Fair and effective markets review

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Speech by Tracey McDermott, director of supervision, investment, wholesale and specialists, at the Financial Conduct Authority (FCA), delivered at the ICMA Public Sector Issuers Forum, London on 24 June 2015. This is the text of the speech as drafted, which may differ from the delivered version.

Thank you for inviting me here today to talk about the Fair and Effective Markets Review.  

It is difficult to overstate the importance of your role as representatives of debt management offices and other agencies across Europe to the overall functioning of the markets. There are currently over EUR 9 trillion of outstanding government debt securities, forming a critical part of the holdings of many market participants. This group, of course, also sits within the broader ICMA structure, which aims to represent all sides of the global bond markets and to put bond markets in a real economic context.  

This is a huge and important market, not just for the governments you represent, but also for investors who rely on your securities as a safe home for their cash within their portfolios. And particularly, for those same investors who need government securities increasingly as high-quality collateral for their risk management trades. You are a critical group of users within the vast complexity of today’s wholesale securities markets.

While public sector issuance has its unique features, it also has many similarities with other parts of the global securities markets. These include many of the players and structures which make up the primary and secondary markets in your securities, which includes the firms we at the FCA regulate. And it is your market, and those like it that formed the focal points for the Fair and Effective Markets Review, or ‘FEMR’ as we call it.  

The financial crisis which hit the UK and global economy in 2007 led to widespread state interventions in financial institutions worldwide.  Here in the UK, huge amounts of public money were ploughed into bailing out major UK banks in 2008.  

Public anger was significant and the reverberations and impact on the real economy have been profound.  There has been a massive policy, legislative and regulatory response aimed at ensuring that never again could banks benefit from the implicit taxpayer subsidy.  And, over time, people started to talk about a return to ‘normality’, with Bob Diamond in 2011 famously talking about the time for remorse being over.  

That sentiment got little sympathy at the time. It got even less in 2012, when regulators around the world began publishing findings in respect of banks for the attempted manipulation of LIBOR.  Public outrage was palpable.  

To many this confirmed their suspicions – the system was working better for those within it than for those it was supposed to be there to serve. The emails and messages between traders seemed to sum up a culture where there was complete disregard for the integrity of the markets and fair play, and the test seemed to be what you could get away with and not what was right – morally, ethically or indeed legally.

The bank chiefs said they were appalled – reprehensible, unethical behaviour. In the UK, the Chancellor of the Exchequer formed a parliamentary commission to look at what went wrong and recommend ways to ensure it didn’t happen again.  

The parliamentary commission on banking standards reported in 2012 and made a number of recommendations for changes to the banking system. One of the themes of this commission’s findings was a lack of individual accountability – a theme I will come back to later.  

However, just a couple of years later we were back there again.  Announcements of huge penalties for the manipulation of the foreign exchange market were accompanied by those dismayingly familiar trader messages.  

Here again we saw participants in an unregulated yet hugely important market demonstrating a cavalier disregard for the interests of their clients, their employers and the wider market. Once again, the question was raised as to why, and how, it was that people still had just not got it.

There was clearly still a gap between what markets are intended to be for – delivering for the good of society – and where they ended up – with some in them focused only on their own gains; and where cross-firm tribalism was more important than the interests of their clients or their firms. And where firms had failed, despite the lessons of LIBOR, to identify and manage the risks they faced.       

Although far from representative of the behaviour of most market participants, these are the actions that stick in the mind of the public and which have contributed to the significant failures in trust and confidence.  

I think we would all agree that it’s been disheartening for regulators and others to see examples such as this; to see issues arising in one market, followed by promises that lessons will be learned from those involved, but with the same types of issues by the same parties appearing again in other markets a short time later.


So, that is the why – but what was FEMR?   

Both manipulation of LIBOR and FX happened in the mostly unregulated space of the Fixed Income, Currency and Commodity – collectively FICC – markets.  

In light of the misconduct and allegations, and recognising the importance of these markets to the UK, the Government announced FEMR – a wholesale review of how these markets operated. An attempt to identify the root causes that had led to the misconduct we had seen and to think about how it could be avoided in the future.

The aim of the review was to help restore confidence in FICC markets and to influence the debate about future trading practices.  

The year-long review by the three UK authorities – the FCA, Bank of England and HM Treasury – has now concluded. The report was published two weeks ago.  

It set out an extensive analysis of the causes of misconduct in FICC markets and made a total of 21 recommendations – directed at the UK authorities and government, international standard-setting bodies like the FSB and IOSCO and finally to firms themselves.

These recommendations cover issues as wide and diverse as the regulatory perimeter, market structures, individual accountability and use of market power.

