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Speech by Dan Waters, Director of Retail Policy Division, FSA
BBA Conduct of Business seminar
8 December 2006

Introduction and background

Good morning ladies and gentlemen. I am delighted to be with you today to talk about one of the most important developments in the FSA’s move to more principles based regulation (MPBR). That is, the radical revision of the Conduct of Business sourcebook. This is the part of our Handbook - as you know - that covers the requirements of investment firms in their relationships with their clients - be they retail, institutional or professional. Of course, MiFID addresses some of these issues at a European level for the first time, so we have folded the changes mandated by Europe into our overhaul of the Conduct of Business Sourcebook.

What makes up the core of the move to more principles based regulation? In my mind, there are three key components.

First: the FSA being clearer on the outcomes that really matter, hence the focus on principles and high-level rules rather than pages and pages of detail. In that spirit, you will have seen that our new proposals are half the length of the old COB sourcebook.

Second: firms will have more flexibility to deliver those desired outcomes, taking account of their particular business models.

Third: the FSA will adopt a more interactive and positive approach in giving guidance to firms about acceptable standards, including working with industry trade associations that wish to issue guidance or adopt codes of their own in appropriate circumstances.

Before I turn to NEWCOB, I want to take a moment to respond to some concerns that have been bubbling up recently about more principles-based regulation. These have arisen largely, but not wholly, in the context of our Treating Customers Fairly work, but they are relevant to the philosophy and operation of principles-based regulation more generally.

As you know, our TCF initiative is intended to bring about a step-change in the behaviour of the financial services sector and therefore to deliver better outcomes for retail consumers. We do not see achieving these better outcomes as requiring us to make new rules. They are implicit in our existing Principles for Businesses, and in particular in Principle 6, which states that 'a firm must pay due regard to the interests of its customers and treat them fairly'.

In taking forward TCF we have used a range of approaches - for example the publication of case studies and of statements of good and poor practice - to help firms to interpret for themselves the meaning of relevant principles and to challenge firms to review their practices and to facilitate change.

We recognise that some firms may prefer that the FSA focused solely on detailed rules. We have been asked, “what are the minimum standards with which firms are required to comply?’ Surely, the answer is blindingly obvious: the requirements in the Handbook. But, in a way, the question risks missing the point of more principles-based regulation which is to encourage a thoughtful and individual engagement by senior management and firms with the core of what regulation is trying to achieve. MPBR is about developing understanding of how the Principles and high-level rules apply in practice, in the real world, in the circumstances of particular firms. It is not about a mindset which implies that once I’ve met the minimum, I can forget about regulation. Life changes, firms and their business models change, the implications of the principles and high-level rules in the day-to-day life of firms change too. MPBR is about thoughtful, challenging engagement, firm-by-firm, with fundamental regulatory questions. There is no rulebook, however long, that could contain the answers to these questions.

It has also been suggested that the TCF initiative has resulted in a significant increase in the rules that firms need to comply with. Again, this is not the case. The initiative has asked senior management to put in place a review (proportionate to business size and complexity) of the degree to which they currently meet the existing FSA Principles and high-level rules, and to remedy the position where they find they are adrift. There are no new requirements here.

We are pleased by the very constructive way in which senior management in many firms have recognised that they were less compliant with the Principles than they at first supposed, and have sought to address the issue - often increasingly recognising the commercial benefits of doing so.

Thirdly, it has been said that the material we have published on TCF is equivalent in its impact to the rules and guidance in our Handbook, but that because it is not formally defined as such, it is not subject to the same process disciplines of consultation and cost-benefit analysis. For our part, I would re-iterate that we are clear that TCF is not a new regulatory requirement. Nor is it something that we have developed without consultation. We have had very valuable assistance from the TCF Consultative Group, which meets regularly, and provides advice and input on our strategy and overall approach.

But, more worrying to me is the apparent mindset that lies behind these process-based criticisms. It seems to rest upon the assumption that the FSA cannot, working with the industry, find flexible and creative ways for individual firms to interpret and apply principles and high-level rules in their own particular circumstances. Instead, we must proceed by formal consultation and rule-based approaches that dictate solutions across the board. We need not look too far to find the sort of regime that a defensive, legalistic approach will lead to. How many years would it take before we had our very own Enron? For my part, I would rather take the path, which no doubt has risks, of seeking a proportionate regulatory regime that tries to build upon trust between the regulator and the regulated, rather than one that relies upon the illusory certitude of detailed rules - which in reality is more likely to lead to escalating cycles of legalistic gamesmanship to evade them.

