“It will be of little avail to the people that the laws are made by men of their own choice if the laws be so voluminous that they cannot be read, or so incoherent that they cannot be understood.” – James Madison, fourth President of the United States.
One of the less remarked upon regulatory developments to have happened in the decade since the global financial crisis is the creation of a raft of new, voluntary, industry-written market codes and standards. Their goal? To improve behaviour in global financial markets, create clarity around acceptable practice, and restore trust following post-crisis misconduct scandals. Chief among these new codes is the BIS Global FX Code – a public-private global initiative to improve trust and define what ‘good’ and ‘acceptable’ look like in spot FX markets that still bear the scars of past misconduct scandals. There are many more examples covering banking, money markets, gold bullion, debt trading, and even Blockchain technology. In the UK, groups like the FICC Market Standards Board (FMSB) and the Banking Standards Board (BSB) are enthusiastically writing new ‘standards’. In fact, a major trade-body confided in me recently that they believe large financial institutions operating globally follow, by their count, over 100 different, mostly new, voluntary ‘market codes’ and ‘standards’.
But with firms already facing a sizable number of new binding rules from regulators around the world, what value do they see in further voluntary ones? Do they make things clearer - more black and white? And will they be effective in raising ethical standards and creating trust?
Standards of many stripes
The plethora of new codes that have sprung up post-crisis can be broadly categorised into two types.
The first addresses ambiguities in market practice (so-called ‘grey areas’) by making explicit what is acceptable and what isn’t. To take a non-financial example, consider the UK’s Highway Code. It may surprise you to know that the Highway Code itself is not law, although it is given some effect by judges interpreting the Road Traffic Act. This code defines, among other things, the common agreement that on a UK road with two lanes of traffic, drivers should drive in the left-hand lane (Rule 137). There is no real merit in driving on the left or right of the road (as demonstrated by the various practices around the world). But there is merit in a common agreement within a single country… The sheer terror many of us have experienced on finding ourselves on the wrong side of the road in car journeys abroad is testament to that.
With this in mind, it seems eminently sensible that real ambiguities in market practice, which are causing real problems (the financial equivalent of head-on car collisions), are clarified through common agreement in well-written and publicised codes or standards. To take a technical but important example the FMSB have been mulling: how can issuers, investors and underwriters of new securities ‘hedge’ their related exposures in the market fairly, if those transactions impact benchmarks used to price the new securities?
Standards can play a role in illuminating acceptable behaviour in problems like this. The key caveats in this author’s view though are that:
- such problems genuinely constitute ambiguity (they’re not simply areas where some market participants find their obligations to others an inconvenient constraint on what they would otherwise like to do); and
- the solution is agreed by all and benefits all.
By which I mean, a cynical author of such a code does not seek to purposefully re-interpret, misunderstand or obscure rules that are inconvenient rather than unclear. Solutions should not be designed to entrench practices that benefit one set of market users unfairly over another. A manufacturer of right-hand drive cars would clearly have a vested interest in Rule 137, for example. Anxiety about interpreting rules correctly is widely felt, but it can also be feigned by those who find rules to be awkward constraints on their activities.
The second broad category relates to codes that aim to set high-level normative standards. For as long as there have been groupings of people there have been social norms governing acceptable and unacceptable practices, and for as long as there has been writing, someone will almost certainly have jotted-down those norms as education for new members of the community, and reminders for the rest. Law naturally follows, when communities use their collective authority to appoint parties to investigate breaches of those norms, judge the guilt of the accused, and apply punitive sanctions if guilt is established.
Some of the oldest and most well-known codes are religious – for example, the Christian Ten Commandments. Their prescriptions are not formal law, they are principles-based, high-level in nature and describe what one would consider ‘right’ and ‘good’ in the community, even in the absence of stone tablets. They are statements of ‘core values’.
Such considerations are reflected in codes of a more modern nature. The FX Global Code, for example, has a first principle on striving for the highest ethical standards, including acting honestly, fairly and with integrity in dealings with clients and other market participants. Such principles require a dose of judgement to interpret in marginal circumstances, but should be widely understood by all.
