LONDON, TUESDAY 19 OCTOBER
Howard Davies
Chairman, Financial Services Authority

I cannot now quite recall why Angela and I chose the title “FSA: Myth and Reality”, for my speech to you today. I suppose it must have seemed like a good idea at the time.

I think perhaps what I was thinking about was that we were then in the midst of some exciting legal debates about the extent of the Authority’s new powers, the interaction between our régime and the European Convention on Human Rights, and all that.

Since then, of course, the Government have made some changes to the Bill in response to the report from the Joint Committee to which you put in evidence. And my impression is that a lot of the heat has gone out of those arguments in recent months.

There remain some points of controversy, of course. One or two of them relate to the terms of the Bill. I am thinking particularly of the market abuse clauses. They are matters for the Treasury, since the Bill is now in Committee. Others relate to the way in which we will operate under the new legislation. Particularly, how we plan to operate our disciplinary régime.

We have therefore been trying in recent weeks to give the market some reassurance in important areas.

For example we have put out a statement on the way in which we will provide guidance to market participants when they regard the regulatory environment as uncertain. We have also responded to the points made in consultation by producing a revised set of the FSA’s principles applying to financial businesses, which have been generally well received.

But of course, as Michael Read, Angela Knight and others continue to remind me, the proof of the pudding is in the eating. Firms will wish to know how we operate the new régime in practice, before they know whether it is one with which they are comfortable. And of course we still need to flesh out quite a lot of the details in our new handbook of rules and guidance.

Against that background, rather than stick too closely to the question in my title, I thought the most useful things I could do today would be

- First, to give you our updated view of the timetable of change – both in terms of the legislation, and our own rules, guidance and codes.

- Second, to say a few words about the consultation process, whose intensity and speed are of course linked to the legislative timetable and

- Third, to give you some preliminary thoughts from Canary Wharf on a few of the major challenges facing your industry, arising from technological and infrastructural change in the markets in which you operate. We live in interesting times, as the Chinese curse has it.

I am uncomfortably aware that while we engage in the exciting process of reforming the regulatory system, the markets out there are themselves undergoing a process of fundamental transformation. If we do not recognise that, we shall end up devising an elegant, sensitive, perfectly formed regulatory régime, ideally suited for yesterday’s financial markets.

But, first, a word or two about the timetable.

As some of you will be aware, the Financial Services and Markets Bill has been used as a constitutional experiment, in two ways. The Modernisation of Parliament Committee, which reported in the year after the election, recommended that some technical Bills should be subject to scrutiny by a Joint Committee of both Houses of Parliament, which, unusually, would be able to take evidence and cross examine expert witnesses. In our case – the first of its kind – that was the Burns Committee, chaired as you know by Lord Burns – former Permanent Secretary to the Treasury – but also including people with financial experience.

They did a pretty thorough job on the Bill in the spring of this year. But that process did, of course, delay the Bill’s introduction to the normal procedures of the House of Commons, and the second reading debate only took place at the end of June. It is important to note – and I emphasise this because it was scarcely reported at the time – that the Bill was given an unopposed second reading. The Opposition noted that there were areas in which they wanted the Bill changed. But they explained clearly that they saw it as an important piece of legislation, the broad lines of which they were happy to support.

The Bill then began in Committee in July and made reasonable progress before the summer recess. In fact they only covered 20 clauses or so out of 370 . In eleven sessions, that doesn’t sound too good. But I am told that such a rate of progress is not abnormal in the early stages, and of course the first four clauses are the most chunky in policy terms, covering our objectives and principles of regulation.

The Committee stage restarts today, this morning in fact, and will continue – well I suppose until they have finished. But this is where the second constitutional innovation kicks in. This Bill is supposed to be subject to something called a carryover procedure, whereby a Bill which has not completed all the stages in one session may, with Opposition agreement, be carried over to the next, where it picks up where it left off. Our current expectation is that carryover will be agreed, that the Bill will finish its Common stages by around Christmas, then go into the Lords early next year and eventually achieve Royal Assent around Easter. (Of course we don’t quite know what sort of House of Lords it will visit, so the timetable is bound to be a little uncertain). There will then be a period of transition while various practical things are done, notably winding down the existing SROs, particularly the SFA in your case.

We therefore hope that the full new, all-singing, all-dancing FSA régime will come into being around twelve months from today. No doubt you are even now planning celebratory parties for next Halloween. And that is why we have been pumping out consultation papers at a fairly hefty rate in recent months, and why we expect to continue to do so at that rate over the winter.

I well understand that this process creates some difficulties for the industry, and particularly for the trade associations and their committees which do so much of the hard work in analysing what we propose and trying to understand the practical implications and – frankly – to identify the areas where, with our first stab, we have got it wrong.

Having run a trade association myself, I recognise that it is difficult to organise this work, that you rely on the unpaid efforts of many people who have other more fascinating and remunerative things to do. But I have to tell you frankly that I do not think we have much alternative but to press on with this work.

