Market fragmentation can arise for a variety of reasons. Fragmented markets can reflect a range of natural barriers and frictions. These can include investor preferences as to the location of their investment (eg home bias) or transactions (eg for trading at venues with specific price and counterparty transparency). Fragmentation can also reflect differences in the development of financial systems (eg the depth and breadth of capital markets, relative sophistication of banks) and financial cycles (eg their lack of synchronicity). And finally, it can reflect a range of domestic policies (eg taxation and competition).
Besides these factors, market fragmentation can also arise due to differences in financial regulation and supervision. It is not just national or regional rules that can generate frictions in financial activities that are international in nature. Fragmentation may also result from differences in the implementation of international principles or standards across jurisdictions or from overlapping or inconsistent implementation of international standards by financial institutions’ home and host regulators and supervisors.
As a consequence, market participants may choose not to engage in some forms of cross-border activity to avoid the associated duplication of costs and supervisory burdens. Fragmentation may be bad for financial stability. But fragmentation and financial stability themselves may also be subject to a trade-off.
This review makes clear how little we know about the existence of any trade-off and its exact parameters. The paper makes the following proposals by way of a more formal approach to reviewing and, possibly, undertaking policy actions. The starting point is more thorough analysis: What is the degree and type of fragmentation? What are the causes of fragmentation? What degree of fragmentation is good for financial stability? What is “bad”? What needs to be assessed here is the overall social costs and benefits of fragmentation, and this needs to be done across jurisdictions.
The related question is whether the “bad” elements of fragmentation are prone to escalate to the level of systemic risk. Some may, but the rest may not. A joint assessment of the causes and a possible trade-off could supply us with a menu of policy options. The second step is to select from that menu the options that can reduce fragmentation while also improving financial stability.
The aim is to identify improvements along the upward sloping part of the “iso-quant” financial stability-fragmentation curve. All the drivers involved, not just regulation, would need to be assessed. Such a review may well conclude that the answer to many of the outstanding questions is to continue harmonizing regulation and implementation, and enhancing information-sharing processes regarding possible policy actions and the like.
This is an extensive agenda, including on cooperation, information and data-sharing, but much of it is already underway. Another, parallel step would be to encourage the private sector to provide (more of) its own solutions to complement public interventions. There are many examples of the private sector already using cooperative models to address fragmentation at the global level. For example, CLS Bank is playing a role in wholesale cross-border payments. Consideration is being given to developing more such private (interbank) settlement systems. Policymakers can only welcome that and other private sector approaches.
A final step is to intervene using the right tools. There are a number of elements to this. One is to choose the most efficient instrument with which to intervene. For example, there can be differences between price- and quantity-related regulations in terms of effectiveness and benefits in the presence of uncertainty. There is also much to learn from private sector solutions, which can be built on. Another element is to allow for some state contingency in applying the instrument chosen, eg barriers to the allocation of liquidity and capital are clearly more costly in times of stress. Analyzing and then addressing these elements will help ensure that the public sector intervenes not just when necessary, but also with the most effective tools.