Preventing and combating market abuse
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Speech by Sally Dewar, Director of Markets Division
FSA Wholesale Conference, QEII Conference Centre
17 May 2006
Introduction & Overview
The Wholesale Business Unit takes the FSA's leading role in pursuing our aim of maintaining efficient, orderly and clean financial markets. Preventing and combating market abuse is a major part of this.
As you know the London markets attract a huge amount of global investment. London has by far the biggest share of the non-domestic equities market and the OTC derivatives market. London also has a considerable presence in the international bond market, cross-border lending and the assets under management with hedge funds. So it is essential that we follow that aim to sustain our global position and to foster continued growth of these markets.
Today I would like to focus this session around the clean financial markets aspect of our overall objective. Of course it is in all our interests to maintain clean markets so I particularly want to talk about how we, the FSA, and you, the firms, need to work together to achieve clean financial markets in the UK.
I am going to speak to you for about 20 minutes following which Peter Sherratt of Lehmans will speak about the issue from a firm's perspective and then we will take any questions you may have. Dilwyn Griffiths who heads up the Market Monitoring Team at the FSA has also joined us on the platform to answer any questions. Firstly I am going to look at how we can measure the impact of our actions on the cleanliness of our markets. I will then set out our current priorities and the various projects and thematic work we have being doing as well as further work we have planned for the year ahead. I will cover some of our recent enforcement successes and then finally set out three action points for firms to ensure we work together to combat market abuse and achieve clean financial markets.
Measuring market cleanliness – the study
Firstly then, I would like to consider how we know when we are achieving market cleanliness and how we can measure the impact of our efforts to combat market abuse. This is a question which we have recently put to FSA economists and no doubt many of you are aware of the result of their findings which we published in our Occasional Paper on Measuring Market Cleanliness in March.
The aim of this study was to measure market cleanliness by looking at the extent to which share prices move ahead of certain regulatory announcements companies are required to make to the market. In doing this, we have developed a robust analytical tool which we believe will allow us, over time, to measure the impact we are having in tackling market abuse. It also plays an important part in the FSA's drive to establish key indicators that will help us understand better how successful we are at achieving the intended benefits of regulation.
We believe this study represents an important step in establishing the starting point against which the FSA's future work in tackling market abuse should be judged. We welcome any comments on the methodology and analysis.
Measuring market cleanliness – analysis & results
So what did the researchers do? They analysed two kinds of market announcements: those relating to take-over bids in 2000 and 2004 and those relating to the trading performance of FTSE 350 listed companies between 1998 and 2003 - around 1500 announcements in total. They then examined announcements that led to a large or abnormal share price movement, since these are the announcements most likely to contain information of use to an insider trader. They then assessed the proportion of such announcements that were, in fact, preceded by an apparent "informed price movement" which could indicate that some trading on unpublished information had occurred.
The analysis of FTSE350 announcements covered a period before the Financial Services and Markets Act came into effect, and a later period, when FSMA was in force but the FSA had yet to complete any enforcement action against market abuse. The analysis indicated that there was no change in market cleanliness in relation to announcements by FTSE 350 listed companies.
The analysis of announcements relating to takeovers included 2004, when five mis-use of information cases were completed, and showed that there was a small but statistically significant increase in informed price movements suggesting a deterioration in market cleanliness. The results do not show exactly how much market abuse is going on but the researchers detected price movements which suggested that some informed trading may have taken place prior to 28.9% of the takeover announcements and 21.7% of the FTSE350 trading announcements which were identified as being most likely to contain information of use to an insider trader. Obviously we would want to see an improvement over time in these figures.
The first enforcement cases in relation to mis-use of information under the new rules were concluded in 2004 and resulted in comparatively low fines. We believe that visible enforcement action imposing significant penalties may be the key tool in our work to reduce market abuse, although there are others which I will come onto later.
Going forward we will continue to use the methodology I have just described to continue testing the cleanliness of the markets. We intend to repeat the analysis later this year for the period up to the end of 2005.
Strategic objectives
Looking now to our current strategy and specifically to the issue of market abuse, I just want to briefly run through our current priorities and what we are doing to address them. As you are probably aware through previous press coverage, our current focus in respect of our market monitoring activity is in respect of institutional market abuse.
Our view is that although the majority of individuals and institutions using the financial markets adhere to high standards, there is a small minority of both who do not. This raises costs for all market participants: unfair markets are inefficient ones. There have been a number of cases over the years which have demonstrated the adverse impact of poor market standards. For example, the Sumitomo case during the 1990s undermined confidence in the global copper market and particularly the London Metal Exchange. The impact was felt directly by consumers of copper across the globe as the price of copper soared following the manipulation of the market. I should add that markets can soar for reasons other than manipulation and that speculation is not co terminus with market abuse.
