1.2.1 What Makes a System Resilient? Insights from Ecosystems Theory

Resilience is the ability of recovery to the state of equilibrium that a subject would have depending on the risk management strategy it will employ. Resilience in ecosystems can relate to efficiency, control, constancy, or predictability (coined “engineering resilience”). In such, rather static, ecosystems, because uncertainty is low, the focus is on optimal performance. However, resilience can also relate to persistence, adaptiveness, fungibility, variability, and unpredictability (coined “ecosystem resilience”). In dynamic ecosystems, variability and novelty result in high uncertainty. As the latter form of resilience focuses on the interplay between stabilizing and destabilizing properties of a given system, it appears to be the most useful for developing sustainable social orders.Footnote ⁶

Resilience would emphasize the capacity to absorb stress and reorganize after the occurrence of a disturbance that upsets the equilibrium; thus, it presupposes a phase of growth and accumulation, followed by a phase of reorganization and renewal; a resilient system would survive successfully through these four phases.Footnote ⁷ Perturbations can lead to a critical point (“a tipping point”) of such a disruptive nature that triggers a paradigm shift, thereby creating a new equilibrium, allowing for the continuation of the system. The occurrence of a tipping point is typically evidenced by the delay of recovery or by the fact that a system has become more vulnerable or fragile to small changes, resulting in critical transitions.Footnote ⁸ The transition is nonlinear and the new equilibrium reached is not necessarily better or worse.

Resilience would entail flexibility rather than rigidity and persistence rather than collapse.Footnote ⁹ Overall, it appears that systems are more resilient when they are moderately connected while maintaining high levels of heterogeneity.Footnote ¹⁰ More generally, a system, subject, institution, or idea is resilient when it can weather episodic or gradual change and emerge closely resembling its former state and functionality after a disturbance.Footnote ¹¹ Such a process of demonstrating adaptability may entail the change of resilience strategies without changing the fundamental attributes of a given system.Footnote ¹² This reemergence of a given system into a feasible alternative status would also be efficient from an economic viewpoint.Footnote ¹³

When applying these theoretical insights to private regulation regimes, we observe that a man-made system like a regulatory system can show its resilience by internalizing any succession of regulatory and governance paradigms (growth and accumulation). This can eventually lead to new constructs of alternative governance (reorganization and renewal), provided that the characteristics of the previous regime remain largely intact. Resilient private systems cannot survive without the idea that underlies them being resilient to shocks. Ideas can show resilience through adaptive processes of metamorphosis (old ideas returning in new guises), absorption (of seemingly contradictory ideas), and hybridization (adaptability in different contexts).Footnote ¹⁴ This approach would emphasize the heterogeneous and inclusive nature of ideas that aspire to be (or have been) resilient, as long as a connecting factor, even if only loose and remote, could bring them together. This coalescence can be the result of centripetal forces but many times will result from active inclusion management of a strategic nature.Footnote ¹⁵

1.2.2 The Rise of Private Collective Action to Authority as a Manifestation of Neoliberalism

Much of the governance carried out in the last thirty years has been indirect, delivered via several private rule-making bodies acting as governance intermediaries, be it trade associations; professional bodies; private contractors delivering public services such as transport, health, security, or education; or associations of firms to which the State delegated a given task.Footnote ¹⁶ The retrenchment of the State that fitted the neoliberal ideological framework proved fertile ground for this development, allowing for market-led governance and the gradual introduction of self-correcting processes, eventually leading to a reconfiguration of the role of the State.Footnote ¹⁷

Privatization and deregulation of monopolies and later public authority was the inevitable consequence of the coalescence between the economic and the political. Economics (notably the Chicago School and the Law and Economics movement)Footnote ¹⁸ came to corroborate and justify such a constellation early on by finding that public goods such as regulations can be produced by non-state actorsFootnote ¹⁹ or demonstrating how the use of nonlegal mechanisms such as informal rules and social norms can bring about efficient outcomes in the marketplace.Footnote ²⁰

These developments would pave the way for the ultimate decoupling of the regulatory function from the executive function. Regulation would merely shift “penholders” to become the very responsibility of the regulatees (often experts in a highly technical and complex field).Footnote ²¹ Proponents of market-led governance and self-regulation would advocate that a bottom-up approach to authority is more apposite due to expertise and insider knowledge that only the professionals possess.Footnote ²²

Various resilience-related attributes mentioned above can be identified in the modus operandi of private regulators: malleability, flexibility, and relatively low costs have defined the resilience of private regulators and the ideas they advocate.Footnote ²³ Private bodies can draft and review rules more swiftly and flexibly than any public authority.Footnote ²⁴ Norm-making groups can also adapt more quickly in the wake of exogenous shocks, thereby demonstrating their transformative capacity and mutability traits.Footnote ²⁵ Furthermore, with the proliferation of technological advances that facilitated global exchange of ideas and commercial transactions, new layers of regulation at the national but also the international level would emerge, allowing for the creation of co-regulatory constellations and other types of partnership between the private and the public.Footnote ²⁶

The evolution of private regulation can be attributed to early successes of self-regulatory patterns. In other words, self-regulation is directly associated with the phenomenon of private regulation in that the former established solid foundations for the evolution of the latter. In turn, the very foundation of self-regulation (and, a fortiori, private regulatory power) is the legal principle of private autonomy, going back as early as the Roman times.Footnote ²⁷ Self-regulation entails an explicit or tacit transfer of authority to private bodies, which allows them to delineate a sphere of expertise,Footnote ²⁸ establish conditions for membership, limit competition for the excluded nonmembers (either because they objectively do not qualify or because the incumbents want to maximize their rents), and impose deontological rules of conduct on the regulatees.Footnote ²⁹ Self-regulation further entails monitoring of compliance with such rules and instituting enforcement mechanisms based on the deterring impact of potential exclusion, transforming compliance into a “normative demand.”Footnote ³⁰

Private bodies have been key pillars of contemporary regulatory governance.Footnote ³¹ The emergence of private regulatory regimes has often been the result of a well-functioning, self-contained ecosystem, whereas in other cases it can be enlisted as part of experimental regulatory governance.Footnote ³² In this respect, professional associations are a good example. Certain associations gained immunity from public interference decades or even centuries ago and established normative principles of professional elitism.Footnote ³³ These principles are meant to regulate access and pursuit of a given profession in the public interest: they are set out to ensure high levels of consumer protection and service quality. However, other than protecting public interest objectives, professional associations should also protect the interests of their members. This dual mission may lead to undesirable conflicts of interest.Footnote ³⁴ Additionally, there is always the danger of regulatory capture from within,Footnote ³⁵ as special interests are well-organized and homogeneous.

The concerns described above may become even more serious, as monitoring and harnessing the behavior of private bodies becomes more complex once private regulation of a given economic activity becomes borderless at the transnational level.Footnote ³⁶ An interesting feature of these regimes is that procedural requirements become essential due to their reach and type of addressees, impact, and increased level of regulatory tasks that they have.Footnote ³⁷ Issues of jurisdiction and conflict surface, and, quite interestingly, their complexity nourishes the evolution of transnational regulation, post-national legal authority and private ordering.

Similar concerns apply to co-regulatory constellations. Co-regulation or cooperative regulation in several sectors of the economy is a form of regulation that goes beyond the coercion that State authority can exert. In theory, co-regulatory approaches allow self-regulation, private regulation, and state regulation to come together with a view to optimizing regulatory performance and more efficiently addressing market failures and certain malfunctions.

As a rule, rule-making within such bodies is highly political. Internal politicization can often turn into a battle for internal dominance, which requires an investment of sometimes substantial financial resources and effective representation.Footnote ³⁸ However, toward the external addressees, a persistent problem has been the high level of immunity from liability that private bodies largely enjoy. Immunity for some is the result of theories of corporation and liberalism that have dominated economic activity over the years. In such a framework, liability becomes an abstraction, scattered in the private regulatory sphere.