On the surface, it would be very easy to dismiss some of these normative codes as nothing more than symbolism; a sop to angry politicians and the public at large, to show something is being done. Is it really necessary to spell out the need to be honest, be competent, and treat customers fairly? Furthermore, without the force of law, what value do these statements have? The FX market in the UK, pre-scandal, was governed by an (admittedly imperfect) code and this wasn’t followed. Why would a new code, especially a voluntary one, bring different results?
Trust, touchstones and self-imposed tenets
This criticism notwithstanding, many believe normative codes are more substantive than they may first appear.
Advocates of normative codes argue that they are a vital tool for restoring trust in markets post-crisis. The authors of the UK’s Fair and Effective Markets Review (FEMR) believed that, without that trust, markets can never serve society effectively because the public won’t grant them a social licence to operate. The argument goes that the clear provisions laid out in normative codes mean the old excuse that expectations were not explicitly stated or not known can no longer exist.
But in order to be truly effective, actions must match words. Whether normative codes strengthen trust in markets, time will tell, but it strikes me that the key ingredient in restoring trust is the likelihood of commitments being met. In an ideal world with perfectly transparent and competitive markets, breaches of standards would be met with the loss of business, incentivising adherence. At the extreme, those in breach would be ostracised from the community. But we don’t live in an ideal world, and such a Shangri-La is hard to create. It also seems unlikely, given previous experience, that moral pressure alone will be enough to encourage compliance with such standards. There has to be some ‘stick’ and ‘carrot’ – real world consequences – of failing to adhere. These must be robust, and apply both in meeting the letter and the spirit of the codes. I have seen some good suggestions for adherence mechanisms, including that central banks will refuse to deal with those not following relevant codes (a real threat). So it can be done.
A second reason for the development of codes is that industry-ownership of the standards expected of those engaged in financial services may be treated differently from expectations externally imposed upon them. In short, we feel more inclined to abide by the standards we set ourselves than those dictated to us by a third party. It is interesting to note that industry-written codes often closely mirror formal regulation, but perhaps industry feels a greater sense of ownership that creates a positive incentive to conform.
Better the regulator you know?
In many cases, an obvious alternative to both types of code, those that clarify ambiguities and those that set normative standards, is that public authorities write rules and principles. In many places, this is exactly what the FCA and other regulators have done. But the arguments often put forward for an industry code have some force:
- Practitioners are likely to have greater market and technical knowledge than legislators;
- Non-legal language (“plain language”) is more widely understood by front line staff;
- Flexible and evolving standards allow for evolving market practice; and
- Innovation can be fostered by market-friendly solutions.
Regulators can play an important role as referee or neutral arbiter, able to balance competing interests and promote the common good. Such bodies, democratically accountable and with duties derived from statute, can be well-placed to judge whether it is helpful to clear up an ambiguity, or whether it is better to have participants exercise judgement to navigate the various practical permutations. Nonetheless, there is no doubt that very detailed binding rulebooks have their draw-backs, and cannot solve all problems. They can’t define what is right for every scenario. Regulators won’t know about every head-on collision. And they cannot be everywhere at once.
The letter killeth but the spirit giveth life
It is perhaps easy to be cynical about the motives behind codes and statements written by self-interested practitioners, with obvious incentives to either appear to be doing something or to define practices in ways that profit them. It could be argued that setting out more detailed requirements in standards benefits market intermediaries, more than it does consumers. However, the efforts themselves, if done openly and with the right intentions, can be valuable. The best codes address a real need, are read, followed and breaches of those codes acted upon.
Adoption of codes is no panacea, but they can complement regulation to help raise broader standards, particularly in markets less covered by rules. There will always be a need for judgement though and you can’t codify an answer to every question about every factual scenario – there is no removing the grey areas entirely. The real measure of success for codes will not be the number of documents written or the lip-service paid to them. It will be whether they are well written, whether they genuinely benefit all parties, and whether they are followed – letter and spirit.