The FSA's Code of Market Conduct – which was published in its original form nearly five years ago – sets out in detail the standards that should be observed by everyone who uses the UK's key financial markets, whether they 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.
We recently conducted a review of where we have been targeting our resources to enforce the market abuse regime and what changes we should make. Since December 2001 we have had a number of successful cases but it is fair to note that the majority have been cases from outside the financial sector.
While we intend to continue bringing enforcement action against individuals committing market abuse, we have become increasingly concerned by the risk generated by institutions exploiting the information they legitimately receive for illegitimate purposes or engaging in other unacceptable behaviour.
Having said that, we don't think that our markets are rife with insider trading or market abuse. But we know that there are pockets of market abuse, as our market cleanliness study has shown. So our spotlight is on, in particular, the 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.
Our future work programme covers pursuing both cases of market abuse and undertaking a series of deterrent measures. We want to get our message across through a combination of enforcement cases and through educating and advising firms as to what standards must be achieved in order to maintain clean financial markets.
Thematic work
Already this year we have undertaken several pieces of thematic work focused on institutions. Recently we have completed some visits to participants in the debt, loan and credit markets. This project has allowed us to consider the increasing involvement of hedge funds and other new investors in this sector and the perceived abuse of material non-public information in these markets. Through this we have improved our understanding of the loan and credit markets so that we have been able to develop a structured approach to monitoring those markets. Going forward, we will be using the knowledge we have gained to proactively monitor the credit markets.
We have also undertaken a review of recent convertible bond issues. We asked the investment firms involved to identify who they had made 'insiders' on these deals – and then using transaction reports we have been able to analyse this information to identify insiders who may have dealt on this inside information.
Going forward we are planning to carry out some work that will look at the leakage of inside information ahead of mergers and acquisitions. I think most would agree that whilst there is never an acceptable level of market abuse, this is now becoming too prevalent for comfort. We will be focusing on specific deals and will be talking to all the key players - the advisors, lawyers, PR firms and the issuers.
We will also be carrying out some visits with our colleagues in wholesale firms division to gain a better understanding of current market practices in regard to block trades. Whilst we have no specific concerns about the appropriateness of the way block trading is conducted we believe it would be helpful for market participants, to clarify our position, based on this work, following the implementation of the Market Abuse Directive.
2006 will also see us continuing our work with firm supervisors to review and, where required, improve firms' anti market abuse systems & controls. We also plan to target specific firms to remind them of the Suspicious Transaction Reporting requirements and discuss with them if they have they appropriate systems and controls in place to comply with this obligation. I will discuss this in a bit more detail shortly.
Enforcement – our aim is effective deterrence
Some recent FSA enforcement decisions have also reflected our strategic approach. We are concerned that key players in the wholesale market ensure that they observe proper standards of market conduct. Recent institutional cases reflect our determination to take the necessary action to maintain and improve the overall quality of markets and will continue to pursue cases that ensure our key messages are made to the market.
In our actions against Citigroup in 2005 and our recent case against Deutsche Bank, the key messages we were seeking to give to the market 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 where conduct does not meet the tests for market abuse.
In the Citigroup case we believe it was reasonable for them to foresee that their trading would have an adverse impact on the efficient and orderly operation of the MTS platform. We reached this conclusion on a combination of price movements, 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 our contacts with market participants we consider the market supports the stance we have taken.
In relation to the recent Deutsche case, we have made clear that we see this as an example of the type of conduct which the FSA will act against in its efforts to ensure proper market standards. We have explained that the market rightly expects that firms involved in running book build transactions ensure that they observe proper standards of market conduct and act with due skill, care and diligence in their activities during these transactions and that we expect firms, and their staff, to be aware of the issues that are inherent in all transactions, and to ensure that they take steps to manage those appropriately. This is fundamental to maintaining efficient, orderly and clean markets.
To achieve this we expect senior management to take responsibility for ensuring firms identify risks, develop appropriate systems and controls to manage those risks, and ensure that the systems and controls mitigate the risks in practice. Failure to manage risks properly is now, more then ever, likely to result in disciplinary action being brought against individuals as well as firms. Senior managers need to understand this and ensure that they are taking appropriate action to identify and mitigate risks to protect their firm.
Upgrading of the Sabre system
Before I move on to the topic of working together to achieve clean financial markets I just wanted to touch briefly on the redevelopment of our transaction monitoring system (Sabre).