1.2.3 The European Example of Private Governance

In the history of European economic integration, the involvement of the private sector is well documented.Footnote ³⁹ The contribution of private authority proved a key ingredient of European integration, in line with the neofunctionalist approach that essentially characterized much of the evolution of European rapprochement, as exemplified by the New Approach in mid-1980s, the controversial Lisbon strategy and the better regulation initiative at the beginning of the twenty-first century, but also the more recent Europe 2020 flagship initiative. The accumulated technical expertise in private bodies and the adoption of a less top-down regulatory approach rendered their involvement inevitable. The contribution of the “depoliticization” desire and the spread of non-majoritarian regulatory agencies that characterized European integration was equally important.Footnote ⁴⁰ In this landscape, private regulators have been to date among the most transformative and motivating forces of economic activity in Europe and an essential component of the EU legal order.Footnote ⁴¹

The Court of Justice of the European Union (CJEU) also played an important role in the creation of a neoliberal normative model for the regulation of markets within the EU. Such a model was based on promoting competition and cross-border market liberalization, thereby giving greater leverage to markets to the detriment of States. The Court adopted a rather agnostic approach as to legal forms and regulatory institutions thereby eroding the role of the State as a monopoly supplier of regulation.Footnote ⁴² The next step taken by the Court would be to consider private conduct as a potential trigger of violation of the fundamental freedoms, allowing other private parties to challenge such contact, coined as the infamous “horizontal direct effect” of the fundamental freedoms. This adoption of a functional approach to authority was decisive: while the Court’s stance strengthened the European rule of law, it also legitimized authority that was previously elusive and internal to the private parties at issue.

Enrolling private actors in the regulatory process has then been a manifestation of so-called Europeanization, a term aiming to capture the influence of EU law on national practice but also a method that aims to cater for the lack of accountability and legitimacy of European institutions, as it brings to the fore more participatory forms of governance and rule-making.Footnote ⁴³ However, this process carries with it several risks as noted earlier; identifying and addressing such risks may become less straightforward once the activities by private actors transcend national borders.Footnote ⁴⁴

From European integration to domestic politics to the development of the global economy, technocracy has flourished within the ebb and flow of European politics, thereby shaping, harnessing, and monitoring economic behavior. In recent times, the intermingling of technocracy and politicsFootnote ⁴⁵ may have contributed to the rise of populism and the antiestablishment movement.Footnote ⁴⁶ In Europe and beyond, transnational (that is, increasingly international, but non-State-centered) private standard-setting became the norm in central areas of economic activity, including financial services and manufacturing. It is in these two areas of economic activity in particular that global interdependence increasingly manifests itself.

1.2.4 Resilience and Crises

Exogenous shocks such as financial crises, technological disasters, or a pandemic increase the likelihood of non-incremental institutional change at the global level.Footnote ⁴⁷ Every crisis brings with it urgent calls for a new regulatory paradigm in dealing with a certain area, be it food safety, technology and its use, finance, or accountancy services. Although the global financial crisis of 2008 has thrust policy-making failures into the limelight, such regulatory disasters have been diachronic, albeit with a varying degree of specific configuration, probability (ex ante) and casualties (ex post).Footnote ⁴⁸

The current scholarship appears to suggest that the State (previously a monopoly regulator) has been transformed into the orchestrator of private regulatory activity. In this setting, the State, via soft influence and other voluntary means, enlists the third party (here, a non-State body) through material or ideational support and nudges it toward governance goals that align to the State’s.Footnote ⁴⁹ Such enrollment may be beneficial for both sides: whereas the State economizes on resources, the private body at issue increases its legitimacy as the prime collaborator of the State in a given issue area.Footnote ⁵⁰ Other theories focus on the delegation relationship, suggesting that agency-related challenges shall be resolved by the State as the last resort and ultimate commander; for instance, information asymmetries shall be addressed via transparency-related legislation or disclosure requirements for financial institutions.

If one attempts to apply these theories into practice, it would expect a new era of significant State intervention in case of misuse of delegation or deviation from the pursuit of public policy objectives, thereby upending conventional wisdom about self-regulation and private authority.Footnote ⁵¹ Arguably, the great return of the State has not really happened as of yet.Footnote ⁵²

This reveals the need for more theoretical and empirical work on the mechanics of the transformative, motivating, adaptive, and reinvigorating forces of private economic regulation. We suggest that particular focus shall be given to finance and manufacturing, where striking levels of resilience with obvious consumer welfare implications are particularly discernible. Several scholars have previously pinpointed the various conflicts of interest that permeate private regulation, from credit rating agenciesFootnote ⁵³ to professional associations,Footnote ⁵⁴ label accreditation bodies,Footnote ⁵⁵ and ICT private standard-setters.Footnote ⁵⁶ However, in these two areas, private collective action has dominated the field, taking a largely unchallenged pole position despite crisis events.

In addition, in both issue areas, private regulatory activity was translated into an important degree of constitutionalization (which suggests an effort to increase legitimacy but is also indicative of a higher degree of institutional complexity), although this characteristic did not render it crisis-proof. For these reasons, the two fields identified are significant test-beds for the theoretical background of institutional resilience and the role of crises described above.

In what follows, we briefly identify certain illustrative examples. Our modest intention is to instigate further research in the two important issue areas of private standard-setting through the conceptual lens proposed in this chapter, rather than exhaustively present them and confirm our hypotheses.

1.2.5 The Role of Crises, Regulatory Disasters, and Tipping Points in Challenging Resilience

Exogenous crises (but also internal heated situations such as intra-institutional conflicts or inter-institutional pluralism and ensuing competition)Footnote ⁸⁷ that amount to tipping points are opportunities for organisms and systems to test and demonstrate their resilience. A crisis brings disorder with it: it is a moment of – often severe – mutation that leads to a rapid and intense oscillation of a given process or system. It typically is a moment at the interstices of regularity in that it follows the business-as-usual process and time period. Such a critical moment is expected, depending on its severity, to allow for recovery or the establishment of a new status quo. However, it may lead to disruption and the collapse of the system as well, depending on the system’s resilience and internal dynamics.Footnote ⁸⁸ For the final repercussions of such a critical moment, whether the crisis is endogenous or exogenous is critical. An endogenous critical juncture may follow from an exogenous episode that shakes and raises doubts about the fundamentals, object, and purpose of a given system due to new ideas, revelations about the functioning of the system in a previous period or other new information that calls for a reorientation of the system as a whole.Footnote ⁸⁹

A crisis is not necessarily a moment of decline for a particular system. Crises can be of a varying magnitude, thereby affecting the choice of the moment of intervention against the disturbance. In that case, internal dynamics and past behavior is a significant variable. Organization studies have identified several characteristics and safeguards that institutions may have to ensure the continuation and recovery of a given system in times of uncertainty. For instance, an important feature of such a system would be its intrinsic value for those attached to it. The more established a system is the lower transaction costs will be (e.g., those relating to enforcement of private norms).Footnote ⁹⁰ The possibilities that members have to raise their voice and be part of a potential way out of the crisis is another significant variable.Footnote ⁹¹ Another feature relates to the cultural construction of the institutional preferences in a given system, which may allow taking advantage of an uncertain situation to promote reform and even normative change strategically.Footnote ⁹² Docility of the actors involved and the system as a whole is also an important trait allowing for the continuous fitness of a given system.Footnote ⁹³

Whereas actions, decisions, or omissions of individuals may play a decisive role for a crisis to occur, the organizational context where individuals and systems interact and affect each other is important.Footnote ⁹⁴ Individual responsibility and behavioral bias may be significant in all parts of a failing regulatory chain.Footnote ⁹⁵ However, focusing on individuals alone may lead to drawing only incomplete lessons from a crisis. Often, inadequate training and skills of senior staff; incentive-related challenges that do not align with the goals of the regulatory system at issue; poor leadership and oversight management; and lack of or inefficient internal communication and coordination channels within and among the relevant stakeholders in the system, including in the vertical axis regulator-regulatee, are common causes that lead to regulatory disasters.Footnote ⁹⁶

Regulatory disasters and crises are quite significant in understanding institutional dynamics and resilience-related strategies. Yet events of lower scale can also bring about disruptive changes within institutions in the medium run and therefore are worth examining if we are to describe a more comprehensive picture of the complex private standard-setting ecology in manufacturing and finance. Thus, depending on the institutional and organizational context, certain turning points within organizations are decisive moments to test adaptability and change, including regime interaction and disruptions due to State-driven actions.

