Speech by Hector Sants
Goldman Sachs CIO Conference 2005, Paris
21 April 2005

  1. Good morning and thank you to Goldman Sachs for the invitation to address this very eminent group.

  2. My theme today is efficiency and fairness, with particular focus on transaction issues in equity markets. My objective is to give you a brief overview of our current and future work in this area and how it impacts you.

  3. However, before diving into the detail, to put this work in perspective may I spend a moment on outlining the general approach of the FSA to regulating this area. 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.

  4. 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.

Soft commission and bundled brokerage

  1. After that introduction, I would like to turn, as I have been asked to, to the issue of unbundling. I am sure that many of you – not least Paul – are familiar with the history behind our work on soft commission and bundled brokerage arrangements over the last two years. Our initial conclusions on soft commission and bundled brokerage arrangements were that there were incentive misalignments between fund managers and their clients – conflicts of interest – due to the opaque nature of the arrangements under which fund managers make direct charges to the funds they manage, by way of commission, to purchase goods and services in addition to execution. In addition, the lack of transparency and accountability mechanisms in the relationship between brokers and fund managers made it very difficult for the customers to judge whether their interests were being well served by the fund manager and consequently meant market controls were weak.

  2. So what is our suggested way forward? First, we want to restrict the services that commission can pay for to the traditional "stockbroking" process of execution and research. Please note here that sales in our view is a transmission mechanism not a product. Secondly, we wanted to increase transparency to all participants in the economic chain to encourage improved accountability and rational decision making.

  3. We decided that a market-led solution could be the optimal way to deliver our desired outcomes, and that the industry should be given an opportunity to deliver it.

  4. On our first outcome, the key challenge was to define research and execution to ensure a clear perimeter. We believe there is a good degree of consensus on what constitutes execution. Most fund managers have a clear view on the nature of the execution service they expect from their brokers, and how that may vary depending on the type of execution required. The fund management industry has consistently told us that execution quality is – or should be – the key factor in determining the choice of broker. We agree this should be the case.

  5. We see broad agreement that the essential components of an execution service that may be recovered through commission charges include booking and processing of orders and related costs arising directly from trading.

  6. We acknowledge that other elements of a broker’s service, such as sales and trading advice, post-trade analytics, clearing and settlement services and custody, do not fall neatly into "execution". In some cases, these services might be treated as research. In others, they should be treated as non-permitted services and therefore paid for by means other than commission. Fund managers have more detailed knowledge of the precise nature and purpose of the particular services they acquire from brokers and others and are well placed to apply principles-based descriptions.

  7. Research is a less tangible concept, although we are clear that it covers the product offerings of both brokers and independent providers.

  8. We believe that research should be capable of adding value by providing new insights that inform fund managers when making investment or trading decisions about their clients’ portfolios. That is, the output (in whatever form) represents original thought; has intellectual rigour; and involves analysis or manipulation of data to reach meaningful conclusions.

  9. In the November consultation paper we made abundantly clear that we do not believe that raw data and market information is research, nor information that is publicly available. Some broker services, such as sales support, may be costed to research – as already mentioned our view is that ‘sales’ is generally a distribution mechanism for a product or service so it is necessary to look at the nature of the ‘support’. And some of the services of market pricing and information service providers may be similarly classified. We can also see that it may be possible to categorise various elements of these services differently.

  10. Following the broad support received for our consultation paper published in November 2004, we have published a final consultation paper, setting out necessary changes to FSA rules to implement our policies. We have crafted high-level, non-prescriptive rules, under which a fund manager will be expected to make reasonable judgements. It is our expectation that fund managers will be accountable to clients through the process of explaining these judgements to clients in the context of enhanced disclosure.

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Enhanced Transparency

  1. Which brings us back to the second outcome, that of bringing clear information to clients of fund managers, and the industry programme of enhanced disclosure. It is unlikely that disclosure will provide information which clients will be able to put to meaningful use in addressing conflicts, unless there is a system of regular reporting which shows clients not only the total amount of commission paid, but a breakdown into the amounts paid for execution and other services. The purpose of disclosure is, after all, to stimulate and inform a dialogue between manager and customer about how transaction costs are managed in the customer’s best interests.