The SROs have already remained in being now for 2 ½ years since their death sentence was announced. I have huge admiration for the Boards of the SROs who have stuck to their task manfully and womanfully throughout that period. But there comes a point at which it is no longer reasonable to ask people to continue to administer an old régime. Particularly where that old régime begins to fray at the edges because it is not being updated as thoroughly as it would be if it future life were indefinite, and indeed where the regulators themselves are increasingly focused on designing the better mousetrap. So I do not wish to preside over a transitional period for any longer that is absolutely necessary, and I think it is in the industry’s collective interest to arrange the switch to a new rulebook as quickly as is consistent with doing it carefully and thoroughly.

A year or so ago now I issued a wake-up call to trade associations in the City to prepare for a major consultation process, and I know that some – notably APCIMS – have responded well to that call. Mark Powell chairs your FSA committee, and it makes a lot of sense to have a committee of that kind focused on us. It will be a pretty busy one in the next twelve months, I forecast.

Let me emphasise, lastly, that I am not saying that we must introduce every change by October 2000 and damn the consequences. If there are sensible reasons for a later date in some cases, then let us have a look at the arguments. But it would be a grave mistake, I think, to slow down across the Board.

I am sure you will have further questions about this process, and about the strategy and style of the FSA in the future, and I will be happy to answer them later. But I would like also, as I said at the start, to comment on some of the other key issues you – and we – are facing in today’s rather exciting market place. There are three points which particularly concern us:

- the changing nature of exchanges and trading system

- the advent of Internet trading and, of a rather different order so far

- the particular issue of day-trading.

Exchanges

There is no doubt that we are entering a period of rapid change in the way in which equities are traded in the UK, in Europe, and around the globe.

The traditional exchanges themselves have been working hard to develop an alliance, which may in due course lead to a single trading platform for large equities across the EU. For the time being, rather than a full merger, they have settled on an approach which involves harmonisation of the “front ends” of their trading systems. We shall see how things develop from there.

But of course, as the exchanges themselves are well aware, there are new competitors on the block as well. Tradepoint has been around for a while, but has recently been recapitalised by some important institutions, who may be expected to put business its way. And there are other ECNs also operating here, such as Instinet and Posit. There are also some electronic trading systems in other markets, notably in the bond market. There is the Italian system Euro-MTS and the International Securities Market Association (ISMA) is preparing to launch COREDEAL, an electronic order book.

What is striking about the scene at the moment is that most major market participants have placed a number of bets. Perhaps that is not surprising given that the ECN market is at an early stage of development. But it makes it particularly difficult to forecast winners and losers. And I do not think it is straightforward to look across the Atlantic for a sneak preview of what will happen here. It is true that on NASDAQ ECNs like Instinet and Archipelago have taken around 30% of the market. But one reason for that is that the US exchanges were not themselves offering electronic order books, as is the case in London with SETS, and in Frankfurt with Xetra. So it is by no means clear that the US experience will be repeated here.

But, you may say, these are just idle speculations. What is the rôle of the regulator, in the face of new market and technological developments such as those now underway?

My starting point is that the regulator should be careful not to stand in the way, whether wittingly or unwittingly, of developments which might bring about improvements in liquidity, and reductions in cost for investors, allied to an increase in competition between rival trading systems. One must surely start from the principle that competition in this area, as in any other, is likely to bring benefits to the end-users, whether institutional or retail investors.

But there are risks, too, perhaps particularly in a period of transition. Risks related, principally, to transparency and liquidity.

Electronic trading systems may make it easier for traders to conceal their true intentions, and in particular the true size of their orders, whether on the sell or the buy side. But of course it is also true that even open order books may not be as straightforwardly transparent as they appear, with the opportunities they hold for speculative and information seeking orders to be placed. But if regulators are to ensure that the interests of less informed retail investors are properly protected in these new markets, which is in all our interests in the long run, we will need to ensure that the transparency of business done is adequately secured. That is one principle to which we will try to hold in the new world.

There is also the linked question of liquidity.

On the one hand, electronic trading systems have the potential to enhance liquidity by reducing transaction costs and opening up access to the markets to a wider range of participants. There may also be more transactions, which would again promote greater liquidity.

On the other hand, we have seen in the US that the arrival of a number of ECNs onto the scene has resulted in some dispersal of liquidity around different trading systems. It may be possible in due course to ensure that there are sufficient linkages between the systems to overcome this potential fragmentation of liquidity. But that may involve some regulatory intervention to ensure it happens.

There can be other implications for the regulatory régime, too. We need to think hard about the best execution requirement in a more fluid trading environment. The SFA’s best execution standard has been capable of being met in the past by ensuring that prices on the LSE have been used as the benchmark for a trade. That may or may not be appropriate as a standard in the future. If markets fragment and liquidity is diversified it may be difficult for firms to obtain a definitive benchmark price which would evidence best execution, particularly where there is no central price forming mechanism or real time price feed. With the advent of ATSs best execution may mean different things in different firms, which makes it more difficult to set a meaningful minimum best execution standard.

We propose to consult soon on this issue, because we recognise the need to provide greater clarity about what best execution may mean in a more distributed trading environment. We will particularly welcome comment from APCIMS members on that consultation.