1.3.1 The Initial Rise to Authority

The retrenchment of public authority in recent times is inextricably associated with the ideational continuity and appeal of neoliberalism. Free trade, competition, liberalization, and laissez-faire are essential features of a neoliberal dogma, mediated through law,Footnote ⁹⁷ which increasingly limits the powers of the State. The latter may focus on greater social obligations, in line with the ordo-liberal ideas that strive for a strong role of the State in certain areas and otherwise a facilitative function when it comes to market governance. As described earlier, this results in the failure of the State to get a handle on private rule-making bodies, also due to intermittent crises and unpredictable episodes, which keep the public-driven entities busy with remedying the consequences of such events. Arguably, this creates ideal conditions for opportunism by private rule-making bodies. In practice, a crisis event allows private bodies to consolidate their autonomy and move forward with proactive usurpation of regulatory power.

Crises, unfortunate regulatory disasters, and broader institutional changes in a given organizational ecology are the triggering points that empower such private-driven forces or generate new ones, whereas existing checks and balances and a rigid approach toward the enforcement of rule of law fail their initial purpose. Such private-driven forces are virtually uncontrollable vis-à-vis their alleged principals, the States. The initial delegation mandate of powers or the enhanced oversight-related responsibilities that the State may have in theory are not sufficient to reverse such a situation. Potential cooperation with the State is not the outcome of orchestration by the State whereby governmental actors steer interactions to improve regulatory performance. After all, orchestration at the transnational level is difficult and costly;Footnote ⁹⁸ rather, it arguably is yet another expression of a strategy to increase the terrain occupé of private authority. That moment of increasing authority would occur in the wake of intermittent crises when the possibility for opportunism is at its highest, as the State and public-driven entities are in their most vulnerable phase, busy with alleviating the negative impact of such crises.

When delegation of regulatory power backfires, the State takes most of the blame in the public opinionFootnote ⁹⁹ and acts through extreme instruments such as bailouts or the enforcement of import bans. However, in the meantime, a peculiar organizational progeny evolves apace “in the shadow of the State,”Footnote ¹⁰⁰ detached from political constraints, which is difficult for the State (in its capacity as principal) to reverse due to substantial network effects that accompany the creation of new governance structures, coordination challenges among their overseers (principals),Footnote ¹⁰¹ political interferences that call for a light-touch regulatory and supervisory approach,Footnote ¹⁰² or cognitive constraints that the regulators face and that lead them to inferences that are often skewed by systematic information processing biases.Footnote ¹⁰³ The fact that such public regulatory and supervisory authorities enjoy policy and bureaucratic autonomy exacerbates such phenomena,Footnote ¹⁰⁴ as such independence is contained by ideological, operational, and communicative factors.Footnote ¹⁰⁵

We term the underlying phenomenon “free riding of private ordering” and are interested in the evolutionary process that nourishes private authority in finance and manufacturing activities. Arguably, the use of this theoretical construct has sufficient analytical power to cast new light upon the social processes of authority transformation described in this chapter rather than being a mere example of a trend that it seeks to explain.

Free riding refers to an individual or group that benefits from group actions without bearing the corresponding share of the costs incurred by the group or without contributing any efforts or sources to the beneficial group actions. Typically, free riding is discussed in the political theory but also the trade policy literature to explain intrinsic motivations of political or social groups in influencing (trade) policy formulation.Footnote ¹⁰⁶ The pioneering work in this field is by Mancur Olson, who revised the prevailing theory at the time, which would preach the virtues of very large groups, to instead suggest that small group size allows for better coordination and more optimal outcomes.Footnote ¹⁰⁷

The concept of free riding and its features relating to the enjoyment of the benefits of collective action without incurring the costs is particularly appealing for our purposes. We argue that, in the two areas of manufacturing and finance that we study, such free riding has been reactive for the most part. More specifically, it is the result of a process whereby, at the initial stage, private bodies respond favorably to calls for assistance conveyed by the State; these could entail, among others, the creation of hybrid partnerships or engaging in co-regulation.Footnote ¹⁰⁸ One example among many is the private and hybrid European governance fervor that followed the European Commission’s White Paper on Governance in 2001 – itself a reaction to a regulatory disaster at the time.

For our purposes and according to the vernacular we use here, free-riding has occurred in that private bodies benefited from increased legitimacy without however internalizing the costs of, first, acquiring this legitimacy and, second, regulatory disasters with substantial financial consequences for taxpayers. Typically, in such situations, the State will bear virtually all costs associated with this occurrence (a result of moral hazard that agency creates). This free-riding is even more astonishing if one considers that private bodies are also responsible – at least in part – for such catastrophic events.

1.3.2 The Transition to Proactive Free-Riding

As exogenous crises disturb the balance of distribution of authority to public and private actors, it appears that significant power shifts with potentially long-standing effects take place. We submit that, in recent times, we witness a transition from a phase of reactive free-riding, that is, a process where private bodies were offered authority by the State, toward a phase where private bodies actively seek and claim authority by a worn-out State that is occupied with addressing the effects of a crisis within the society. We argue that proactive free-riding has become a growing empirical phenomenon, which emerges out of several decades of bounded rationality, untested theories of uncontested technical superiority, the ideational flexibility of neoliberal rhetoric, and an increasingly globalized – and stateless – economic activity that domestic laws fail to regulate due to their non-extraterritorial application.

Proactive free riding is VEA’s very manifestation at the transnational level. The success of proactive free riding derives from the core rule-making activities that such private bodies undertake, notably the continuous promulgation of voluntary standards that are promptly prepared, adopted, and diffused to preempt rules by public rule-making competitors and thus ensure increased authority and continuous dominance.Footnote ¹⁰⁹ Paradoxically enough, this phenomenon is particularly manifested and appears to grow stronger in the wake of regulatory failures and even disasters that raise doubts against the adequacy of the regulatory philosophy in a given field and the aptitude and fitness for purpose of private authority.Footnote ¹¹⁰ Against all odds, reclaiming authority in that material time comes at a relatively low cost.

More and more, private bodies take advantage of the procrastination of the State, grow stronger, and create norms more assertively in a strategic manner, overriding and even substituting for State powers. Regulatory disasters leave them intact. Rather, such crises constitute opportunities to accumulate wisdom and develop the capacity to expect the unexpected, absorb it, and grow.Footnote ¹¹¹ Absent organizational hierarchies, formal accountability structures, scrutiny, pressure, and obligation, private bodies enhance their collective memory and identity and eventually use a critical shock to become grow stronger.Footnote ¹¹²

Proactive free riding results from a lengthy process of volatility and shifting authority in complex regulatory areas where complex adaptive organizations are present. Private power accumulation is a continuous process that starts with the delegation (explicit or tacit) of power and thus the transfer of legitimacy to a private body. Thereon, through rule-making and intensive drafting of standards, the private body accumulates knowledge and builds trust toward its addressees as a reliable interlocutor.

