Market abuse and conflicts of interest: The FSA approach
Speech by Hector Sants, Managing Director, Wholesale & Institutional Markets, FSA
The Financial Crime Forum Asia Pacific, Hong Kong
5 June 2006
One of the overarching objectives of the FSA is to maintain efficient, orderly and clean financial markets. Through the collaborative work of the teams monitoring financial markets and supervising wholesale firms and investment banks, the Wholesale Business Unit takes the lead in the FSA in pursuing this objective.
Preventing and combating market abuse obviously plays a major part in this, closely allied with our work on conflicts of interest. Today I would therefore like to focus this session around the FSA's approach to these separate but linked areas; what our strategies are here; and how the two strands of work knit together.
Turning first to the issue of market abuse, I want to briefly run through our current priorities and some of the work we are doing to address them. The current focus of our market monitoring activity is on countering institutional market abuse.
Let me say at the outset that we don't think that our markets are rife with insider trading or market abuse. We consider the majority of individuals and institutions participating in the UK's financial markets do adhere to high standards. However, a small minority do not and are prepared to engage in unacceptable behaviour. 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 – or indeed fall - for reasons other than manipulation and that speculation is not coterminous with market abuse.
Institutional abuse is obviously particularly insidious as the opportunities for the unscrupulous are more frequent and the potential for damage to market confidence greater. So while we will continue to take enforcement action against individuals who commit market abuse – and the majority of our completed cases so far have been against individuals from outside the financial sector - we are now targeting our resources primarily at institutional cases.
We have become increasingly concerned by the risks generated by institutions exploiting the information they legitimately receive for illegitimate purposes or, less directly culpable but still serious in terms of its impact, failing to ensure that inside information is kept confidential. We know from work we have carried out on assessing market cleanliness that too often for comfort there are price rises in stocks ahead of M&A announcements which suggest that informed trading has taken place.
Our focus 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. But we are also focused on proprietary trading. The more that investment banks make money from buying and selling securities for their own account rather than from traditional investment banking activities, the more potential there is for conflicts of interest to arise and possibly be abused.
Our future work programme covers both pursuing 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.
As part of this strategy of deterrence we think it is important to carry out proactive surveillance rather than simply waiting for cases to be reported to us by exchanges or other market participants. So already this year we have undertaken several pieces of thematic work focused on institutions – many focusing on the potential to abuse conflicts of interest. Recently we have completed some visits to participants in the 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.
We have also reviewed some recent convertible bond issues. We asked the investment firms involved in managing these issues to identify who they had made 'insiders' on these deals. Then by using transaction reports made to us we have been able to analyse this information to identify which of these insiders may have dealt on this inside information. We are now considering what enforcement action might be necessary in cases where there does appear to have been misuse of information.
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 we will continue to pursue cases that ensure our key messages are made to the market.
In our actions against Citigroup in 2005 (the so called 'Dr Evil' bond trading strategy) and our recent case against Deutsche Bank, the key message we have been seeking to make to the market is 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. Poor systems and inappropriate behaviour can have the effect of harming market confidence even in cases where the conduct falls short of being market abuse.
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. This case arose from two separate transactions conducted by Deutsche during March 2004. The first was in relation to a book build which involved the bank's former Head of European Cash Trading. While being actively involved in the book build, he gave instructions for proprietary trading which occurred at a sensitive time during the book build. This trading was not transparent to the market and was of a size and manner that contributed to material changes in the share price of the relevant stock during the book build. It prevented potential investors from gaining a full understanding of the nature of supply and demand for the shares that was independent of the bank. Despite his role in the book build, he gave the instructions to commence the trading without notifying or seeking clearance from the Bank's compliance or senior management or checking the Bank's own restricted list.
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. Our message is that failure to manage risks properly is now, more then ever, likely to result in disciplinary action being brought against individuals as well as firms.
This illustrates the linkage between the topics of market conduct and conflicts of interest and I will now discuss conflicts in more detail. By conflicts, I mean those between a firm's interests and the duties owed to its customers - or instances in which the interests of one client conflict with another.
Conflicts of interest, and potential conflicts, are ubiquitous in the financial services industry. Although the potential for conflicts to arise is likely to be greater in large organisations providing a range of financial services, even the smallest firm which, for example, is paid to act as an intermediary for a client, can have interests which conflict with those of its client. We recognise that it can be the very expertise which attracts a customer to a firm that may create the potential for conflicts to occur. But whilst the existence of conflicts is inherent in the business models of some firms, this does not mean the FSA is prepared to accept conflicts as an unavoidable fact of life.
Proper management of conflicts of interest is at the heart of maintaining fair, orderly and efficient financial markets. To do this, the FSA expects firms to put in place arrangements to identify, manage and mitigate risks arising from conflicts. The key, of course, is how effective these arrangements are. As some recent examples have spectacularly demonstrated, the costs of failing to manage conflicts, in loss of reputation, as well as direct costs, can be substantial. And the impact of the loss of consumer trust, is no less significant. Regulators around the world are rightly concerned with standards and expect strong management oversight and control of this aspect of firms' affairs, given the potential for detriment to customers of the firm concerned, (to the firm itself) and to market confidence.
