The New Market Infrastructure

Keynote speech by David Lawton, Director of Markets, at the Economist Bellwether Conference. This is the text of the speech as drafted, which may differ from the delivered version.

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We are now in an intense period of implementation. Firms will need to adapt their business models to meet regulators’ and policy-makers’ expectations and, importantly, put customers at the heart of their businesses.

Good morning, and thank you to the Economist for inviting me to share with you a regulator’s view on the evolving structure of today’s capital markets.

I should say right at the outset that I am not going to attempt a complete survey of the topic. While that might be the perfect scene-setter for the rest of the day, I am afraid that it is probably beyond my capabilities. And it is almost certainly beyond my allotted timeslot.

Instead, I would like to offer some reflections on what makes for successful capital markets, what the raft of regulatory interventions have been trying to achieve over the past few years, and some of the main challenges arising from change in the period to come. My key messages will be that:

  • The crisis has prompted a seismic shift in the regulation of markets. A major focus has been on measures to stabilise the system against future shocks.
  • We are now in an intense period of implementation. Firms will need to adapt their business models to meet regulators’ and policy-makers’ expectations and, importantly, put customers at the heart of their businesses.
  • Implementation and adaptation inevitably carries risks, which we all need to be alive to.
  • Looking forward, the policy debate is likely to shift from stability to growth.
  • Against that background, it will be ever more vital that the capital markets that will exist in the future will be more efficient, cleaner, safer and transparent.

Why regulators are interested

Let’s start with some basics. Capital markets are obviously an essential part of the global economy, indispensable to facilitating business growth, and wider economic prosperity. They are the mechanism for channelling the savings of individuals and businesses, via various intermediaries, to those requiring funding for investment and growth. The markets themselves provide liquidity, means for price formation, and channels for managing risks.

So, for example, in the year to date, approximately £6.15bn has been raised via the UK’s domestic stock exchange to fund new and existing businesses, while bond issuances in the UK have provided a further £43bn of funding. Without the ability to raise funds in this way, undoubtedly, the UK economy would be worse off.

Given the importance of capital markets, we need to consider carefully how they can be underpinned and developed. There are, to my mind, three broad factors determining the shape of these markets, and their success:

  1. the wider economic environment
  2. the legal and regulatory framework in which they are set
  3. and, finally, the business models, activities, and behaviours of the firms, intermediaries and infrastructures which collectively go to make up the markets

It is the second and third of these I wish to focus on today, but with the caveat that regulation cannot fail to influence and be influenced by the first factor – the wider economic environment.

Regulation, while of course not the whole story, is an important part of the picture. Given the asymmetries of information between participants, the possibility for conflicting interests, and the systemic risks arising from network effects and the ‘too big to fail’ issue, regulation is needed to ensure that markets:

  • are providing an appropriate degree of protection for their users
  • are stable – including being fair, clean and resilient to operational shocks
  • work on the basis that firms compete on factors such as price, innovation and quality of service for their customers, and not on risk

Market stability and regulatory reform

Why we need reform – the crisis

The main focus of regulators and policy-makers more broadly over the past few years has been on restoring stability after the financial crisis. In the time allotted, I couldn’t hope to cover why the crisis happened in full, but it seems to me that part of the problem was the structure of the markets themselves. Individual firm failure, the drying up of liquidity, and extreme volatility exposed the weakness of existing structures. Some firms at the centre of the market were too big to fail. Other firms providing key inputs to the markets were unregulated and lacked oversight. Markets were not providing sufficient transparency about the risks being generated, and who was bearing them.

The resulting regulatory reforms were driven by agreement at the highest political level. Much of the capital markets agenda can be traced back to the G20 communique from the 2009 Pittsburgh summit. The G20 aim was to bring about ‘growth without cycles of boom and bust, and markets that foster responsibility not recklessness’. They called on Finance Ministers and Central Banks to:

  • Build high quality capital and mitigate pro-cyclicality
  • Reform compensation practices to support financial stability
  • Improve over-the-counter derivatives markets
  • Address cross-border resolutions and systemically important financial institutions

In short, they sought to provide for financial markets that serve the needs of households, businesses and productive investment by strengthening oversight, transparency, accountability and stability.