Crucially, whereas the values and objectives of a complex adaptive system of this type are aligned, the characteristics and motivations of the group as a whole are not necessarily homogenous. Rather than this being an inhibitory factor, heterogeneity allows a particular group to overcome distress and adversity, thereby enhancing its resilience. In line with the discussion above relating to and the lessons drawn by the study of resilience of ecosystems,Footnote ¹¹³ diversity and heterogeneity are important traits for any group that aspires to harness its complexity for its benefit and establish solid foundations for exercising such authority over the long run.Footnote ¹¹⁴ Such traits appear to equip a given group with sufficient flexibility to be shielded from internal challenges of due process and balance of interests and external attacks of arbitrariness and lack of legitimacy.Footnote ¹¹⁵

In a given turning moment, the critical transition occurs: the private rule-making body overrides State power and reigns over a regulatory field, thereby slowly creating a new hierarchy; in other words, a different equilibrium and stable state of authority in a system.Footnote ¹¹⁶

Much of proactive free riding is detached from any particular territory. Such free riding is led by powerful transnational elites that reinforce their independent norm-creating authority and expand the group of these norms’ addressees,Footnote ¹¹⁷ gradually moving into the creation of legal authority and the production of authoritative collective action. In this emerging constellation, the State and the private bodies are no longer complements but rather substitutes (Figure 1.1).

Figure 1.1. The evolution of free riding on authority

How can one explain the mismatch between the expectations vis-à-vis public supervisory authorities and their lack of action? First, as we argued earlier, it appears that path dependencies and the irreversibility of delegation weakens their leverage. Supervisory authorities often make irrational decisions and adopt similarly irrational processes in their supervisory tasks. Additionally, cognitive biases developed during the interaction with the regulatee negatively affect the enforcement of existing laws and the appetite for decisive and timely action.Footnote ¹¹⁸ It has been argued that such inaction may be the result of cultural capture, that is, the interaction of supervisors with interest groups that increases industry influence through certain mechanisms.Footnote ¹¹⁹ Second, on the brink of a crisis, regulators and supervisors are occupied with reflecting on how to address and lessen the effects of the crisis. Eventually, stricter regulations that follow are frivolously enforced or the regulators have recourse to cosmetic changes, a type of indulgent regulation that allows for the maintenance of a system that turns random disruptive advantage to lasting advantage for private bodies.Footnote ¹²⁰

2.1.1 Beyond State-Centrism: The Dialectic of Globalization and Fragmentation

A range of diverse governance processes are increasingly integrated into complex, heterogenous ways to other interactive, overlapping, and/or competing processes and institutions – what we elsewhere call “heterarchy.”Footnote ⁹ Furthermore, globalization itself is all too often perceived to be a structurally homogenizing process, requiring new forms of intergovernmental cooperation or global governance. Dimensions of homogenization are said to include economic globalization, the ideological hegemony of neoliberalism,Footnote ¹⁰ socio-cultural convergence, technological innovation and change, liberal internationalism and global governance, and the emergence of a particular kind of so-called flat world.Footnote ¹¹ Normative calls for a world state follow this logic – so-called global governance.

Therefore, in a world that is increasingly characterized by complex interdependence, states, domestic political systems, and public policymaking are vulnerable to cross-cutting and intersecting independent variables they cannot control. In the structural environment of the third (and/or fourth) industrial revolution(s),Footnote ¹² and the complex forces undermining neoliberal globalization and the state, whether ideological, social, or material, there is also a trend toward developing diverse forms of neoliberalism from the quasi-democratic to the authoritarian.Footnote ¹³

This structural transformation revolves around the interaction of fundamental technological transformations and the interrelationships of business and politics in an ever-evolving dialectic of globalization and fragmentation.Footnote ¹⁴ These transformations involve a wide range of economic processes that include information and communications technologies (ICT), new forms of research and development (R&D), the shift of investment from expensive and hierarchical production processes to profit-making through distribution and the embedding of a consumer culture, artificial intelligence, digitalization, the advent of Big Data, the increasing use of algorithms,Footnote ¹⁵ robotics, the growing vulnerability of labor processes and their replacement by flexibilization of diverse kinds,Footnote ¹⁶ and the transformation of finance to “financial alchemy,” including increasing dependence on debt and leverage or credit. The businesses that adapt successfully to these changes are crucial in shaping the relations between business and the “reactive state.”

Political agency is therefore no longer defined by interest groups seeking out the levers of state power, because these levers are seen to be largely impotent or politically suspect.Footnote ¹⁷ Related to this turn from the state is “deterritorialization” or the “poverty of territorialism.”Footnote ¹⁸ Structural homogeneity between state and society in specific geographical/territorial locations, crucial to the unitary coherence of the nation-state, is being undermined by cross-border linkages.Footnote ¹⁹ In particular, the kind of strong, secure borders that are supposed to characterize the sovereign nation-state are becoming impossibly porous and in many cases more analogous to fluid, premodern “frontiers.”Footnote ²⁰ The increasing complexity of this system raises questions about whether this complexity will lead to endemic conflict or a “durable disorder” in which key actors are engaged in various forms of “brokerage” to smooth over the underlying dysfunctionality of the system.

One way to conceptualize these processes is thinking of them in terms of the kind of ongoing process that Rosenau calls “fragmegration”Footnote ²¹ – the dialectic of globalization and fragmentation in a “postinternationalist” world. The European Union, for example, is in continual structural quasi-crisis, trying to deal centrally with plural tensions between the local and the transnational dimensions. Indeed, the United States has always been characterized by internal socioeconomic division.Footnote ²² Furthermore, austerity and the erosion of the rights of labor are undermining the mid-twentieth-century social contract on which the welfare state and liberal democracy have been based.Footnote ²³ Political leaders in unstable states are either engaged in attempting to restore authoritarian repression, as in Russia, China, Egypt, and Turkey, or are ensnared in the breakdown of the political system, as in Brazil, Venezuela, and a range of African countries, leading the emergence of quasi-authoritarian populism, including what has been called “personalist autocracy.”Footnote ²⁴

Rationalities of marginal utility have transformed statehood itself into a marketizing, commodifying processFootnote ²⁵. Furthermore, the state has itself become a promoter of financialization rather than welfare or social democracy, prompting the financialization of society itself – replacing decommodifying welfare and public services through austerity and undermining the potential for what has been called the “entrepreneurial state” concerned with providing public goods.Footnote ²⁶ Nevertheless, the state continues to be the primary provider of welfare programs, and finance cannot do without it either, for a host of public goods rely on finance for credit.

Actors develop and maintain particular institutions and structures over time. Society and polity shape our interactions through people and material processes that connect them.Footnote ²⁷ They take place through our interactions with the computers, logistics, and groups of people “next” to us in an increasingly intangible world of “capitalism without capital.”Footnote ²⁸ The process is itself nonlinear and causally complex.Footnote ²⁹ For example, actors and political processes can only react to price changes that are independently produced by market and institutional transactions, many of which are increasingly automated, and certain sectors like communications and social media require further regulation. What governance levels would be necessary for such regulation? Would it be effective? The United States and the European Union are dealing with this question through different and contrasting approaches, with the European Union paradoxically taking a more comprehensive and centralized approach with one main regulator, whereas the United States has maintained its divided regulatory system among a range of sectorally specific regulatory bodies.

Furthermore, actors’ social positioning shapes their range of possible responses to material processes in multi-nodal fashionFootnote ³⁰. For example, information and communications technologies that circle the globe also create the potential for backlashes of diverse kinds as awareness of global-level problems, inequalities, and instabilities spreads through our everyday practices. Indeed, business actors are sometimes not only captured by preexisting state-based structures and practices but paradoxically also see them as valid reactions to globalization and transnationalization – what Bohas and Morley call an “anomic mindset.”Footnote ³¹ The dialectic of globalization and fragmentation thus decenters the state itself by placing it alongside and competing with other social and economic groups and organizations – rather than above the social and below the international.Footnote ³² Strategic actors are able to mobilize resources, ideologies and mindsets, and knowledge to take advantage of the constraints and opportunities and to pursue their interests. This has led to the consolidation of a range of “extra-state authorities”Footnote ³³ and regime complexes across a range of institutions and processes including “low-capacity states,” fragmented global governance and oligopolistic, sectorally differentiated quasi-corporatist policymaking and regulatory and policy implementation processes.