Sabre stores all the transaction reports received from firms executing transactions reportable to the FSA. This post trade data comes to us from a variety of approved reporting systems and in the Markets Division we use this information to identify situations of potential market abuse, and to undertake market surveillance which helps alert us to potential new risks to market confidence arising from significant market developments. The data also provides us with useful market information. For example we have used it to look at growth in the use of equity CFDs & the take up of covered warrants.
Market abuse needs to be investigated in a more detailed way than is possible with the current Sabre system and our aim, in developing our new system, Sabre II, is to create a world leading market surveillance system.
Post 2007, with the implementation of MiFID, the FSA will also be required to monitor transactions in commodity and interest rate derivatives. The current system therefore needs to be redeveloped to allow for the monitoring of these additional financial products. We plan to make a presentation to the industry later in the year setting out more details about our plans for the new Sabre system.
How firms can help the FSA achieve clean markets
Finally, then, I would like to set out how we believe firms can help the FSA achieve clean markets and what we expect from firms in our collective efforts to combat market abuse. As a starting point firms must observe "proper standards of market conduct" which means more than just trying to avoid engaging in market abuse. We 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 few years 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.
But we need more - it is in all our interests to have clean markets and we need to work together more to achieve this. In our view there are three key ways in which firms can work with us to help us achieve our aim.
- Firms need to properly manage conflicts of interest – this cannot be stressed enough!
- Firms need to comply with their obligation under the Market Abuse Directive to provide us with suspicious transaction reports.
- Firms need to self report if they uncover wrongdoing by their employees. But they should also let us know if they see behaviour by their counterparties that they think is harming markets.
Firms need to manage conflicts
We have put conflicts high on the agenda in recent years. Our aim has been to work with the industry to improve standards of conflicts management through the identification of best practices. We all recognise that the investment banking business model contains inherent conflicts of interest and we think 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.
Our colleagues in supervision 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.
Firms are required to comply with the STR requirement
One of the more fundamental changes that came about as a result of the implementation of the Market Abuse Directive was the introduction of the requirement to report transactions suspected of constituting market abuse to the relevant competent authority. It is worth highlighting particular points in that guidance and indicating the FSA's approach in regard to STRs. But first just let me remind you that this is an obligation for all firms who arrange or execute securities and derivatives transactions – not just small retail broking firms but large wholesale banks as well.
In deciding what transactions to report, the key test is that there are reasonable grounds for suspecting the transaction involves market abuse. Our rules and guidance on suspicious transaction reporting make clear that notifications require sufficient indications that the transaction might constitute market abuse and that a firm will need to explain the basis for its suspicion when notifying the FSA. It is also worth noting that the reporting requirement applies to transactions, not orders to trade – although if any firm voluntarily wishes to bring a suspicious order to trade to our attention, they are welcome to do so.
We have consistently given the message that the FSA is interested in quality not quantity of suspicious transaction reporting. We have said in the past that we would vigorously pursue cases where firms are notifying transactions without seriously considering whether they meet the test of reasonable suspicion, and that defensive reports made without reasonable suspicion would not conform with the requirements of the reporting regime. This message seems to have been taken on board. On the whole we have received quality STRs and the response from firms has been measured. We recognise that identifying suspicious transactions is not an easy task and it is not realistic to expect that every possible case will be picked up, but we are now nearly a year into the regime and our statistics show where there are gaps – we can see firms who have not reported any STRs where their peers have, and during the latter part of 2006 we will be following up with these firms to ensure that they have the necessary systems and procedures in place to meet our STR requirements.
Self reporting
The third and final point to take away with you is self-reporting. This is crucial to us achieving our aim of maintaining clean financial markets. Our message is simple - if staff engage in misconduct, and firms know it has happened, we require firms to inform us. If a firm has good systems and controls and can show it is complying with them, we won't pursue the firm in an enforcement action. Instead we will pursue the individual. So in all cases we expect to be informed of an individual's abusive behaviour.
We would also urge firms to bring to our attention any examples of significant misbehaviour by other market participants they comes across. As those involved in the markets day-in day-out, you are obviously in a position to pick up things which may not be apparent to us or at least not so quickly.
Conclusion
In conclusion, then, my key message to you is that as well as the FSA taking steps to combat market abuse, 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. We know market abuse happens and, if we find it, we will take it very seriously. But I would emphasise that this does not mean a confrontational relationship with firms. Our objective is to work with the industry to counter abuse and ensure proper market standards are maintained – to the benefit of all.