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The Harmony Trap

A widespread feeling exists that European integration is proceeding sideways, if not backwards. But in at least one field, real progress has been made: the Commission's endeavor to build a single market for financial services.

An ambitious Financial Services Action Plan - launched in 1999 to bring about a single European wholesale market, open and secure retail markets, and state-of-the-art prudential rules and supervision - envisaged 42 measures to be implemented by 2003-2005. After a slow start, rapid progress has been achieved, with 36 measures formally adopted, including important directives on market abuse, prospectuses, financial collateral, distance marketing, collective investment schemes, and a common set of International Accounting Standards for the consolidated accounts of all listed companies.

A common position has been reached on four more measures, including directives on investment services, on transparency, and on takeovers. There has also been an institutional leap forward with the adoption of the so-called Lamfalussy method for quick adoption of implementing measures and approval of a European regulators' committee.

Impressive results. But to assess their relevance, three questions must be asked: was such harmonization necessary? How satisfactory are its results, over and above the sheer number of measures adopted? Most importantly, is completion of the FSAP sufficient to achieve the single financial market?

The first question reflects a long-standing and apparently philosophical dispute between Britain - more accurately, the so-called British financial industry, which comprises almost exclusively non-British firms - and the Continent. A one-size-fits-all approach, the British argue, is incompatible with existing differences between EU states: all that is needed is mutual recognition, leaving the rest to competition and investors' choices.

Insufficient harmonization, however, has often allowed member states to erect barriers to competition, which can only be removed by consistent implementation of laws and standards. This is why securities law, unlike company law, has federal status in the US. A more level playing field, achieved by a gradual increase in the level of harmonization that is driven by both institutions and markets, will in the end provide a better opportunity for the fittest to survive.

As for what has already been achieved, some measures deserve unqualified praise. Adoption of a common set of advanced accounting principles will remove a key obstacle to meaningful comparison of European listed companies' profitability, although more needs to be done to achieve common standards of enforcement, as recent corporate scandals show.

The directive on market abuse provides European regulators with greater investigative and sanctioning power, as well as enhancing cooperation. The prospectus directive allows companies to issue shares and raise capital in all European markets by using the same prospectus as approved by each company's national authority.

The most delicate issues are those raised by the Investment Services Directive, on which only a majority of member states have reached a common position. The directive firmly, and rightly, frees competition among all trading venues, removing the privileges enjoyed by "official" exchanges. Trades must no longer be concentrated on an officially regulated market, which means that assessment of "best execution" remains an open question, especially when trades are "internalized" by intermediaries acting as counterparts to their customers.

No obvious solution to this problem exists in a multi-venue world, where "best execution" can neither be presumed nor categorically defined. But the fullest possible information in executing trades is a necessary condition: hence the imposition of pre-trade (posting orders and prices) and post-trade transparency for intermediaries trading on their own account with retail investors - a requirement that has been firmly opposed by all the states where the relevant "internalizers" reside. This resistance should not be allowed to prevent the European Parliament from endorsing the common position: markets and regulators alike urgently need a new ISD, as innovations have made the old one obsolete.

Thus, while certain necessary requirements for the existence of a single European financial market have been established, they are far from sufficient , at least at the retail level. This is not so much because further top-down measures are needed, but because market failures hamper the required bottom-up drive. "Markets are created and developed by market participants, not by rules and regulation," says the City of London. True, perhaps but the record is far from brilliant.

The persistent fragmentation of privately owned European exchanges is not due primarily to regulatory obstacles. More relevantly, the high cost of cross-border transactions reflects inefficiencies in the post-trade stage, especially clearing and settlement. As stated in the so-called Giovannini Report to the European Commission, "The post-trade landscape could be significantly improved by market-led convergence across national systems." But a major obstacle to this is the existence of local rent-seeking franchises and monopolies.

Silent progress is instead being made on another front. As a result of the Lamfalussy report, not only was the legislative process improved, but an important institutional status was conferred upon the Committee of European Securities Regulators. Apart from its consultative role in drafting legislation, the CESR has now been mandated to set guidelines and common standards for national regulation and enhancing cooperation. This is potentially the most important step towards establishing a level playing field, as the transposition of Community legislation into national regulation still leaves too much room for discretion.

The plea for a single European regulator (a "European SEC") is, at the moment, misguided: there is no legal basis in the Treaty (or in the draft constitution), member states' legal systems are too different, rules are not sufficiently harmonized, and Community law appears to be moving towards decentralization. A gradual approach, based on growing coordination of national regulations and regulatory practices at the CESR level, appears to be the most viable alternative.