These embed the “privileged position of business”Footnote ³⁴ and transnationally powerful interest groups, including intangible sectors such as ICT,Footnote ³⁵ banking, and finance, etc., as well as transnational corporations, supply chains, and other linkages transcending and undermining state territorial and economic boundaries. States themselves have sought to benefit from these transformations by sponsoring the competitiveness of domestically located firms, leading to transnational oligopolization and rent-seeking.Footnote ³⁶ Paradoxically, the state is not shrinking in size, but the “macro-state” is less and less structurally dominant and bureaucratically effective in the face of these meso-state, micro-state, and trans-state apparatuses.

Crucial in this restructuration process are a range of private sector–dominated regulatory agencies. For example, in the derivatives market – the “world’s biggest market” – regulation is provided by such bodies as the International Swaps and Derivatives Association (ISDA), central counterparties (CCPs), trade repositories (TRs), and other bodies dominated by “dealer banks” (the G16), which do not constrain speculative trading, ignoring “calls for bans on derivatives products that were particularly associated with destabilizing speculative trading such as ‘unattached’ (or ‘naked’) CDS contracts [credit default swaps] in which the purchaser does not hold the underlying bond to which the contract is linked.”Footnote ³⁷ In other words, the only form of regulation that it is possible to institutionalize is dominated by private sector firms and actors. Recent history suggests that the development of an effective global governance structure as a way to reorganize world politics is increasingly unlikely, even moving in the opposite direction.Footnote ³⁸ Biermann et al.Footnote ³⁹ refer to the “fragmentation of global governance architectures” as the dominant trend in the twenty-first century.

In this context, the globalization/fragmentation dialectic opens up those processes to precisely the kind of special interests that have been identified in the long-standing critical domestic interest group, elitist, corporatist, and neopluralist literature of the twentieth centuryFootnote ⁴⁰. And the proliferating literature on multinational corporations and transnational production chains, the advances of information and communications technologies, and, in particular, the power of quasi-globalized financial markets and institutionsFootnote ⁴¹ demonstrates that global governance itself can be even more vulnerable to whipsawing, bypassing, capture and manipulation, even corruption, than the traditional domestic public policy sphere. LindblomFootnote ⁴² refers to this as “the privileged position of business”.

At the core of these processes, furthermore, is the hybridization of the public and the private. Key actors – the more powerful economic interest groups, state actors in particular issue areas, certain NGOs, etc. – have differing and sometimes conflicting interests. In this heterarchical political process, actors depend upon the capacities of real-world, cross-cutting “interest” groups – including both “sectional” (or “material interest”) and “value” groups,Footnote ⁴³ civil society groups, NGOs, and social movements – to manipulate constraints, to identify and take advantage of opportunities, and to shape new directions through processes of competition, coalition-building, “forum shopping,” or “venue shopping” and the like. What is new, however, are the rapidly evolving transnational linkages among groups in a growing range of overlapping transnational webs of power. The most important movers and shakers are no longer simply domestic political forces, institutions, and processes but transnationalizing ones: whether in terms of economic interdependence; social interconnections, migration, the movement of people, and transnational awareness through world communications and social media; relationships of violence and force (including terrorism); “transgovernmental networks” cutting across governments themselves; problem-solving “epistemic communities”;Footnote ⁴⁴ technological change from the Internet to a growing variety of human activities; ideological conflict and competition; and a whole range of other deep trends.

Governance itself is therefore being transformed into a “polycentric” or “multinucleated” global political system operating within the same geographical space – and/or overlapping spaces – in ways analogous to the emergence of coexisting and overlapping functional authorities in metropolitan areas and subnational regions.Footnote ⁴⁵ In the economic sphere, post-Fordist forms of production based on flexibilization have transformed “techniques of industry,” labor markets, finance, and the like, thus leading to a “capitalism without capital.”Footnote ⁴⁶ The particular shape a transformed international system is likely to take will be determined primarily by whether particular sets of groupsFootnote ⁴⁷ that are able to exploit the structural resources or political opportunity structures available to them take advantage most effectively in a period of structural flux.

Key sets of groups that have in the past been closely bound up with the territorial nation-state and state actors themselves are increasingly captured instead by transnational sectors. These actors do not merely set state agencies and international regimes against each other – a process sometimes called “venue shopping,” “forum shopping,” or “regulatory arbitrage.”Footnote ⁴⁸ They also cause them to try to network in an increasingly dense fashion with their peers in other states and simultaneously instill them and their transnational private/public links in state elites too. Among the major losers are trade unions and other groups with few transnational linkages and less clout in an intangible economy where labor has become more “flexible” and, indeed, “commodified,” although they are sometimes still in a position to obtain compensatory side payments from national governments.

Operating in such a changing world is leading to new problems of management and control, what Lake has called “the privatization of governance”Footnote ⁴⁹ and others have identified as the emergence of “private authority” in international affairs. Private actors decide the rules of their conduct and act to ensure order in the markets, facilitate trade, and protect private property.Footnote ⁵⁰ Institutions and formal processes of global governance do not have the direct sanctioning power that has been at the core of state development in the modern era – especially in the form of Weber’s “monopoly of legitimate violence.” In the meantime, the sovereignty of states is only partially and unevenly pooled through the development of intergovernmental institutions and processes – what authors often refer to as the concept of “soft law.”Footnote ⁵¹

Significant issue areas, including accountancy, auditing, and corporate governance, have witnessed ongoing negotiation processes among firms; private sector organizations representing particular industrial, financial, and commercial sectors; as well as governments and international regimes, in order to reconcile conflicting standards and move toward a more level playing field. Also, decision-making processes related to many significant issues moved from elective arenas to places presented as politically neutral with the consequence of a loss of political character of such issues and the annihilation of divergences and conflicts within the field of political actions.Footnote ⁵² Consequently, it is becoming more and more difficult to organize politically effective resistance to globalization as such, especially in the more developed capitalist states, although recent examples of the growth of populism on both right and left has been at the forefront of recent politics.

Furthermore, in an era where states compete to attract foreign direct investment, transnational corporations can make strategic actions independently of the interests of the countries in which they operate. Also, they have an increasing role in law-making processes that they exercise through lobbying activities. Often, they turn to practices of self-regulation, private governance, risk management, and alternative dispute resolution.Footnote ⁵³ Their resources come from private sources – even if governments very often support transnational corporations (TNCs) through public investments and favorable tax conditionsFootnote ⁵⁴ – and are used to earn profits for a restricted circle of actors that in most cases are involved in private decision-making processes. At the same time, transnational financial agencies operate in several economic-financial fields, including the insurance, accountancy, and risk management sector, affecting the allocation of resources between social groups, national economies, and commercial enterprises.Footnote ⁵⁵ Indeed, they assume an institutional role consisting in ensuring trust among participants in economic-financial transactionsFootnote ⁵⁶.

2.1.2 Sectoral Differentiation

In this context, different sectors at different levels and organizational structures play differentially powerful roles in this process. Analysts including Gordon,Footnote ⁵⁷ Piketty,Footnote ⁵⁸ and StiglitzFootnote ⁵⁹ have argued that the third and fourth industrial revolutions have reduced the profitability of the real economy, leaving capitalists fewer alternatives to financial manipulation to gain income and wealth compared to the second industrial revolution era,Footnote ⁶⁰ leading to growing inequality and economic instability.Footnote ⁶¹ This process, combined with the increased capacity of transnationally linked financial special interests and pressure groups to lobby and capture state and international policymaking agencies and processes, leads to an uneven heterarchy of the kind we have elsewhere labeled “transnational neopluralism.”Footnote ⁶² Also, this process includes reorganizing political institutions, realigning political forces and coalitions, reforming policy processes, and restructuring ideological space, thus reinventing the social dimension of politics through new policy and coalition “spaces” populated by a wide range of new and old political actors in both the developed and developing worlds.

