The FSA's Wholesale agenda
Speech by Hector Sants, Managing Director Wholesale & Institutional Markets
SHCOG 2005 Conference
7 July 2005
Good morning and thank you for inviting me to address you today.
When I stood before you this time last year, I had only recently joined the FSA. I set out for you then some of the key pieces of work we anticipated. I will review the regulatory developments of the past year but also want to look ahead to the priorities and challenges for the coming year where we are seeking to engage with you.
Underlying and guiding the work of the Wholesale Business Unit is the mission statement that we have established for ourselves in the past year. To be consistent and effective you need a philosophy. We seek to "promote a well regulated wholesale market which is efficient, orderly and fair. We also seek to ensure that it is internationally attractive and sustainable." That is our mission statement.
A key underlying point is that our approach to policy is to intervene only when we can demonstrate market failure or an opportunity to improve market efficiency, and the proposed solution passes a cost benefit analysis. When intervention is justified our preferred approach is via stimulating market solutions, using a process of partnership and discussion with market participants. At the end of the day underpinning good quality markets are good quality participants demonstrating good judgement. As an aside, may I point out that although our preferred approach is to only intervene when it is justified, there are times when we are required to regulate by Europe. Notwithstanding that point, given that is our methodology, how do we interpret our efficiency agenda? The main tool here I believe should be increased transparency. I should perhaps make the point that we are not a price regulator. I believe transparency gives the marketplace the opportunity to act rationally and thus more efficiently to the benefit of the community as a whole, although to be clear we do understand the interplay with liquidity. May I conclude here by emphasising the theme behind our philosophy of intervention is that we look to be your partner as well as your policeman.
This slide gives an indication – in broad terms – of how we think about our mission statement mapping against the workstreams in our current business plan.
The year in review
I would like to start by briefly looking back over the year. It is noticeable that the regulatory landscape of the past year has been dominated by a small number of high impact, large scale issues: MiFID, Basel / CRD, the Market Abuse regime, the Listing Review & Prospectus Directive and Softing & Bundling.
A few of these have moved on significantly so that the FSA's direct involvement will start changing to reviewing implementation. With softing and bundling, for instance, we are continuing to look to the industry to deliver. I am sure that most of you are familiar with the history behind our work on soft commission and bundled brokerage arrangements over the last two years. I would only add my belief that changes to firms' business models should be expected and you have an important role in ensuring that compliance functions match the pace of change. Similarly, in respect of the Listing Review, Prospectus Directive and Market Abuse Directives our attention is turning to working with you to ensure good implementation.
Other issues, of course, have progressed in the past year but have not reached a conclusion and still require the active focus and engagement of the FSA, firms and their trade bodies. Clearly the most prominent of these are the Capital Requirements Directive and MiFID. In both cases they are making their way through the European legislative process and continue to occupy significant amounts of FSA resources. Over the past year the industry has shown itself to be fully engaged with these issues through various working groups. We must work together to ensure that constructive relationship continues to work at that level. And each of you – with your firm's senior management – need to ensure that your firm is engaged with and prepared for the coming regulatory changes.
Themes for the coming year
Looking ahead, there are three key issues I want to highlight to you today which require the wholesale market's focus: market abuse, conflicts of interest and hedge funds. This slide gives you a sense of how we see market abuse and governance relating to our other work, with hedge funds cutting across several of these boxes.
Market Abuse
I would like to focus for a moment on market abuse. Market abuse is a topic that often generates media interest around specific cases, but I am not convinced that it is understood in terms of the impact of such behaviour on market transparency and efficiency.
Although most individuals and institutions that use the financial markets adhere to high standards, there is a small minority who do not and consequently raise costs for all market participants: unfair markets are inefficient ones.
These are far from just theoretical concerns. There have been a number of examples over the years which demonstrate the adverse impact of poor market standards. For example, though having an international impact the Sumitomo case during the 1990s undermined confidence in the global copper market and particularly the London Metal Exchange. The impact was also felt more directly by consumers of copper around the world as the price of copper soared as a result of the manipulation of the market.