With those words about more principles-based regulation, let me turn now to NEWCOB. Where have we got to so far? As you know, at the end of October, we published two consultation papers: CP06/19 on Reforming COB Regulation and CP06/20 on Financial promotion and other communications. And it is actually BOTH of these papers that set out our proposals for a new COB sourcebook (NEWCOB) which will replace the current COB sourcebook on 1 November 2007 (to coincide with MiFID implementation).

The BBA's press release was supportive of our proposals to simplify our COB rules - so thank you for that! Ian Mullen stated that the BBA was 'pleased with the move to principles based regulation, which should provide far greater flexibility for banks to remain innovative and competitive'. We have since received the BBA's response to our consultation proposals, which again demonstrates the BBA's general support for our principles-based approach to rule-making. We also acknowledge, however, the BBA's concern that we set and maintain the right balance between the flexibility of a principles-based approach, and the need for firms to have certainty over their daily operations. We are currently considering various ways in which we can provide 'working good practice' so that firms will have enough certainty as to how we will approach issues.

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What does NEWCOB look like?

As you will have already seen, the draft rules look different from current COB in both structure and presentation. Our aim has been to produce something that is easier to understand, comply with and amend than the current version.

It's shorter by half, and has a new chronological structure that follows the different stages of a firm's relationship with a client (starting with marketing and financial promotions, moving through to advice, and then selling and so on). Some material has moved into free-standing chapters outside this chronological structure, where this would make it easier for readers to follow (for example, on distance marketing, with-profits business and pensions).

We have adopted an ‘intelligent copy-out’ approach to implementing European directives, and this has also influenced NEWCOB’s presentation. We have labelled rules derived from European legislation (indicating which directive has been copied out). We will also be identifying key rules to make it easier for readers to get an overview of the regime.

What’s new in NEWCOB?

My colleague, Jennifer Long, will cover off the key changes to look out for in the retail area of NEWCOB in her presentation later on this morning - and that will include:

• Suitability
• 'Appropriateness'
• Client categorisation
• Product disclosure
• Financial promotions

What I would like to highlight now, however, are a couple of areas that the BBA advised me were of particular interest to its members. These are Best execution and the [MiFID] Article 4 notifications - both of which go beyond the retail matters that Jennifer will deal with later.

Best execution

MiFID's requirements for best execution will replace all of our current Handbook provisions [non-scope]. Best execution requirements will apply to firms that execute client orders, manage client portfolios or receive and transmit client orders. Time today does not permit me to go into any detail about the main changes, so I'd prefer to touch on what the current issues are.

Over the last few months, discussions on the MiFID best execution requirements have focused on four main issues: scope, the relative importance of price, the use of internal models, and the use of benchmarks. I will summarise the current state of play on each of these issues in turn.

Scope

In the October Reforming COB Consultation Paper, we set out our view that under MiFID, firms operating in quote-driven markets may - but are not required to - provide best execution. But firms that provide quotes to customers without providing best execution must make their customers fully aware of this and any related consequences.

This approach is possible in both retail and dealer markets on the basis that the customer decides for itself where, and with whom, it wants to deal - resulting from its own selection of available products and prices. In such cases, the dealing firm responding to the customer’s acceptance of the quote is not "executing orders" as such.

Both the buy and sell-sides are now raising concerns about the analysis we have put forward to support these conclusions; they believe the analysis has the effect of preventing buy-side firms from being "clients" of sell-side firms with respect to quote-driven transactions. They believe that this "non-client" status is detrimental because it deprives them of certain MiFID protections, including conflicts of interest and client money protections. In particular, they are concerned that "non-client" status would allow practices - such as front running - which are currently prohibited or, at a minimum, require disclosure to clients. Some on the sell-side have recently indicated their support for the buy-side view and have represented that they have no wish to treat buy-side firms as "non-clients" for quote-driven transactions.

