It’s convenient that so many IFCs are islands, judging by the geopolitical and regulatory waves that continually land on their shores. The constant lapping of pressure from elsewhere can feel never-ending but IFCs have specific capabilities to endure those metaphorical tides.
That those pressures come from all directions and all parts of the globe should be unsurprising. There is a degree of envy of the irreplaceable task that IFCs perform and envy is, sadly, a universal trait. Moreover, so long as investors seeking to pool capital in IFCs come from every corner of the world, one should expect regulatory pressure to come from there too.
Of course, the most successful IFCs have globally-relevant propositions that attract investors from everywhere equally. Few could survive if they catered primarily for a single market. Not only does attracting worldwide investors leave IFCs with more potential clients but also gives clients higher returns due to the potential to co-invest with investors with different risk and liquidity profiles.
Unlike financial centres that cater for domestic markets, the need for international investment makes it particularly attractive for IFCs to adhere to global rules and be seen to adhere to them too. As a result, the most successful IFCs are usually exemplary at meeting those standards and are expert and engaged participants in the international fora at which those standards are discussed.
This confounds the critics that allege a race to the bottom or say that success is linked to bypassing international standards. To the contrary, it is manifestly in IFCs’ interests for there to be clear global standards that are designed impartially, adhered to universally, and assessed fairly. It’s in IFCs’ interests to abide by those standards and implement them exactingly, so those standards being clear and global increases investment certainty and ensures a level playing field.
IFCs Are Collateral Damage
Nonetheless, difficulties can arise when standards adopted unilaterally by major onshore jurisdictions conflict or – as has become increasingly the case – standards are adopted that specifically target IFCs. One example of that is the requirement for substance adopted by the EU and OECD.
It’s a common misconception, but IFCs are not the main targets of the EU’s tax blacklist. They are instead, in some regards, collateral damage in positioning between different institutions within the EU to decide who controls wider tax policy. However, demanding substance requirements in zero or low tax jurisdictions is one way that the intra-EU battle has played out.
Yet their necessary neutrality is one of the reasons that IFCs are so easily targeted, even as collateral. Their unique selling point of certainty and stability is not limited solely to domestic legal and political certainty. It also comes from not being dragged into geopolitical posturing, instead abiding by global standards that evolve steadily and predictably.
However, this neutrality also means that IFCs cannot close themselves off to any markets for anything but the best of reasons, or in advancement of global standards. Otherwise, they will undermine that certainty and openness and damage their own unique selling point. As a result, it’s simply not a credible threat for IFCs to retaliate in anger to global pressures, nor should the industry that relies on neutrality and stability want them to. That guarantee that they will remain cool, calm, and collected is itself a benefit.
This simultaneously offers the neutrality that IFCs need, but also means that foreign governments that want to flex their muscles know they won’t be subject to retaliation, whether withholding taxes or market access denial. The only sanctions that bigger countries will face are the self-harming ones that they impose themselves.
IFCs are not rule-takers, as they have specialised in developing their own sophisticated, investor-friendly legal frameworks that set them apart. But they are standard-takers in the sense that their own unique selling point means they must meet global standards, as they emerge, as an article of faith, and also attempt to comply as best they can with anything their clients’ home jurisdictions require.
It would be a mistake to do anything else, but this nonetheless narrows down the strategic options available to IFCs. It means that adaptability to those circumstances is all-important. To paraphrase Muhammad Ali, if you can’t sting like a bee, you’d better float like a butterfly.
You don’t have to look far to see flexibility and adaptability ingrained in most IFCs’ national and territorial identities. From Bermuda’s national motto of “Whither the fates carry us” to the Manx motto of “However you throw it, it will stand”, it’s right there. BVI even cuts to the chase and just makes its motto one word: “Vigilant”. Well, you’d have to be in a world like this.
That adaptability and dynamism is vital in the face of regulatory threats. It’s only a culture of constant innovation and improvement that can offset ever-accumulating compliance costs or reputational smears.