These new political processes are therefore differentiated more by sector and issue area than by physical, geographical, or territorial space. They involve a combination of vertical, horizontal, and diagonal restructuring of institutions and policy domains. In purely economic terms, this means that firms with extensive specific assets are more efficiently organized through quasi-monopolistic, hierarchical governance structures.Footnote ⁶³ The key dimension here concerns the configuration of interests, characteristic of the industry, or activity concerned. There are essentially two aspects of this dimension: the mobility of physical capital and cross-border price sensitivity.

In firms and sectors that are highly integrated or linked into such structures and processes, especially where there is a “world market price” for a good or asset that determines local prices, lobbying pressure from firms in that sector and from industry organizations is likely to be organized through flexible “pentangles” (coalitions that include transnational actors from outside the national “container” and which operate at the transnational level to influence global governance processes) rather than simpler iron triangles.Footnote ⁶⁴ The politics of key issue areas like financial regulation can play a catalytic role in reshaping global economics and politics as a whole, imposing their particular market and policy structures on other sectors and issue areas too.

2.1.3 Finance and Politics in the Twenty-First Century

Finance plays a unique role in the processes outlined above, and financialization is a key independent variable in the structuration of business-politics relations over the past half century. Unlike the “real economy”, finance is the ultimate intangible sector, because it links and shapes all the others. On the one hand, economic and social progress have required the development of finance and money to grow. In this sense, finance and politics can be seen to be mutually interdependent, with effective policymaking requiring support for the development and institutionalization of finance in order to pursue wider social and political goals and to develop systemically relevant structures and processes, both macroeconomic and microeconomic. Without finance, whether private or public, there would be no economic development. On the other hand, however, the creation of financial instruments and the evolution of financial markets in a range of circumstances can permit finance to become autonomous from the real economy and to develop a dynamic of its own.

However, the contemporary evolution of finance and money since the middle to late twentieth century is unique in history. We will examine three distinct but inextricably intertwined trends and variables that are shaping the relationship of politics and finance today. Together they are making finance more independent, opaque, and disconnected from the real economy than ever.

The first of these structural trends is the restructuring of the world political economy around the transnationalization of special financial interests. The second is the structuration of the financial sector itself through the development of a range of complex financial instruments, especially securitization and derivatives, which disconnect finance from the real economy and therefore from political and social objectives. The third trend involves the wider political context and impact of government and transnational regulation of finance.

This leads to various attempts by the “reactive state” and overlapping and competing transnational “regime complexes” to manage the workings of the financial system in ways that support that system and its market mechanisms. These attempts not only led to the Global Financial Crisis (GFC) of 2007–2008 but also have continued in its aftermath.Footnote ⁶⁵ In this context, we will consider a range of crucial social and political consequences of what has been called “financialization.”Footnote ⁶⁶ The evolution of the world political economy is widely seen as increasingly problematic and dysfunctional as a result.Footnote ⁶⁷ The role of finance in the world economy has been evolving in the general direction of financialization since the 1950s.Footnote ⁶⁸ There have been several factors driving this process:

• growing trade and pressures on the international system to reallocate capital across borders as a result, with the postwar financial system becoming more flexible and extensive;

• domestic budgetary and other pressures on the postwar welfare state, leading to policies of budgetary belt-tightening and to neoliberal economic policies across various levels and sectors;

• leveraging – of the role of debt – in both the domestic and the international financial systems, including the ideology of “financial inclusion”;

• and the predominance of new financial instruments and institutions like securitization and “shadow banking,” which will be examined more closely in Section 2.1.4.

In the post–World War II period, the internationalization of banks and the increasing flow of financial assets across borders led to pressures for significant structural changes in the international financial system. Most writers focus on the emergence of the Eurodollar market in the 1950s and 1960s, in which a combination of international pressures and the role of domestic institutions – originally involving the Midland Bank in the United Kingdom – led to increasing regulatory tolerance for American financial assets, especially those obtained outside the United States, to be deposited in the United Kingdom, outside the scope of US regulations. This process encouraged and reinforced increasing cross-border financial flows in general, augmented politically as well as financially by the tradition of sterling as an international currency and the historical role of the City of London as an international financial center. In this context, financial firms and institutions developed strategies consistent with the wider process of globalization. Indeed, transnational finance has often been identified as the key independent variable driving globalization.Footnote ⁶⁹

Furthermore, one of the approaches that several important authors have taken is to apply the theories of Hyman Minsky.Footnote ⁷⁰ He argued that financial crises are endemic in capitalism because periods of economic prosperity encouraged borrowers and lenders to be progressively reckless. This excess optimism creates financial bubbles and the later busts. Therefore, capitalism is prone to move from periods of financial stability to instability. This is a type of market failure and needs government regulation. It is the flexibility, complexity, and opacity of finance that gives it its strength and significance in controlling and coping with political and bureaucratic processes such as regulation and, in particular, crisis management, especially in the context of the “Great Recession” of the mid and late 2000s.

2.1.4 The Development of Financial Instruments and Institutions

As financial flows expanded in the postwar period and virtually exploded in the 1980s and 1990s and since, financial firms and actors sought to devise new ways of trading on increasingly complex financial markets, moving away from traditional trading processes and structures including established stock and securities markets. This trend required several developments in the nature of the tradable instruments. The first was flexibility – the ability to trade an increasing range of instruments in a growing array institutional and noninstitutional public and private markets and informal quasi-market networks. The second involved the “tradability” of those instruments, namely their widespread acceptance and use in an interconnected range of settings from the local to the global. The third involved widening the range of financial market actors, from financial firms themselves to households and individuals, which has been called “financial inclusion” or “the financialization of daily life.”Footnote ⁷¹ The fourth has been the restructuring of the overarching financial industry itself into fewer and fewer “SIFIs” – systemically important financial institutions, both controlling the overall process and strengthening special relationships with regulators.Footnote ⁷² The fifth required the extremely rapid expansion of leverage to finance these developments, rather than redistributing profits or assets from the real economy.Footnote ⁷³ The sixth has been the doctrine of “shareholder value” capitalism, in which the first priority of all firms is the making of profits that are transferred to shareholders rather than reinvested in a real economy firm’s production and exchange processes that include labor and other “stakeholders.”Footnote ⁷⁴ The final development, probably the most controversial, has been said to be the consolidation of a new form of rentier capitalism, in which profits are skimmed off by financial elites, impeding rather than enabling growth in the wider economy and leading to increasing inequality.Footnote ⁷⁵ This final trend is also sometimes said to enable and entrench illegal activities and the rigging of economic and financial outcomes, what Veblen called “sabotage.”Footnote ⁷⁶ As the result of this set of developments, Sawyer argues that the twenty-first-century financial system is “dysfunctional.”Footnote ⁷⁷

The financial instruments at the core of the process are not technically new but have been dramatically expanded in the context described above. They mainly involve “securitization” and “derivatives.” Traditional banks, both commercial and investment, operated on the basis of what has been called “originate-to-hold.” In both cases, those banks keep the financial instruments they deal with on their books. In contrast, what have been called “non-bank” financial firms and institutions restructure and sell the instruments they originally “own” in a range of formal and informal financial markets. They transform them into new kinds of securities in a process known as “securitization” and the value of those securities comes from the prices they attract as well as their salability in various formal and informal markets.Footnote ⁷⁸ Derivatives, in turn, are securities the value of which does not derive from the original securities themselves but from their being based on the market value of these securities themselves when bought and sold. They are, in effect, insurance policies on the prices and market value of the securities from which they are “derived.”Footnote ⁷⁹

Securitization is a complex process in which the original securities themselves are “sliced and diced” into “tranches,” namely segments created from a pool of securities that are divvied up by risk, time to maturity, or other characteristics in order to be marketable to different investors. Each tranche of a securitized or structured product is one of several related securities offered at the same time but with varying risks, rewards, and maturities to appeal to a diverse range of investors. Different tranches will have different credit ratings, appealing to different buyers with senior tranches for the highest and safest credit ratings, junior tranches for the riskiest ratings, and mezzanine tranches for a generally small intermediate category. Typical investors of senior tranches tend to be conduits, insurance companies, pension funds, and other risk-averse investors. Junior tranches are more risky investments because they are not secured by specific assets. The natural buyers of these securities tend to be hedge funds and other investors seeking higher risk/return profiles.