We will be considering these issues and any other responses we receive during the consultation period before we reach any conclusions. At the same time, in pursuing its Level 3 agenda, which includes best execution, CESR has written asking the Commission to comment on this question. We await the Commission's response and we will, of course, attach due weight to it.

Price

Some respondents to our best execution Discussion Paper said that price has no place in the best execution analysis for many OTC instruments. At Level 1, we argued successfully that Article 21 should not prescribe weightings or priorities for relevant factors to preserve flexibility. But that was in the context of the broadly accepted policy agreement that best execution requirements are intended to drive efficient price formation.

We continue to support the need for flexibility in applying MiFID's best execution requirements but, given the responses to our Discussion Paper, we believe it is necessary to remind firms that price is important. Therefore, we have proposed guidance to clarify that ordinarily, price will merit a high relative importance in obtaining the best possible result for the execution of client orders. The guidance, however, also acknowledges that, in some circumstances, for some financial instruments or clients, a firm's execution policy may appropriately determine that other factors are more important than price in obtaining the best possible execution result. Initial industry feedback on this proposal has been positive.

Internal Models

Several respondents to our May Discussion Paper on best execution said that firms should be permitted to rely on their internal pricing models to demonstrate compliance with best execution requirements. Our view is that the "best possible result" for an OTC transaction refers to the best possible result having due regard to the wider market in any relevant instrument. So, a firm may rely on an internal model only where it allows the firm to obtain the best possible result in that wider sense.

Benchmarks

In the DP on best execution, we explored whether firms that execute client orders by dealing on own account could comply with best execution by relating their prices to robust external benchmarks. Industry response to this idea was quite negative, on the basis that we would transform this safe harbour into a super-equivalent requirement and impose it on transactions in illiquid markets. I can assure you that was not our intention. Nevertheless, we do not see the point in proposing guidance that the industry considers unhelpful, so there was no benchmarking proposal in the October Consultation Paper. We continue, however, to see benchmarking as a valid approach to best execution in some markets and we will be open to discussion should the industry decide that benchmarking would be a useful item to address in their own codes.

Going forward

At the same time that we are trying to finalise the Handbook text, we are also working with you to consider what these requirements might mean in practice. We understand that you are also moving forward with your own work in this area, which is likely to result in some industry-led guidance.

CESR

The Committee of European Securities Regulators is also on the implementation case, as I mentioned above. As part of its Level 3 work, CESR is now preparing a paper that will address what they regard as the key issues of implementation. In deciding where to place their focus, they are considering the issues that you have raised with the regulators in particular Member States, including in response to our best execution DP and the consultation paper from the French AMF. The FSA is playing a very active role in this work, drawing heavily on your feedback to our best execution DP, as well as the regular communications we have had over the past six months.

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NEWCOB and retention of requirements in addition to MiFID

The BBA also asked me specifically to speak to our approach in relation to those areas of NEWCOB that may go beyond European requirements. I want to stress at the outset the very rigorous approach we have taken in respect of this issue. As you'll appreciate from my earlier comments and from the NEWCOB consultation papers themselves, the FSA's reform of the existing COB regime - in conjunction with MiFID implementation - has involved a review and challenge of almost every aspect of our current COB sourcebook. In assessing our approach in a European context, it is also important to realise that MiFID brings regulation of many aspects of the intermediation of advice and financial promotions to some European jurisdictions for the first time. By contrast, the UK has nearly twenty years experience of regulation in these areas. We have learned a lot, some of it the hard way, about what does and does not work in the world of regulation of retail financial services in the UK. And we are still learning, and still reassessing.

Regrettably, MiFID was not developed on the back of similar experience, nor can it be said that its approach to conduct of business regulation was informed by the same degree of research or analysis of effective regulation of retail consumer transactions, or any meaningful cost-benefit analysis of retail regulatory intervention. This has meant that in some areas, the MiFID solution can perhaps be described as, at best, sub-optimal.

So we have had to examine very carefully any areas where the MiFID standard alone may not be an adequate substitute for core elements of the UK retail regulatory regime. In the end, however, we have decided to seek to retain only a handful of additional key provisions - as I will explain. And the hurdle we set for retention of these provisions was very high indeed.