How small IFCs do that with such constrained resources is really nothing short of a miracle. That doesn’t mean their governments are poorly staffed – in most small IFCs, the financial regulator is one of the largest employers, public or private. Indeed, the British territories’ financial regulators have between 20 and 50 times as many employees per capita as the UK’s own financial regulators do.
But in absolute terms, small centres do not have the raw resources that would ordinarily allow them to stay ahead of countries 1,000 times their size. It requires processes that allow the leveraging of those capacities and a culture of doing so constantly.
In management theory, the skills needed to reinvent and adapt are called dynamic capabilities. Dynamic capabilities are the capacity or culture of an organisation to continually develop and reconfigure their competences to adapt to challenges and opportunities. This concept has become increasingly influential in business management. It nonetheless applies equally to the systems that small IFCs adopt to remain ahead of the game.
These dynamic capabilities should be distinguished from operational capabilities required to maintain any pre-existing market position. Due to regulatory pressures, IFCs have to innovate more quickly than competitors just to stay on the same spot. However, it isn’t a simple matter of dynamic capabilities being better-executed than operational ones but rather that they are fundamentally different.
Dynamic capabilities are based on changing operational capabilities so that the material resource base is stretched further and can pivot to face changing threats and opportunities. They are often based on network effects, marshalling and managing knowledge, and adopting processes that leverage their advantages on a rolling basis. Because of their small absolute size, dynamic capabilities are inherent to IFCs and key to their market position.
There are at least three major ways that IFCs maintain their dynamic capability and adapt constantly to respond to external pressures.
First Mover Advantage
The first is an instinctive commitment to first-mover advantage. Larger countries find it difficult to innovate in regulation or jurisprudence as such innovation directly impacts large bases of consumers.
However, by having legal systems that cater specifically for business-to-business transactions, IFCs don’t just have an initial advantage in market position but a dynamic capability to adapt their specialisations in response to new opportunities, from captives to crypto. The English legal and administrative tradition of flexibility positions territories that follow British lineage in particularly good standing. This gives small IFCs a permanent advantage in adaptation.
The Geography Of Finance
The second is leveraging the advantages of the geography of finance. If they’re sufficiently specialised, even small IFCs benefit from economies of scale. This leads to agglomeration effects of a high concentration of similar experts which itself attracts evermore similarly-specialised professionals and investors.
This has created professional and social networks that increase the spread of innovation within IFCs through spill-over effects. It’s also helped by the large number of multi-jurisdictional professional firms – which is a feature of many IFCs – as they assist the spread of innovation across IFCs facing similar challenges. This creates jurisdictional reputation and trust, such that all market actors in the jurisdiction benefit from the innovation of some. Given the importance of reputation and trust to investor certainty, this is particularly valuable to IFCs.
Private And Public Sector Collaboration
The third key area is a close collaboration between private and public sectors. Successful IFCs each have well-trodden and established paths of policy development. This means that policy is sign-posted to stakeholders and communicated to clients. Importantly, draft regulation is open to early contributions from (and preferably led by) market participants themselves.
The same applies to marketing and strategy. Being smaller jurisdictions focused on financial services leads to market positioning that aims to preserve the financial services’ sector’s long-term interests. This may be in contrast to larger countries, where short-term political interests or the interests of other sectors take the lead.
In these ways, IFCs have maintained and developed dynamic capabilities that allow them to overcome their small sizes and punch well above their weight. That continual reinvention and adaptation is vital, as only ever-evolving dynamic capabilities can overcome the ever-evolving regulatory and reputational threats.
Maintaining these and using the framework of dynamic capabilities to think about how else IFCs can remain nimble will be crucial to ensuring they stay one step ahead. General George Patton said that fixed fortifications were monuments to the stupidity of man, and it’s equally true of IFCs – if they stand still, they’ll drown in the tides.
Oliver Cooper leads on policy in Stikeman Elliott's London office, working on international tax and regulatory matters. Oliver acts as counsel to the IFC Forum, which is the voice of major law firms, corporate service providers, and other investment intermediaries across IFCs. Oliver has acted for a number of governments as well as private clients and financial institutions on matters related to international regulation. He also has extensive experience in public policy and politics in both the UK and the EU.