We shall also be consulting soon on the nature of the overall regulatory framework we wrap around exchanges and other trading systems. Are the current distinctions between recognised investment exchanges and service providers appropriately specified? How do we fit ATSs into the new régime in the future? What are the appropriate regulatory requirements to place on exchanges and other trading systems, particularly in a more competitive environment?

We need to look at these issues domestically, but there is an important European dimension, too. At the Forum of European Securities Commissions, FESCO, we have recognised that there is a need for greater clarity about the minimum standards which should be applied across Europe to alternative trading systems. And at the last meeting, last month, I was asked to chair a working group to look at the regulatory environment for ATSs across Europe, a working group which will begin to meet shortly. Once again, we will be interested in the views of market participants, and especially those, like your members, interface closely with retail investors.

On-line trading

These developments in trading systems are obviously also very closely linked to the ways in which investors themselves access the markets. And the Internet has opened up radically new possibilities in that area, too. Here we have seen very rapid developments in the US recently, where, from a standing start three years or so ago, Internet trading now accounts for around one in six equity trades. Your own figures suggest that, here, the volumes are still considerably lower, just under 1% of trading, rather than the 16% or so we now see in the US. Though your surveys recognise that the growth here is now rapid, with the number of trades up from 29,000 in the first quarter of this year to 51,000 in the second. And that growth is expected to accelerate in the coming months as more brokers develop Internet facilities.

There are two ways in which a customer may use the Internet:

- submitting orders via e-mail, which are then executed by a firm rather as if they have been received in the post. Most of the large volume of Internet business in the US so far takes that form.

- Alternatively the customer may have access to an order - entry screen as a firm’s web site, where an order placed by the customer passes straight through for execution in the firm’s systems. There is, as we understand it, relatively little of this type of activity in the UK at present. But no doubt it will grow rapidly at some point.

Internet trading poses some interesting problems for brokers. On the one hand, it may well increase client members, and attract greater volumes of business. On the other, Internet traders have come to expect significantly lower charges. In the US commission on Internet trading is typically only around 20% the rate for traditionally executed business. That seems to be roughly the case here, where such business has been done. It will be a challenge for you to secure a corresponding reduction in your costs, without compromising the integrity of your business.

That, fortunately, is a problem principally for you. But there are issues for regulators too. Again, it is important for us not to stand in the way of technological change, where that change can be seen to be bringing benefits for investors. So we must ensure that our requirements keep pace, and that our future rulebook incorporates no bias in favour of paper-based systems, whether explicitly or implicitly. We will need, in particular, to ensure that we can accommodate the use of digital signatures to evidence customers’ agreement.

This, again, is an area in which we need to work together. We have no monopoly of wisdom which tells us how best to secure and maintain a sound regulatory environment in these new circumstances. I hope APCIMS will be prepared to put ideas to us.

Day Trading

My third and, you will be pleased to know, last new area is day trading.

Though they may be facilitated by the same technology, day‑trading is distinct from on-line Internet share dealing. There are unique features normally involving a full-time commitment by an individual with specialised broker-dealer firms who:

  • Sign up individual day trades
  • Charge them for training, special software and on-site trading facilities
  • Provide specialised market information, and
  • Provide direct access to instant order execution systems.

Day trading has taken off in the US, in a big way, even though it is estimated that around 70% of day traders lose money. For some of us, it looks – as a hobby – to be right up there with playing slot machines or collecting Toby Jugs as a boring way of wasting cash. But many Americans see things very differently.

Could it happen here? Well, quite possibly, though there are some reasons to believe that day trading may not take off as rapidly in the UK as it has across the Atlantic. Our stamp duty régime, which is so dear to APCIMS and its members, is one major reason. But there are other factors too, which may moderate the trend here. There is a lack of ‘fast markets’ in small but liquid shares, such as Internet stocks and, so far, the absence of dedicated day trader shops.

But it is nonetheless quite possible that day trading will grow here on the back of Internet trading. And one firm has just announced a day trading service using contracts for differences, to avoid the costs of stamp duty. This will be a leveraged service enabling customers to trade on margins requiring investors to put up only 20% of their long or short position. It is aimed at relatively well-heeled investors, with a £10,000 minimum to open an account.

Should regulators be concerned? In principle, perhaps not. There is nothing illegal or unethical about day trading. (There is nothing illegal about collecting Toby Jugs either). But is important that the individuals who get involved are aware of the risks they run and that they understand the nature of the expenses they will need to cover before turning a profit. That is particularly important in the case of margin trading. We are issuing an Investor Alert covering these points today.

From a firm’s point of view there will be a need to conduct comprehensive credit checks on prospective customers and to ensure that they can adequately monitor their nominee accounts for movement of stock and cash in and out. They should also satisfy themselves that their money laundering controls are in place, and working well. The control of password access to web-sites and the integrity of Internet systems generally will all be crucial.

There are also some particular issues with chat rooms. Firms need to monitor them for unauthorised investment advice, or share ramping through suggestions or gossip. Investors need similarly to be on the alert. They should beware of stocks which appear to be being ‘promoted’, when the interests of the promoter are unclear.

All of these are commonsensical points. They should not get in the way of the development of new trading systems – rather they should ensure that they develop sensibly and safely.

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