In response to these issues, we have made changes to our regulatory framework. On the sell-side, we have introduced new rules and guidance concerning the management of conflicts of interest around the production of investment research. They closely follow the principles published by the International Organisation of Securities Commissions (IOSCO). We tightened our requirements on Personal Account dealing and dealing ahead of research. We have also looked into conflicts around IPO allocation and introduced new guidance on management of conflicts in this area.
On the buy-side, we introduced rules to address conflicts between the buy-side's own commercial interests and the interests of their clients which were often exacerbated by arrangements by which commission was used by fund managers to acquire goods and services in addition to execution, now commonly known as soft commission and bundled brokerage arrangements. Because these practices were not transparent, market forces on the buy-side were weak, and investors had insufficient information to judge whether they were getting value for money from expenditure on ancillary services provided along with trade execution.
So what do we expect firms to do to manage their conflicts of interest? Firstly, it is important to recognise that there is no 'one size fits all' approach to conflicts of interest that can address the full range of conflicts that may arise in an individual firm's business. In fact we want individual firms to be thoughtful about the specific issues relevant to them and tailor their conflicts management policies accordingly. Conflicts are a very dynamic issue, and firms' responses to them will need to evolve to reflect changes in market practices and legitimate client expectations.
We aim to work with the grain of the market. Wherever possible, we seek market-based solutions. Where we identify an issue, our preferred approach is to work in partnership with the industry to find solutions. Our aim is to be prescriptive only where absolutely necessary. And we place great importance on the role and responsibilities of senior management in securing compliance with our requirements. We believe it is the responsibility of a firm's senior management to implement arrangements, policies and procedures to manage conflicts effectively.
Through the significant supervisory and thematic work the FSA has undertaken on conflicts, we have identified characteristics of good practice which we expect to find in a well managed firm, these include:
- senior management being fully engaged in conflict identification and management at their firms
- senior management taking an holistic view of conflicts risk and conflict mitigation within the full range of business activities for which they are responsible
- senior management having some means of achieving a consistent treatment of conflicts of interest throughout their organisation
- senior management receiving management information on the extent of, and mitigation of, conflicts of interest in their business in order to control their business effectively
- the firm reviewing on a regular basis the types of mitigation it considers acceptable to address conflict risks
- the culture of an organisation is a key mitigating tool for the proper management of conflicts of interest
The EU's Markets in Financial Instruments Directive, or MiFID, which comes into force across 25 EU member states on 1 November 2007, includes organisational provisions for firms which maintain the European focus on conflicts of interest.
Firms subject to MiFID will be required to establish, implement and maintain an effective conflicts of interest policy set out in writing and appropriate to the size and organisation of the firm and the nature, scale and complexity of its business.
Our current requirements cite disclosure to a customer of an interest in a transaction as one of the reasonable steps a firm may take in order to manage a conflict of interest. Our proposals under MiFID also require disclosure of an actual or potential conflict of interest as a method of managing a conflict, but only where the firm is not reasonably confident that its other procedures and measures for managing the conflict or potential conflict will prevent the risk of damage to the client's interests. This does not imply that disclosure cannot be the appropriate method of managing a conflict. But it does change the emphasis – a firm must consider whether other measures will be effective before resorting to disclosure.
I have discussed some of measures the FSA has taken to promote the effective management of conflicts, but what is important is not the regulator's rules and guidance in themselves, but rather the impact they have in changing firms' behaviour. In light of this, in 2005, the FSA reviewed whether regulatory action in relation to conflicts in investment research had caused firms to change their behaviour. The work focused on both the buy and sell-sides, and examined whether firms had implemented effective policies and procedures to comply with the new rules, and whether clients were better able to make investment decisions with a clear understanding of whether research is impartial.
The findings of the analysis were broadly positive. They indicated that conflicts of interest in the production and dissemination of investment research were better managed than a few years previously, primarily as the new regulations had focused industry's attention on the importance of conflicts of interest.
We all know that conflicts of interest will continue to exist. But we must not become complacent - firms and regulators alike must ensure effective management of conflicts remains a high priority. And this focus on conflicts remains a global issue – as demonstrated by the recent proceedings filed by the Australian Securities and Investments Commission against Citigroup Global Markets Australia for not having in place adequate arrangements for the management of conflicts between its own interests and those of its client and for breaching insider trading rules.
In conclusion then, my key message to you is that as well as the FSA taking steps to combat market abuse, we have made it clear that it is incumbent on the senior management of the firms we regulate to manage its firm's conflicts and guard against the risk that their staff will commit, or facilitate, market abuse. The FSA would much prefer to deter than to enforce: it is more cost effective and better for market confidence. We have therefore been open about our new institutional focus. We know market abuse happens and, if we find it, we will take it very seriously. But 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. To that end we have made it clear that if staff engage in misconduct, and firms know it has happened, we require the 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. We won't however be afraid to pursue the individual.
Thank you for your time.