Tranches allow for the “ability to create one or more classes of securities whose rating is higher than the average rating of the underlying collateral asset pool or to generate rated securities from a pool of unrated assets.”Footnote ⁸⁰ This is accomplished through the use of credit support specified within the transaction structure to create securities with different risk-return profiles. The equity/first-loss or junior tranche absorbs initial losses, followed by the mezzanine tranches, which absorb some additional losses, again followed by more senior tranches. Thus, due to the credit support resulting from tranching, “the most senior claims are expected to be insulated – except in particularly adverse circumstances – from default risk of the underlying asset pool through the absorption of losses by the more junior claims.”Footnote ⁸¹ Some tranches are sold and traded separately and some as parts of single, combined securities.

Virtually the whole political economy literature on securitization and derivatives discusses their complexity, opacity, and disconnectedness from the real economy. However, in the context of the free market, neoliberal and deregulatory ideology of national governments, and transnational regime complexesFootnote ⁸², such financial instruments and processes are still treated lightly and warily by both policymakers and regulators. A crucial part of these developments is the transformation of the financial institutional infrastructure itself. Increasingly important over time is the restructuring in recent years of banking and other financial institutions and markets and the macrofinancial and microfinancial structural shifts involved, adapting ways of doing things from the “shadow” sector in order to compete.

The highly institutionalized commercial and investment banks described above have historically been the core of traditional financial systems and until recently have been highly regulated and insured by governments in order to underpin the stability of the system as a whole. This was particularly true of the US Emergency Banking Act of 1933, which divided up commercial and investment banking and administered them separately. In particular, the act set up the Federal Deposit Insurance Corporation to underpin the commercial banking sector, insuring deposits originally of $2,500, increased over the years to six deposits in different accounts of $250,000, for a total of $1,500,000 in 2011. While these banks are still propped up by the US Government, they have increasingly had to compete with what PIMCO (Pacific Investment Management Company) executive director Paul McCulley at a FED (Federal Reserve System) annual meeting in 2007 called “shadow banks.”

Nesvetailova provides a useful definition of the difference:

In other words, shadow banks have not only used securitization and derivatives to make greater profits than is available in traditional banking but indeed have triggered a system-wide change in the nature of finance. The authors cited in this chapter and many others have noted that the way shadow banks have done business over recent decades has forced the reconstruction of traditional banks too. In order to compete, other institutions have to jump on the bandwagon because that’s where the money increasingly goes, creating “long and opaque chains of credit intermediation.”Footnote ⁸⁴

This is particularly true of what are called “universal banks,” which originate consumer and corporate loans, package loans into asset-backed securities (one of the major dimensions of the securitization process) and what are called “collateralized debt obligations” (CDOs), create over-the-counter (OTC) derivatives whose value are derived from loans, and distribute the resulting securities and other financial instruments to investors. Furthermore, complex financial institutions have used the OTC strategy to maximize their fee income to reduce their capital charges and to transfer the risks associated with securitized loans to investors. Other structural shifts include the setting up of Special Purpose Vehicles (SPVs), Structured Investment Vehicles (SIVS), and other nonregulated, quasi-independent institutions in which to park, especially less profitable or endangered securities the markets for which have slowed or shut down. Regulated banks in effect become shadow banks because they had to restructure and become opaquer and complex in order to compete.Footnote ⁸⁵

A major consequence of rise and dominance of shadow banking therefore concerns the shift of investing from cash and investment in the real economy to the circulation of the purely financial instruments described above. For example, pension funds have grown dramatically as the result of the shift from defined benefit to defined contribution pensions (the result of the declining power of labor unions in the real economy), along with money market mutual funds (MMMFs), hedge funds, etc.Footnote ⁸⁶ Thus, there are two tendencies: the accelerating pace of financial innovation and the capture of monopoly-like rents through “‘shrouding,’ or embracing complexity.”Footnote ⁸⁷ In other words, growing demand for profitable investment increasingly creates more and more supply because of and facilitated by the abstract nature of finance itself.Footnote ⁸⁸

The future of governance of the financial system has not been resolved and some argue the concerns may be growing and intensifying as regulatory stopgaps unravel. All national governments and regional organizations such as the European Union have considered and even attempted to implement a range of regulatory changes in the financial sector, and all of these have been critically scrutinized and found wanting. Furthermore, the Dodd-Frank Act of 2010 in the United States has been seen as in some ways counterproductive because of (a) maintaining competing regulatory bodies (in the United States) that have different approaches, (b) leaving actual regulation-making to these bodies in the future, resulting in partiality and whipsawing, (c) insufficient transnational convergence,Footnote ⁸⁹ and (d) limitations on the capacity of the Financial Stability Oversight Council (FSOC) to create policy consistency. Indeed, The Trump Administration engineered a partial rollback of Dodd-Frank in 2018, the Economic Growth, Regulatory Relief, and Consumer Protection Act. Finance is the hegemonic sector in the structural transformation of the simultaneously globalizing and fragmenting intangible economy.

3.2.1 China’s Choice for the ITU

The ITU is one of the oldest global regulatory agencies.Footnote ⁴ Originally founded as the International Telegraph Union in 1865 to promote cooperation among international telegraphy networks, the ITU has contributed for more than 150 years to the connectivity, interoperability, and standardization of telecommunications, from the use of the Morse code to satellite communications. As a UN specialized agency since 1947, it has evolved into a unique platform for global public–private partnerships and has firmly embraced the corporate sector and other stakeholders, proudly announcing on its website that its “global membership includes 193 Member States as well as some 900 corporations, universities, and international and regional organizations.”Footnote ⁵ More accurately, there are two types of members: 193 Member States and the 900 “Sector Members.” Since 1994, Sector Members are allowed to formally participate in the decision-making processes of the ITU and since 1998 they are recognized as having formal rights of participation under the ITU Constitution.Footnote ⁶ The ITU has three sectors: Radiocommunication (ITU-R), Telecommunication Standardization (ITU-T), and Telecommunication Development (ITU-D). Corporations or organizations may become a member of one or more sectors and may join as a Sector Member or Associate.Footnote ⁷ Importantly, much of the regulatory dynamics in the ITU starts in “Study Groups,” which are renewed every four years. Each of these Study Groups, in which “thousands of experts representing government, industry and academia” participate, is responsible for progressing ITU work in a specific field of the ITU’s mandate; they develop the technical basis for ITU agreements, standards, and reports. The mandates and leadership teams of each Sector’s Study Groups are decided by the Sector’s respective governing bodies, that is, the Radiocommunication Assembly (RA), the World Telecommunication Standardization Assembly (WTSA), and the World Telecommunication Development Conference (WTDC).Footnote ⁸ It has been observed by members of delegations to the ITU that ITU standards – which typically take around two years to be developed – “are increasingly written by companies, rather than governments”.Footnote ⁹

It is in this context that China has displayed a remarkable drive to shape international standards, reflecting “long-standing concerns that Chinese representatives were not at the table to help set the rules of the game for the global Internet.”Footnote ¹⁰ The country is known for sending the largest delegation to the ITU’s Study Groups, including Huawei and other state-owned enterprises. Huawei itself is said to have introduced some 2,000 new standard proposals to ITU Study Groups on topics such as 5G, cybersecurity, and artificial intelligence.Footnote ¹¹ More in particular, since the autumn of 2019, through quite a number of its technology corporations, China has been pushing two initiatives in the ITU: (i) a new standard for facial recognition and (ii) a new Internet Protocol (“New IP”). It was the Financial Times that disclosed on December 1, 2019, that a battle was looming within the ITU regarding the shaping of facial recognition standards.Footnote ¹² The newspaper reported that

