far, we have only suggested multilateralizing the comparability assessment and having it carried out by “international organizations” without designating which specific organization is meant. A proposal that does not name any particular organization, however, remains incomplete. Instead of juggling names of organizations, it is best to outline the existing options, identifying and balancing the relevant interests at stake.

1. Specialized Organizations vs. Organization With General Mandate

The responsibility for carrying out the comparative analysis can be assigned either to one organization with a general mandate, which then covers all areas of financial law relating to deference, or to several organizations, each of which is then responsible for the field of deference in which it specializes in.

In principle, three different alternatives exist. First, a new international organization could be established by the states with the sole responsibility of adopting recommendations regarding deference. But such a new project aimed at liberalization is very unlikely to succeed in the current global political situation and against the backdrop of smoldering trade conflicts and increasing protectionism. In addition, there are already several well-established organizations in the financial markets field that are reliable, which is why a new organization is unnecessary.

A more realistic option is to assign the entire preparation of technical analyses to an institution with a broad general mandate, such as the FSB or the International Monetary Fund (IMF). Yet such an approach carries the risk that the workload associated with that massive undertaking will overburden a single organization. This could slow down the progress of comparability assessment and thus hinder the much-needed breakthrough of deference. Moreover, deference is a cross-cutting concept that is embedded in very different areas of financial law. It would be almost impossible for an organization with a general mandate to specialize in all the areas covered by this concept, which could compromise the quality of the technical analyses.

Against this background, a cross-institutional collaborative approach is proposed, that is, the reports on deference are prepared by a competent organization that is specialized in the field in question. This solution reflects that deference is a cross-cutting concept. It also bundles competences within the organization, which often already carries special knowledge due to its role in setting international standards and monitoring their national implementation. At the same time, this solution promotes specialization and enables the relevant organization to acquire and deepen specialist knowledge and experience in the given field. For overarching issues or issues for which no specialized organization exists, organizations with a general mandate could step in.

The problem with this solution is that different organizations may develop different standards, methods, and procedures, which would jeopardize cross-sectoral uniformity and the integrity of the concept of deference. To address this issue, it makes sense to designate a “guiding” or “leading” organization for others to follow. The most suitable organization for this purpose is IOSCO because its committees already cover a large spectrum of deference regimes. Among others, IOSCO comprises the Committee on Financial Benchmarks, the Committee on Credit Rating Agencies, and the Committee on Derivatives. Therefore, IOSCO is the natural key player to be entrusted with this task.

2. Close Ties to National Governments vs. Utmost Independence

Another salient issue is whether decision-makers in international organizations should be closely linked to national governments or be as independent as possible. The argument in favor of the former is that close ties with national governments ensure that national perspectives and national interests are taken on board from the outset. This raises the odds that the recommendations of the international organization will be followed and implemented by the states. The inclusion of national interests at the international level also leads to the multilateralization of negotiations on deference and prevents such negotiations from taking place primarily bilaterally, where they are less transparent and less amenable to influence for other states.

Excessive national influence on the staff of international organizations, on the other hand, can lead to overloading the process with political considerations. The comparative analysis is designed primarily as a neutral and technical one. If the staff of international organizations is more independent of their home states, fewer clashes between national governments will spill over into the technical analysis.

As a result, the international organization should select a body or organ for the analysis that strikes a reasonable balance between the two extreme positions described above. The members of this body should not be completely detached from national interests, but their home states should equally not be able to exert excessive influence over the members.

3. Member Structure of the Organization: All States vs. Selected Circle

A point of criticism that could be raised against many of the organizations mentioned here is that they never represent all nations; developing countries, in particular, are often left out. This problem of representation can be mitigated if organizations commit themselves to carry out comparability assessments also for those states that are not members of the organization. In addition, representatives of the states concerned could be granted the status of an observer. Besides, organizations with a limited number of members have the advantage of being more efficient than organizations that are too large. Hence, it is best if an organization is not too large but big enough to represent the majority of states active in the financial sector.

VI. Conclusion

Deference is the best mechanism for avoiding market fragmentation or for overcoming it where it already exists. Yet the deference mechanisms that are currently applied suffer from significant defects. In particular, the unilateral perspective of the national authorities that carry out the comparability assessments leads to distorted decisions. In this contribution, we have suggested solving this problem by moving the comparability assessment to the multilateral level. Leaving the analysis and comparison of regulatory and supervisory frameworks to an international organization like IOSCO promises more coherent and equal assessments, the furtherance of global standards, as well as tremendous efficiency gains and cost savings. In our view, the ultimate decision over foreign legal framework recognition should, nevertheless, remain with the nation-state as the ultimate guardian of order and security. This does not deprive our suggestion of its value, as it will still place the burden of compliance or explanation on states and their authorities. Multilateralization will not remedy all the ills of the global financial system, but it will be a step towards more open, competitive, and stable markets.