  2. As you will know, the FSA published its latest consultation paper on 31 March. At the same time we were pleased to welcome the proposals developed by the IMA, LIBA and NAPF which will enable clients to understand better what they are paying for execution and research. They address the issues of transparency and accountability and should make the market for execution and broker services more efficient and sharpen incentives. We believe this package of our rules and an industry code of practice, if adhered to, will satisfactorily resolve the concerns we have raised in this area. With respect to the wholesale chain it will also be an excellent example of a market-led solution.

Retail fund governance and research

  1. As an important aside I might mention that we are aware that for retail clients, disclosure-based solutions have their limits. We shall be looking carefully at the solutions proposed by the industry’s working party, and as I have said, if they do not meet our requirements we will consider direct regulation in this area. We also recognise that disclosure alone may not be helpful for all fund management clients. We are, therefore, considering what measures we might take to ensure independent and informed scrutiny, and strengthening the corporate governance generally of the dealing costs of retail funds.

  2. We note that the IMA has carried out its own review in this area, although its scope was limited to reviewing the governance arrangements for UK authorised collective investment schemes, and we will take their findings into account in our work. As we have said in our Business Plan, we intend to make proposals in this area in Q3 this year.

Independent research

  1. Before leaving this topic a word on independent research. We recognise the importance of continuing to allow commission to be directed to all producers of research whether they have execution capability or not. We are clear that we have no objection to the practice of Commission Sharing Arrangements. In passing, we are looking to remove the phrase "soft commission" from the regulatory lexicon. Commission pays for research and execution and executers, on their clients instruction, can pass such commission to research providers. It is as simple as that.

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International

  1. In closing on this subject, I mention that, although we are pushing ahead with our own agenda in the UK, we are also looking for opportunities to work with other regulators. We recognise that global consistency is preferable. In particular, we have been engaged in a useful dialogue with the SEC over the past year and hope that they reach similar conclusions to us.

Developments in Europe on unbundling

  1. How does this affect unbundling in Europe? From our discussions with members of the fund management industry, many firms believe that it is not appropriate to discriminate between UK and non-UK clients in terms of the disclosure that they receive. Moreover, many firms believe that their non-UK clients would benefit from receiving the same information that UK clients do.

  2. Although what we have done is a purely UK initiative, we are aware that there is keen interest from other jurisdictions in our work, both in terms of its objectives and our approach. I would also like to point out that our work has been developed against the emerging background of MiFID.

  3. Therefore, I would see that the challenge is for the fund management industry to consider whether what we are doing in the UK to increase transparency and accountability to customers would be valuable to all of their customers and to act accordingly to apply these principles to all of their clients

Efficiency & fairness pursued through transparency

  1. I was asked to talk about softing & unbundling, but I think it is very important to see it in the context of the FSA 's wider agenda of efficiency and fairness, which we pursue in particular through transparency. There are a number of current live issues that will impact the transparency and efficiency of European equity markets. We do not have time to talk about European developments in best execution, pre- and post-trade transparency and possible further bid activity amongst European stock exchanges, all of which would significantly impact your business models.

  2. Where I would like to focus for a moment is market abuse. Softing & unbundling has – rightly – been a focus of comment, debate and work by the industry over the past couple of years. 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.

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Market abuse

  1. 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.

  2. 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.

  3. The FSA 's Code of Market Conduct – which was published four years ago this week – 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.

  4. 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.

  5. 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.

  6. 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.

Concluding remarks

  1. So let me conclude by saying I believe that today that I am asking you to focus on two issues. Firstly, that our proposed approach to commission transparency is beneficial to the industry and it will bring about changes to your business models. Secondly, that although these changes will promote efficiency and fairness, a focus on institutional market abuse would be also be of substantive benefit to us all.

  2. Thank you to Goldman Sachs for their invitation and thank you for listening.

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