Another Financial Times article, of March 2020, discusses China’s attempts since September 2019 to convince ITU delegates of the need to construct an alternative form of the Internet. It explains why the ITU has been chosen for these two initiatives. As a global organization of 193 Member States and one of the oldest specialized agencies of the UN, it is seen as the de facto standards body for telecoms networks:

It is said that African states in particular tend to follow ITU standards as they do not have the resources to develop standards themselves.Footnote ¹⁴ Moreover, such standards “are commonly adopted as policy by developing nations in Africa, the Middle East and Asia, where the Chinese government has agreed to supply infrastructure and surveillance tech under its ‘Belt and Road Initiative’” (BRI).Footnote ¹⁵ Chinese corporations – particularly Huawei, Hikvision, Dahua, and ZTE – supply AI surveillance technology in sixty-three countries, thirty-six of which have signed up to the BRI.Footnote ¹⁶ It is also known that Chinese corporations are supplying surveillance infrastructure to countries in Africa, including Angola, South Africa, Uganda, and Zimbabwe.Footnote ¹⁷ It has been observed that

While it is often thought that standard-setting organizations like the ITU, the International Organization for Standardization (ISO), or the Electrotechnical Commission (IEC) operate on a mere technical basis with a view to reaching worldwide interoperability, it has been highlighted that their decision-making processes are more political than expected.Footnote ¹⁹ It is clear that the Chinese government – notably through the upcoming China Standards 2035 strategyFootnote ²⁰ – is pursuing a strategy of increasing influence in international organizations, particularly throughout the UN system,Footnote ²¹ and that it is linking this to the offensive interests of its business enterprises, especially in technologically advanced sectors involving 5G, facial recognition, blockchain,Footnote ²² and AI. China has recently spread its influence rapidly in the most important organizations for technical standards: Zhao Houlin was secretary-general of the ITU from 2015 to 2022;Footnote ²³ Shu Yinbiao is president of IEC since 2020; and Zhang Xiaogang was president of ISO from 2015 to 2018.Footnote ²⁴

3.2.2 China’s New IP proposal

In September 2019, Huawei Technologies Co. Ltd. (China), China Mobile Communications Corporation, China Unicom, and the Chinese Ministry of Industry and Information Technology proposed to the Telecommunication Standardization Advisory Group (TSAG) of the ITU to study the radical idea of a New IP, that would replace the current TCP/IP (Transmission Control Protocol and Internet Protocol).Footnote ²⁵ In its proposal, Huawei asserted that the current IP is unsuited for the development of new digital applications, for which the development of a new protocol is needed. It therefore suggested the Study Groups of ITU-T to start a further long-term research in the then ongoing (2017–2020) and the next (2021–2025) study period.

In the meetings of the TSAG from February 10 to 14, 2020, this proposal (which has been given the new title “New Vertical Communication Networks”) encountered critical reactions from Dutch and United Kingdom internet registries. They argued that internet protocols have been developed in a “bottom up” manner and that relevant work is taking place in the Internet Research Task Force (IRTF) and in the IETF.

In the course of 2020, discussions took place in various ITU-T Study Groups, as they are the ones preparing proposals for new study questions to be decided at the WTSA meeting that was scheduled to take place in Hyderabad, India, from March 1 to 9, 2022.Footnote ²⁶ The Chinese New IP proposal was discussed in Study Group (SG) 11 (“protocols and test specifications”) and SG 13 (“future networks”). The United Kingdom, the EU, and its Member States objected to the proposal for a variety of reasons. They saw no evidence that the current standardization setting had failed in developing new internet functionalities nor that foreseeable requirements, such as those linked to the development of AI, Augmented and Virtual Reality, or Internet of Things (IoT), risked being insufficiently addressed. They also expressed their preference that new protocols and standards be discussed in the relevant Standards Development Organizations (SDOs)Footnote ²⁷, in particular in the IETF, where the decision-making process is transparent, bottom-up, and open to all stakeholders (including industry, civil society, and academia), rather than in the ITU, where decision-making is top-down, intergovernmental, and does not involve all stakeholders. Duplicating work at the ITU could lead to higher costs and undermine interoperability. They also expressed the concern that implementing the Chinese proposal for a top-down, incumbent-controlled internet would bring a high risk of fragmentation of the global internet into locally controlled intranets, of decreased network resilience, and could seriously harm the openness of the global internet. This would not be in line with the European vision for the Internet, which is one of a single, open, neutral, free, and un-fragmented network, supporting permissionless innovation, privacy, and user empowerment.Footnote ²⁸

At an ad hoc meeting of SG 13 on December 11, 2020, around 100 Chinese participants participated, strengthened by Burundi, which on behalf of ten African countries expressed support for the Chinese proposals. They encountered fierce resistance by all EU Member States, the United States, the United Kingdom, Canada, and Japan. At the next plenary meeting of SG 13, it was found that there was no consensus for the project, and the discussion was ended.

3.2.3 China Telecom’s Proposal for Standards on Facial Recognition

China Telecom introduced a proposal for a new “framework standard” through a document entitled “Requirements for face recognition application in visual surveillance” in ITU SG 16 (“multimedia”). Already in the spring of 2020, the European Commission raised a number of important concerns. The draft recommendation foresees the use of face recognition for a wide variety of use cases, for both public and private bodies, for example, to confirm the identity of a suspect, for police checks of identity cards, for criminal fugitives, transport, entertainment, employee attendance, trajectory tracking, etc. However, it does not contain any safeguards for the protection of personal data and privacy of individuals. From a European perspective, such a lack of safeguards is very problematic regarding its compabitility with the EU’s General Data Protection Regulation (GDPR).Footnote ²⁹ As the draft recommendation cannot be implemented within the EU (and more broadly the European Economic Area, EEA) and could have a negative impact on transfers of personal data of European to third countries that implement this standard, the Commission strongly submitted that it should be considered under the ITU’s Traditional Approval Process (TAP), which applies to all recommendations with policy or regulatory implications, rather than through the Alternative Approval Process (AAP) proposed by China.

The Commission’s concerns, expressed at a virtual meeting of SG 16 in April 2020, were shared by the United States, Canada, and Australia, which also highlighted the very political implications of the draft recommendation and questioned the mandate of the ITU to adopt norms in this field. In a later contribution, Romania added to the concerns by pointing to the specific risks for fundamental rights of facial recognition techniques, arguing that ethical boundaries and principles needed to be defined, setting clear criteria and limits, before standardization could take place. It also referred to serious concerns expressed by other UN entities, such as the Office of the UN High Commissioner for Human Rights,Footnote ³⁰ pointing to the fact that the ITU is part of the UN family and its values. We will come back to this latter point (Section 3.5).

At the meeting of SG16 of December 14–16, 2000, China Telecom pushed again for the Study Group to consider the proposal and accept the new standard. Twenty EU Member States, the Commission, the United Kingdom, Canada, the United States, Australia, and Japan mobilized and expressed their disagreement. Interestingly, the meeting was chaired by a staff member of China Telecom, who seems to have had difficulties accepting the lack of consensus.

3.2.4 Interim Evaluation

As is clear from the above, the two Chinese proposals concerned have, for the time being, been blocked in the ITU context by a mobilization of Western countries. The latter have become alarmed by China’s tactics, consisting of having Chinese corporations launching at first sight technical proposals in ITU Study Groups that, seemingly, are aimed at pushing through China’s vision on new technologies and the Internet. It can be expected that China will learn from the recent experience and will seek to fine-tune its strategy and approach. The massive investment of resources, including human resources – compare the presence of 100 Chinese participants at SG 13 in December 2020 – the involvement of lobbyists and chairs of Study Groups, and concerted outreach to developing countries, especially in Africa, have made a deep impression on China’s Western counterparts. However, in spite of concerted opposition of Western countries, it can be expected that China and the Chinese corporations and experts concerned will reiterate their proposals – possibly with some minor modifications – at future ITU meetings, capitalizing on their strong presence and influence over other delegations.