As you know, MiFID's highly harmonising Level 2 implementing measures limit the scope for further requirements in the areas covered by the Directive. The constraint is contained in Article 4 of the Level 2 Implementing Directive, which sets out the conditions for the creation or retention of national requirements that go beyond MiFID, and requires that these be notified to the European Commission.

This Article 4 test essentially requires that any extra measures be proportionate and address specific risks not adequately addressed by the Directive, which either

• are of particular importance in the market structure of the Member State, taking into account firms' and consumers' behaviour in that market; or
• emerge after the Directive takes effect.

We had no intention of relying on Article 4 simply for the sake of keeping our existing rulebook. Quite the opposite. We started with a presumption of intelligent copy-out of the MiFID text, and identified where MiFID's different approach seeks to address similar issues in an effective way. So we looked first at the MiFID requirements to see whether they addressed UK market failures we had identified. In some cases, we took the view that MiFID tackled the market failures sufficiently, so we did not need to retain additional domestic rules. But in a few areas, we concluded that the MiFID standard on its own didn't fully address key risks in the UK retail market.

Therefore, after rigorous examination, including cost-benefit analysis, we are proposing to retain some requirements that supplement MiFID in a way that may require an Article 4 notification, though in a small number of key areas only. As we have explained, these are the retention of:

• requirements for an Initial Disclosure Document and Menu - though we'll be looking at these again in the context of our post-implementation review of depolarisation;
• requirements that prescribe conditions to be satisfied by advisers that choose to call themselves ‘independent’;
• a requirement to provide a written explanation of the reasons for advice given to retail clients on packaged products - a less prescriptive development of the current suitability letter requirement;
• requirements for intermediaries to provide certain product information in the form of standardised ‘keyfacts’ documents and simplified prospectuses;
• the recently-introduced ‘use of dealing commission’ provisions which restrict the use by investment managers of client dealing commissions to buying execution and research services, and require them to make adequate disclosure to clients of goods and services received; and
• a non-NEWCOB notification in relation to the retention of requirements relating to senior management responsibility.

Jennifer will say more about some of these areas of NEWCOB later this morning.

We need to file formally our written Article 4 notifications with European Commission by 31 January, and we have promised to publish these for all interested parties to see why we consider that retention is justified.

Home and host state regulatory responsibilities

The BBA also mentioned that they wanted me to address the issues arising from different sets of conduct of business rules that may apply in cross-border business [when a bank branch does cross-border business]. There is not a lot more I can say on this "wider European context" issue at this time. We appreciate that this is important, and - as you may know - the division of home and host regulatory responsibilities has been recognised by CESR as an urgent priority in its Level 3 work. We are contributing to the work of CESR and we would also urge firms to take the opportunity to respond to the CESR consultation paper, if necessary, through the relevant trade body. Matters of legal interpretation are the responsibility of the Commission and again firms should contact their trade body with any concerns. We are aware of the importance of this issue to firms and we will consider what further clarification may be appropriate following the conclusion of the CESR process.

Round-up and close

In closing, let me say how important it is for each of you to engage proactively with the NEWCOB agenda. The first level of engagement is obviously with the Consultation Papers themselves - especially the draft rules. There is a great deal there, some of it new, which warrants your attention. Your comments directly or through the BBA will be valuable and welcome. I know that many of you have already responded on those aspects for which there was a very tight deadline. Thank you very much indeed for pulling out all the stops there. And you'll be glad to know that the late nights are now back with us, as we study your comments. The non-MiFID remainder of the NEWCOB consultation of course runs through to 23 February.

Second, and just as important, is your engagement with the underlying agenda of NEWCOB, namely, the move to more principles-based regulation. That is a challenge for each of you; it is a challenge for us as well. We are looking for an approach to delivery of regulatory outcomes that is dynamic and sensitive to the complexity and variety of financial services businesses in the United Kingdom. In this country, perhaps more than in any other in Europe, there is a plethora of business models, and a profusion of creativity and innovation that we do not want to inhibit through lacklustre regulation.

We firmly believe that, properly and sensibly implemented by firms and by the regulator, a principles-based approach to regulation will set the trend for future regulatory development globally, just as our work on risk-based regulation did at the beginning of this century. But let us be very clear that delivery of this vision is a joint enterprise between the industry and the regulator; it cannot be achieved in any other way. Thank you for your kind attention.

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