The UK has a key role to play in identifying areas of weakness and leading the charge for improved standards.

You here will of course all be aware that none of these markets we are talking about are the small, esoteric markets some might imagine. They are hugely important and almost other-worldly in scale:

  • turnover in foreign exchange markets is some $5 trillion a day
  • the global stock of corporate, financial and government bonds in issuance is nearly $100 trillion – including the $9 trillion of securities issued by the agencies represented in this room mentioned a moment ago; and
  • FICC ‘over-the-counter’ derivatives amount to some $620 trillion in notional terms

Significant percentages of all of these markets are transacted through or booked in London and other European capitals. The UK, by virtue of its prominent role in these markets and its long and hard-won reputation for innovation, fair dealing and consistency, has a key role to play in identifying areas of weakness and leading the charge for improved standards

It’s for this reason that the Chancellor asked the Authorities to look into the root causes of these problems, considering what is already being done and, if necessary, make a set of recommendations for change

How the review was conducted

So, just a word on how the review was conducted. This was a joint exercise of the three authorities – Chaired by Minouche Shafik, deputy governor at the Bank of England, and co-chaired by the FCA CEO Martin Wheatley and Charles Roxburgh, Director-General for Financial Services at HMT.

A team of staff from across the authorities have spent a year studying and discussing these markets with as many stakeholders as possible:  intermediaries, infrastructure providers, end-users, investors. But also governments, standards bodies, interest groups and more.  

Well over 200 bilateral meetings took place, as well as around 800 phone calls and a number of public events in London, Brussels, Washington, New York and Singapore.

In addition, the Review received over 1,000 pages of written submissions for which we were enormously grateful, as these really did help inform the conclusions and recommendations of the report.

The first stage in the process was to define what we mean by ‘fair’ and ‘effective’ markets. This was informed by consultation responses from market participants and leading academics.

The definitions are noted in the report: clear, transparent and honest, liquid, robust, competitive and well-managed. These definitions set a clear goal of where we all want to get to.  

Both parts – fairness and effectiveness - are important and are components of the FCA’s central mission of ensuring that markets work well.

What the Review found

So, what did the review find? Well, this is a classic good news / bad news story. First the good…

As this group will know, the markets broadly work and fulfil their function. They allow you to sell your sovereign and municipal securities to investors. And elsewhere they allow investors, borrowers and those wishing to mitigate their financial risks to have their needs met in most circumstances.  

Further, the markets have broadly offered tight pricing and deep liquidity for lots of liquid instruments (including government bonds) and have offered good levels of customisation for those seeking bespoke options in less liquid markets. And these features have largely remained present even when parties wished to trade in volume or during times of market stress.

But this has not been the topic of public discussion in recent years. The misconduct identified by regulators and authorities around the globe has severely damaged trust and confidence in the markets.  Such damage impacts some participants directly, as it deters parties from participating in the markets, reducing volumes and increasing costs.  

And it has a much more corrosive long-term effect as it destroys trust and confidence in markets and, as such, what colleagues at the Bank of England have described as the “social licence” for institutions to operate. And this is critical, as the effective functioning of these markets will be central in helping to re-build strong and resilient economies.

So what were the conclusions as to the root causes of the misconduct? They fall into six categories:

  • Market structures presented opportunities for abuse – so, the design of benchmarks like LIBOR gave opportunities to the unscrupulous to manipulate. We also saw numerous examples of intermediaries failing to properly manage conflicts between their principal trading activities and their activities where they are acting as agents for clients. We have also seen thin markets in some less liquid asset classes
  • A lack of well understood and followed standards in certain unregulated markets – spot FX being the principle example. There are many codes relating to FX including the NIPs code in the UK, but these were not at the forefront of the minds of those trading in these markets
  • Systems of internal governance and control at firms that placed too much reliance on compliance staff and lawyers to get the right outcomes. Responsibility was not resting where it should have been – with staff on the front line to identify and manage risks to the business – obviously supported by proper training and monitoring
  • Competitive forces not working as we’d expect – particularly, that buyside firms failed to move business between sell-side firms (i.e. exercise market discipline), even when misconduct had been revealed and it was clear that clients were getting a worse deal as a result
  • Poorly designed remuneration and incentive structures – an issue you’ve probably heard regulators say a lot about before, and where we issued further rules yesterday; structures which, in summary, encouraged short-term pursuit of profit rather than long-term sustainable business
  • And finally, what has been described as a ‘culture of impunity’ in some parts of the markets.  By which is meant that certain individuals assumed that, in markets like Spot FX which are outside the primary regulatory perimeter, no one was watching and no one cared about their behaviour.  This led to what the report describes as ‘ethical drift’ – where, essentially, unacceptable behaviour had become the norm over time

So, those are the findings of the Review.  Many of these are not new and, in some areas, steps are already in train to address them.  