The FSA's Code of Market Conduct – which was published just over four years ago – sets out in detail the standards that should be observed by everyone who uses the UK's key financial markets, whether are trading in the UK or from overseas. In particular it makes clear the standards we expect to see maintained through its descriptions of what is and is not market abuse. The Code brings transparency to all market users and lets everyone know what standards can be expected when dealing on UK markets.
But "proper standards of market conduct" means more than just trying to avoid engaging in market abuse. We also expect firms to have due regard for the operation of financial markets as a whole and individual trading platforms particularly when through their overall market share in terms of volume or their ability to trade positions of size they can drive a market in a particular direction or disrupt its operational effectiveness. The standards observed by these "major market entities" will have an impact on the overall quality of a market in terms of efficiency and competitiveness and hence overall confidence in the market. We have been building this in to our risk assessment framework for firms over the last year or so to ensure that a firm's ability to influence the quality of the markets they operate in is properly taken into account in our approach to the supervision of that firm.
Turning back to market abuse more specifically, the three main elements of market abuse are now well known – the misuse of information, creating a false or misleading impression, and distorting the market. The area of greatest focus currently for the FSA I would term "misuse of information for institutional rather than personal gain". I want to focus on the misuse of information element for a few minutes.
The FSA has been active in pursuit of abuses committed by individuals and over the past 12 months we have had a dozen or so market abuse penalties on individuals. The concern I would like to highlight to you is the risk generated by institutions exploiting the information they legitimately receive for illegitimate purposes. Arguably the exploitation of these opportunities by some is costing the system both financially and reputationally more than the issue of commissions. In the last 12 months we have seen price movements of the stocks in those cases where we have pursued market abuse enquiries of up to 29% in the 24 hours preceding an announcement. This is a large amount compared to the cost of 0.2% commission.
As I wrote recently in the Financial Times, I do not believe that our markets are rife with insider trading or market abuse. But there are pockets of market abuse. In order to better understand the prevalence of such behaviour we are working to measure the extent to which corporate announcements are preceded by unusually active trading. A series of visits to, and requests for information from, market participants have also begun. Our spotlight will shine in particular on relationships between investment banks and their clients, because we believe the risk of market abuse is highest where a client can be made an insider on a forthcoming deal. So we are conducting a review of the pre-marketing of selected secondary issues and the trading of potential subscribers who were made insiders to check that they did not make improper use of that inside information. Other high-risk areas – such as the relationship between the proprietary trading desk and the rest of the bank – will also be examined.
It is incumbent on the senior management of City firms to guard against the risk that their staff will commit, or facilitate, market abuse and I would hope that our common desire to promote the UK as an efficient, orderly and fair market will ensure they do so. The FSA would much prefer to deter than to enforce: it is more cost effective and better for market confidence. We are therefore being open about our new institutional focus. However, firms must be warned that we know market abuse happens and, if we find it, we will take it very seriously.
Citigroup case
In passing, given the publicity given to our actions against Citigroup I might note the key messages we were seeking to make to the market in respect of their 2 August trading was that we will use our principles based approach to ensure firms pay due regard to having effective systems and controls and pay due regard to the impact of their trading strategies on the quality of the market, even if the circumstances are not such that it can be caught by the Code of Market Conduct. In the Citigroup case we believe it was reasonable for them to foresee that the consequences of their action would be to impact the efficient and orderly operation of the platform.
Why did we think they could reasonably foresee this? We reached this judgment on a combination of share price movement, impact on visible liquidity and potential operational disruption to the system. In this context we do of course recognise that any principles-based regime carries an element of judgement by the regulator as to when a breach has occurred. However, in coming to our conclusions, we take into account the operation of the markets concerned guided by the views of experienced practitioners. From what we are told, opinion in the market supports the conclusions we reached.
