Unintended Consequences of the Global Derivatives Market Reform

Following the early implementation of the global over-the-counter (OTC) derivatives market reform in the US and the associated increase in trading costs, US banks shifted up to 60% of their OTC derivatives activity abroad, particularly towards less regulated jurisdictions. Consistent with a cost saving incentive of regulatory arbitrage, we find that this flight abroad is driven by costlier blocks of the reform and subsequently causes a narrowing of swap spreads. We further show that this regulatory arbitrage causes an increase in financial risk as more activity is shifted to more lenient jurisdictions.