Regulatory implementation

The past five years has seen a huge programme of detailed legislative and regulatory change in order to deliver this agenda. Where this rubber has hit the road has been in terms of the 1,000+ page Dodd-Frank Act in the US, a number of similarly lengthy pieces of legislation – Regulations and Directives – emanating from Europe, a significant number of high-level international standards from Basel, the Financial Stability Board (FSB) and the International Organization of Securities Commissions (IOSCO) and countless domestic implementations of rules around the world. Each have passed the start line while the economic downturn still prevailed and most are now seeing the chequered flag as economies are starting to show signs of a more sustained growth.

I’ll give you a brief synopsis of what has been done:

  • The European Union has sought to strengthen EU banks by introducing new prudential measures, requiring banks to hold more high quality capital, introducing leverage ratios and setting liquidity requirements. Similar reforms have been followed globally following the standards set out in Basel III.
  • At the same time, in the US, UK and EU, steps have been taken to initiate structural separation of different parts of large banking and investment banking institutions – mostly separating out proprietary risk-taking business from the parts of the firm providing services to clients.
  • Other steps were taken to address the too big to fail problem.
  • In the large over-the-counter (OTC) derivatives markets, moves have been made globally to introduce greater transparency and improved risk management, including mandatory use of central counterparty clearing in specified circumstances.
  • New focus has been given to hedge funds and asset managers, with new regulatory regimes to monitor and mitigate stability risks, trading risks and risks to investors.
  • Finally, regulatory structures have also been enhanced, with major reforms of the UK regulators, greater focus on macro-prudential risks around the world, new pan-European authorities for the three major financial sectors, and greater coordination internationally via bodies such as IOSCO and the FSB.

As an aside, I note that the response to the crisis has seen greater regulatory interest, and sometime the extension of formal regulation, to some areas which support the operation of capital markets, but fell outside of the regulatory perimeter. These include, for example, credit rating agencies and benchmarks. As another example, there is also greater regulatory scrutiny of the interplay between commodity derivative markets and the underlying physical markets. Each represents a key input to the workings of the market where weaknesses or failures carried risks which then propagated through the system.

A period of adjustment for regulators

The challenge for us will be to carefully balance rules designed to meet our regulatory aims, with consideration of the practicalities of implementation and broader effect that this may have on the market.

We are now in a period of implementation by regulators, and of adjustment for firms and markets.

This is a substantial undertaking. Let me illustrate with just two examples which the FCA is closely involved with.

The European Market Infrastructure Regulation (EMIR) was finalised in 2012 and obligations under it started to come into effect last year. It introduces three key reforms – mandatory central clearing of certain OTC derivative contracts (with margining and collateral requirements for contracts which remain OTC); reporting of the details of trades to trade repositories; and harmonised pan-EU regulation for central counterparty clearing houses (CCPs). CCPs are now being (re-)authorised under EMIR, and the first clearing obligations are expected to start in late 2014 or early 2015. These reforms will enhance stability and transparency to the approximately US$20 trillion gross market value global OTC derivatives market. In turn, this is intended to assist capital markets by allowing its users to manage their risks – in interest rates, FX, credit and commodities – in a stable and efficient manner.

And then MiFID 2 builds on the first MiFID text which introduced greater transparency and competition into European equity markets in 2007. This time around, it will introduce more reforms to further refine equity market transparency, push more transparency into non-equity markets, bring more trading on to organised trading venues, bring tighter regulation of high-frequency and algorithmic trading, and set limits on the size of the positions that can be taken in commodity derivatives markets. The agreed primary text will soon be published in the Official Journal, triggering a period of development of the detailed rules for implementation by late 2016 or early 2017.

While significant political discussion has allowed us to reach this stage, it will be the technical debate and calibration of regimes which concludes matters to allow financial institutions to implement the change. As we all know, the devil is in the detail and the FCA and other regulators have an awful lot of detail to get right. MiFID 2, which is our major project this year, alone has around 95 pieces of rulemaking instruments. This ranges from calibrating transparency requirements across traded markets, developing organisational requirements for trading venues, and defining how position reporting and position limit regimes can work effectively in commodity derivative markets. The challenge for us will be to carefully balance rules designed to meet our regulatory aims, with consideration of the practicalities of implementation and broader effect that this may have on the market.