Conflicts of interest
I have already mentioned conflicts of interest in the context of market abuse, and would like to spend a few minutes further on this important topic. Arran Salmon of the FSA is leading a session on this topic tomorrow which will enable you to discuss the details, so I will underline why this is an important issue for the FSA and the expectations we have of firms.
When I spoke to you last year I covered conflicts of interest. In the intervening year we have continued our work. Last September I publicly wrote to chief executives of major investment banks on financing transactions and conflicts of interest. Since then we have undertaken further cross-firm thematic work with the major investment banks which culminated in two roundtable discussions last month with the chief executives of those investment banks. The amount of work and level of engagement we have out into this demonstrates the significance we attach to it.
Our aim is to work with the industry to improve standards of conflicts management through the identification of best practices. Firms must recognise that the investment banking business model contains inherent conflicts of interest and I believe that the industry recognises the need for it to address the concerns of regulators and the public. Of course, having a conflict is not the same as abusing that conflict. Nonetheless, firms need to be able to demonstrate that conflicts are actively identified and managed.
Through our work we have found that many firms have arrangements for dealing with routine, everyday conflicts. There is, however, greater variability across firms in the way and extent to which senior management are engaged in significant and complex transactions.
We have developed a composite model of best practice within a well-managed firm. This model – which does not represent any particular firm – is designed to achieve greater clarity in how our principles based approach can be applied in the difficult area of conflicts management.
We will be continuing our focus on conflicts of interest. We currently anticipate a further Dear CEO letter later this year. So I strongly encourage you to engage with this issue and consider your own firm's practices in this area. Senior management must consider what is most appropriate to their firm's circumstances.
Before moving on, we should note that this work is a good example of how the Wholesale Business Unit can work successfully with firms to develop a mutual understanding of best practice and raise standards in a way that is sensitive to the market and the differences between firms. (Going forward, though, we will also need to have regard to the implications of MiFID.)
Hedge Funds
As I've already alluded to in the context of market abuse, hedge funds are a key focus of the FSA, as you will seen from our two Discussion Papers published last month. Eurohedge estimates there were just over 250 new European hedge funds launched during 2004, and they raised combined total assets of well over $22bn, according to their annual survey of new funds. This compares to $21bn raised by the 228 new funds of 2003. (European hedge funds are here defined as those whose manger has its main head office in Europe).
The direct involvement of existing financial institutions in managing hedge funds is also increasing, with traditional asset management groups and banks acquiring hedge funds or establishing ‘in-house’ hedge funds. Firms are aiming to offer a wider range of investment products to their customers, and at the same time offer talented investment managers and traders opportunities that might otherwise only be available in a specialist fund environment. There can be, however, significant management and regulatory risks arising from these hybrid arrangements, which fund management firms must recognize and mitigate.
For example, significant market and reputational risks could arise in the event of problems with in-house funds, or even funds in which a firm has third-party involvement. Investment banks and asset managers need to manage carefully issues of disclosure and potential conflicts of interest. These include where a long-only asset management firm also manages hedge funds. Conflicts can arise for example when a hedge fund effects short sales of securities, if such securities are held by long-only funds managed by the same advisory firm. Hedge fund managers’ incentives can also be influenced by performance-based compensation structures.
The bottom line is that these and other conflicts must be recognized and managed in a manner that ensures that all the firms’ clients are treated fairly.
You should not assume that because we are undertaking this work that we have decided to seek a dramatic change in the current arrangements. We approach the analysis with an open mind. We will continue an open dialogue on these difficult issues with the industry, consumers and other stakeholders.
Concluding remarks
So let me conclude by saying I believe that today that I am asking you to focus on four issues. First, that we value your engagement and input to the many European regulatory issues facing us. Second, that a focus on institutional market abuse would be also be of substantive benefit to us all. Third, that conflicts of interest should be considered by all firms. Fourth, the consultations on hedge funds are important to all participants in the wholesale market place and we would value your input.
Thank you to SHCOG for the invitation to speak and thank you for listening.
