The Law of Two Prices: Regulatory Arbitrage, Revisited

Abstract

In contrast to financial arbitrage, which causes prices of economically equivalent transactions to converge in the direction of one price, regulatory arbitrage does not lead to such price convergence. In contrast, regulatory arbitrage tends to produce two different prices for economically equivalent transactions that are subject to different regulatory costs: this is what I call the “law of two prices.” The key insight here is that regulatory costs can persist as a “wedge” between the prices of economically equivalent transactions that are subject to differing regulatory costs. Unlike the price gap that financial arbitrage reduces or eliminates, this regulatory cost wedge will persist as long as the relevant regulatory cost differential persists.

The persistence of the regulatory arbitrage wedge raises important and interesting policy concerns that the literature has not previously addressed. Specifically, the analysis here suggests that scholars should no longer describe regulatory arbitrage as “perfectly legal.” Instead, the persistent gap between the prices of transactions subject to differential regulatory costs warrants a more nuanced approach to the analysis of regulatory arbitrage. With respect to the normative analysis of the efficiency and fairness of the regulatory arbitrage wedge, scholars should consider, among other factors, the intentions and expectations of the decisionmakers engaging in regulatory arbitrage to determine whether they reasonably believe certain transactions should receive favorable regulatory treatment. Scholars should consider the law of two prices when addressing questions related to regulatory arbitrage.

Keywords: regulatory arbitrage, arbitrage, law of one price, derivatives, swaps, shadow banking, bribery, culture

JEL Classification: A12, B30, G10, G14, G28, H26, K10, K12, K22, K23, K34, K42, P37