A period of adjustment for firms

With the new regulatory framework coming into place, there will be a significant period of adjustment and change for the structures of capital markets themselves, including the firms and trading venues which operate within them. Over a period of time, firms will have to adjust to the new expectations on them and gear themselves up to providing the services their customers demand in a compliant, effective, and stable manner.

At the firm level, there will be changes at banks and investment banks, including the likely need to spin-out proprietary trading to address concerns about conflicts with their retail banking or agency broking business, investment advisory services and in-house asset management. Business lines will also be reassessed in the light of the new prudential and market regimes. This can be expected to change the way banks allocate their own working capital, and how significant amounts of money are placed in the market. We can already see announcements of major structural changes from individual firms, as they rethink their business models. Most recently, for example, a number of major investment banks have announced that they are exiting large parts of the commodities market.

One outcome already being remarked on is a possible shift at the aggregate level in sources of funding from bank financing towards raising cash in the capital markets. In part, this is linked to so-called ‘shadow banking’, of which capital markets are a part, which has been a continued source of discussion among central bankers and regulators in recent years. The Economist’s own special report on the subject described it as ‘huge, fast-growing in certain forms and little understood’ while also noting British banks had ‘slashed their loans to businesses by almost 30% since 2007’.

But there is also going to be change in the capital markets themselves. So, for example:

  • Greater standardisation of financial instruments, to make them more liquid and easier to price, issue and trade.
  • Greater transparency in the market for all parties.
  • New types of trading venues emerging including ‘organised trading facilities’ in the EU and ‘swap execution facilities’ in the US.
  • A more important role for clearing houses, vying to offer clearing services to the market, and for trade repositories, collecting the mass of new data.

Where can implementation go wrong?

A major set of adjustments such as these is bound to carry risks. There are the obvious operational risks around deadlines, and systems change and so on. But there are also other concerns we all need to be alive to. For instance:

  • What will happen to liquidity as we introduce greater transparency, and more centralised trading and clearing; and as firms adjust to new prudential capital rules?
  • Will trading costs rise or fall for firms and their customers?
  • Could too much change cause missed deadlines and poor firm implementation?
  • What will happen to cross-border operations as we raise protections in the market?
  • How will innovation be affected by new regulatory rules?
  • And how will SMEs be impacted by reforms?

It is these questions regulators and policy-makers have had to continually ask themselves as they have brought forward changes. It is imperative that we do get this right to ensure market structures are optimal for the safe flow of capital to those who need it most.

As we see economies recovering from the retrenchment and recession associated with the crisis, so I think the interplay between regulation and growth will very much come to the fore in public debates. The Australian Presidency of the G20 has initiated an OECD work programme on long-term financing, and the European Commission recently published a Communication setting out its agenda for promoting long term financing. Issues on the table include:

  • Mobilising private sources of long term financing more effectively.
  • Making better use of public funding (provided through channels such as national promotional banks, and export credit schemes).
  • Improving access to capital markets through creating more liquid secondary markets for corporate bonds; reviving securitisation markets; and enhancing private placements and mechanisms such as crowd funding.
  • And improving the corporate governance regime through stronger shareholder engagement and corporate reporting.

One of the risks I have noted was around the international nature of capital markets. London is clearly a central hub of the global capital markets and the international nature of the markets in London is one of the keys to its success. From the regulatory perspective, we place significant importance on keeping markets open, while ensuring standards remain high and are not weakened by parties accessing the market from outside our jurisdiction avoiding some of the rules and provisions we have put in place.

Duplicative or conflicting rules clearly would be sub-optimal, as would gaps between our regimes. So the better alternative, as most – including the FSB - recognise, is to agree that parties may trade in our markets provided they comply with our rules, subject to our supervision, or comply with rules which have broadly the same effect in their home country, subject to supervision by their home country regulator. We have seen previous examples where there have been such conflicts of rules, for example between EU and US rules on clearing. However, we have welcomed recent agreement with international counterparts to defer supervision to home regulators and work on an outcomes-based assessment of equivalence.

Building for long term success

Once the structure of the markets are in good shape, with a strong regulatory regime in place, it is our collective hope that capital will flow and that sustainable long-term funding will be available for those who need it.