Regulatory reforms in Europe like MiFID 2 and the new Market Abuse Regulation, and in the US like the Dodd-Frank Act.  

New regulators like the FCA, setting clear expectations and taking stronger and quicker action against identified failures.  

Firms hiring new compliance staff, establishing cultural change programmes, developing better staff training and listening to customers more.

However, while the review recognises the large efforts already taken, to really ‘end the age of irresponsibility’ and reach the ‘inflection point’ FCA CEO, Martin Wheatley spoke about in the FT last week, it also identified some gaps and areas where more work needs to be done.

This is the domain of the Review’s 21 recommendations.

FEMR recommendations

I don’t intend to go through all 21 recommendations, but will instead note the themes that ran through these recommendations and highlight just a few that are really important to this audience and the FCA.

So, a theme I touched on earlier and a seeming constant in all of this misconduct: a lack of individual accountability. Perhaps a statement of the obvious, but it goes back to my point earlier about cultures of impunity. Those who believe that they will not be caught will push the boundaries and behave in ways which are unacceptable. The recommendations seek to embed accountability with front-line staff for their actions and to make senior managers properly responsible for their role in controlling their businesses and managing their staff.  

These are innovative, ever changing markets and solutions designed by participants are more likely to be flexible, adaptable, responsive and practical.

Second, it is desirable for the market itself to take collective responsibility for maintaining high standards. What we mean here is that it isn’t the ideal solution for the regulators to dictate rules down to the n’th degree. These are innovative, ever changing markets and solutions designed by participants are more likely to be flexible, adaptable, responsive and practical.

Firms who operate in these markets therefore need to take responsibility for ensuring standards of market practice are high. Where standards are clear, firms need to ensure they are met and that staff are appropriate trained.  If a market practice isn’t clear the industry needs to work collectively to find solutions. It’s for this reason that the Review recommends the creation of a new industry body, the FMSB, to help develop standards and encourage, even champion, good practice.  

Third, to maintain a continued credible deterrence and as a back-stop for where standards slip – and to be realistic, in an industry employing over 1 million people in the UK alone, standards will slip from time to time – the regulatory perimeter should be extended. For example, closing the gap that market abuse rules do not cover spot FX markets.

Fourth, recognising that these are global markets, the international authorities must play their part and work collectively to help raise standards.

Senior Managers Regime

I’d like to spend a couple of minutes mentioning three of the recommendations that may be of most interest to this group.

First, the Senior Managers and Certification Regime. The parliamentary commission I referred to earlier recommended the creation of a new regime to ensure greater accountability of senior staff at Banks, Building Societies and certain Investment Banks.  

This regime was created by the Banking Reform Act 2013, which introduced requirements to ensure that senior leaders should be held responsible for the actions of their staff and the conduct of the business that took place under their leadership. Perhaps obvious, but notably absent from much crisis-era behaviour.  

It further applied some basic conduct standards on the much larger number of more junior, front line staff, and required firms to do yearly certifications that their staff were still fit and proper to undertake their roles. Part of that certification is to consider whether individuals meet the requirements of codes and standards.

While this regime was introduced to address the concerns highlighted by the financial crisis, FEMR has recommended that the regime be extended to at least all firms active in FICC markets to address the post-crisis misconduct that has come to light.

It was not envisioned that this extended regime would bring any new parties within regulation itself, but rather it would ensure that those FCA regulated firms that engage in these wholesale markets are captured by this form of regime. For example, asset managers, interdealer brokers, and others.

As with our banking regime, there will be quite a bit of detail underpinning this regime built around the simple concept of accountability. Therefore, following primary legislation, we’ll be consulting on the detail and will be encouraging all interested parties to share their views with us.

FICC Market Standards Board

Also about taking more responsibility, FEMR recommended the creation of a new FICC Markets Standards Board. Before talking about what it will do, just a note on what it won’t do, to address some misconceptions about this group.  

First and foremost, this is not about self-regulation. The body will not be responsible for regulation of FICC markets. It will not set legally binding rules or mandate industry action.  

What it will do is provide a forum to overcome coordination failures in the market, and work with Authorities in the UK and elsewhere to raise standards. It will work with authorities to help spot trends and risks to the market. It will help interpret rules through the production of materials like case studies. It will call out good practice and encourage firms to take note. And it will do this for standards globally.

Nothing it will produce will replace laws and rules set by Governments and Regulators and it will be entirely member funded. But it will help market participants to understand those laws and rules, and think about how best to apply them to real scenarios when providing a high level of service to customers.