Once the structure of the markets are in good shape, with a strong regulatory regime in place, it is our collective hope that capital will flow and that sustainable long-term funding will be available for those who need it.

But there are other areas of reform – in addition to the responses to the crisis - that are also relevant for building for the long term success for the capital markets. Going back to what I noted at the start, we need capital markets that:

  • appropriately protect their users
  • are stable, fair, clean and resilient in operation; and
  • involve competition only on factors such as price, innovation and quality of service


As well as getting the rules and regulations right, we also need to see the right behaviours from market participants. It is clear from the past few years that we need to raise the bar on standards of culture, governance and accountability. One of the FCA’s core priorities, since it was created in April 2013, has been to improve culture within firms and to ensure customers are put at the heart of business models. In the capital markets, this means ensuring firms are best addressing the needs of their customers for suitable and affordable funding and risk management services. There are signs of change, but there is a need to do more. We still see misaligned incentives and instances of poor practice across the market, where business models have failed to adapt to the challenge we have set down. Recent enforcement cases have addressed areas such as fund managers who have failed to follow their investment mandates, parties manipulating benchmark setting processes, clients being substantially over-charged with opaque transition management fees, and firms not segregating and properly protecting client funds. Going forward, we will be working with firms and their Boards to encourage adaptation and the highest cultural and ethical values for those involved in these important markets, so as to restore and maintain integrity and confidence.

Investor Protection

A further necessity for the long term success of capital markets is that those who are investing their money are given sufficient protection to encourage their participation in the market. By this, I mean creating a market which is transparent, fair and has measures in place to protect investors.

One aspect of this is how those that manage investments on behalf of others operate. UK asset managers controlled £5.4tn of funds at the end of 2012 and are, therefore, clearly a sizeable and important part of the capital markets. The FCA’s asset management strategy, launched in October 2013, seeks to ensure that when investors place their trust in firms to act on their behalf, they have a reasonable expectation that managers will act in a fair way and in their interests. By this, we explained that:

  • Distributors and asset managers should not let conflicts of interest interfere with their obligations to make the best possible decisions on behalf of their clients.
  • Asset managers should spend their clients’ money as though it was their own and manage costs with as much tenacity as they produce returns.
  • Investment decisions should comply with the investor’s stated aims and objectives and investors are given easily understood information on the risks and costs of the service.

Our recent work on dealing commission, published last week, is a further step, providing greater clarity in our regime for the use of dealing commission. We think the reform offer firms a real opportunity to show they are putting their clients first and to strengthen the industry’s reputation for transparency.

Competition and innovation

The final piece of the puzzle for the long-term success of capital markets is effective competition and innovation.

The FCA was given a specific remit when established last year to promote competition, where this is in the interest of consumers. I believe in the current climate of technological innovation and economic growth, we will continue to see changes in the structure and composition of capital markets. This is part of the healthy functioning of the financial services market.

We have seen new innovation which is likely to assist the capital market for small and medium sized businesses (SMEs), including new investment-based and debt-based crowd funding platforms and peer-to-peer (or P2P) lenders. We believe that the regime we implemented to oversee this market will make crowdfunding more accessible, will help foster competition and facilitate access to alternative finance options while also providing consumer protection.

We will look to see where competition is not working in the best interests of consumers and seek to use our powers to promote more effective competition. This has started in some of the retail markets we oversee, but will continue in the coming months into wholesale markets as we launch a call for input. This will help us identify where things aren’t working as well as they could from a competition perspective and consumers could be better served by changes to the rules and structures that exist in the market. We are looking forward to launching this debate and speaking with firms, consumers and other stakeholders about some of the issues we could address.


That concludes my short overview of the capital markets from a regulator’s perspective.

We have had five years working hard to bring stability. We are now facing a period of considerable change, as the implementation of that agenda gathers pace. And new issues will come to the fore, as the focus of debate shifts from how to deliver stability to how to promote growth.

Regulators will continue to expect high-standards from the firms we oversee and call on them to improve culture and governance and ensure investors are well protected.

I have spent most of my time talking about the step of putting in place a new regulatory underpinning. I hope that the rest of today’s conference will provide reflection on the other two steps - considering how the industry adapts its structures and business models to meet customer needs, and ensuring funding is made available, in a variety of ways, to businesses in the real economy for growth and prosperity.