Elizabeth Corley from Allianz Global Investors is going to be the Interim Chair of the group, and has already been successful in getting a number of the largest global firms to join the Board.  We wish her well in taking forward this group’s mission. And one thing we’ve been keen on is ensuring that the FMSB, much like ICMA, represents all players in the market.  

Market structures

Finally, to talk about the report’s principles to guide fairer and more effective market structures. While there was certainly consideration of mandating structural change to the way markets operate, it was decided that a combination of technological innovation and reforms already taking place to meet the G20 Pittsburgh agreement (e.g., MiFID 2) were probably sufficient for now. However, the Review does note some high-level principles to guide the future development of markets, including the important of transparency, open access, competition and choice.

There is discussion of some of the different types of market structures – exchanges, voice broking and everything in between – and the positives and negatives their features engender. It considers issues with Markets that rely heavily on benchmarks, particularly those that aren’t effective in their design.  And it thinks about some more thorny issues, such as bond standardisation and allocation practices.

While your markets, in government securities, typically tend to be more liquid that some lesser traded corporates, I’m sure these issues will be equally of interest.  

Whereas you may have a handful of different types of government securities in issuance, by way of example, RBS plc today has over 1,000 outstand bonds available to trade. Other corporates, say the energy company BP, has around 75 different bonds. Such variety (including variety of terms and conditions of the instruments), while perhaps good for the company issuing in terms of flexibility makes secondary trading conditions difficult in terms of liquidity. This in turn increases the costs of trading, and may feedback into the prices issuers can get for new securities in the primary market.  But we are talking about a trade-offs here between cost, efficiency and choice.

Equally, with allocations, there are a number of different practices and way of allocating issuances in the primary market. How fair and effective each is, is a matter of judgement.

With both issues, as examples, it is not the job of the Review, or us as the UK Market Regulator, to dictate on such matters. But they clearly impact on both the fairness and effectiveness of markets, and so the FEMR gives some steer and direction to where things could, or perhaps should, go in future and turns this over to industry leaders to consider the next steps.

International action

The markets we are talking about here are global markets, and the misconduct in these markets has also been occurring globally. There is no point in London ploughing ahead on its own. We want to ensure that misconduct in London does not just migrate to Singapore, or to New York, or to Paris.

So the bigger challenge is at global level. We want to raise standards globally, and for that reason the Review makes several recommendations directly to international bodies. We hope that IOSCO and the FSB will consider these recommendations, and indeed, the IOSCO Board last week committed to the formation of a working group to look at carrying forward the conduct agenda.    

One early example is the work being done by the Bank for International Settlement’s Market Committee, to create a new global FX code. The code will set out clear expectations for the operation of these markets, including on issues such as abusive practices and managing conflicts of interest.

The future

Those are the findings and recommendations of the report. I would encourage you all to read the report, which gives an interesting ‘snap shot’ of where these markets are at today and some of the challenges they face.

In terms of what happens next, many different things have to occur. These include passing of certain pieces of primary legislation by the UK Parliament, our own organisation consulting on rules, industry establishing the new FMSB and regulators coming together in groups like IOSCO and FSB to agree work plans.  

It is important to note that nothing changes immediately and FCA rules remain. But over the next couple of years things will start to change and hopefully encourage change for the better in the markets this applies to.

As one of the authors of the report, we’ll be monitoring progress of these changes and reporting to the Chancellor and Governor of the Bank of England in a year’s time on how this has gone. But we can’t do this alone and there is much for industry to take forward.  

The findings provide colour on what issues can exist, and firms should be thinking about whether they’ve addressed the issues in their own firms. The messages of the report in terms of how markets are structured and how competition is, or is not, working are instructive. We’ll be encouraging buy-side firms and end-users such as your agencies to further exercise market discipline through consideration of whether you are getting the best prices and level of service that you and those you act for expect. If you’re not, we are interested to hear about the barriers that prevent this.

And finally, the publication of the report doesn’t mean the end of the discussion. In many ways it is just the start. Every recommendation that will become rules will be subject to consultation. And we’ll be continuing the good dialogue we’ve started with industry through events and roundtables starting this summer and continuing thereafter.

Firms need to step up. While the authorities have fired the starting gun at this inflection point, this is the industry’s destiny to control and shape.

There is a huge challenge here, but it’s also an opportunity. Firms need to step up. My final message is that, while the authorities have fired the starting gun at this inflection point, this is the industry’s destiny to control and shape. And if the industry does not seize this opportunity it will not get another.

I’m sure you can all see the imperative of undertaking this work, and I’m hopeful that through effective change we can ensure that markets in London and beyond continue to be vibrant and serve their customers fairly and effectively.