Speech by David Lawton, Director of Markets of the FCA at the International Capital Market Association (ICMA) Capital Market Lecture Series 2014 on Monday 3 February 2014. This is the text of the speech as drafted, which may differ from the delivered version.
I thought, given that this is the first seminar of the new year, I would go back to market fundamentals in choosing my subject matter for today’s session.
I want to talk about a subject vital to the functioning of successful and sustainable markets: the integrity of the price formation process.
Ask any markets regulator how the markets are performing, and they will assess the markets and themselves against a central International Organisation of Securities Commissions (IOSCO) principle, ‘ensuring markets are fair, efficient and transparent’. They may also direct you to some of these IOSCO principles of securities regulation:
- there should be ongoing regulatory supervision of exchanges and trading systems which should aim to ensure that the integrity of trading is maintained through fair and equitable rules that strike an appropriate balance between the demands of different market participants
- regulation should promote transparency of trading
- regulation should be designed to detect and deter manipulation and other unfair trading practices1
And the price formation process cuts right across this goal. Fairness in markets requires a reliable price formation process with effective detection and deterrence against improper trading practices and fair access given to investors to market facilities, markets and price information. Efficient markets will reflect the dissemination of relevant information in a timely way in the price formation process. Vital to achieving this is getting the right level of transparency, the right degree of pre and post trade information, publicly available on a real-time basis.
Achieving a high quality price formation process yields dividends that help all participants; reducing transaction and search costs, building investor confidence, and underpinning deep and liquid markets to raise funds, invest, or manage risk.
This is a goal that regulators are continually working towards. It is challenging not just because it requires us to constantly assess our own jurisdiction's markets but because, we need increasing global coordination to ensure harmonised and consistent responses. It is challenging also because of the pace of change we are working with; new technologies bring new strategies, new actors and potential new risks to the price formation process which need to be assessed across markets and jurisdictions.
One of the benefits of the FCA being a new body with new objectives and tools is that it has given us the opportunity to look at old problems with a fresh perspective. Our competition objective gives us a new filter through which to consider price formation and market integrity in general. New schools of thinking, like behavioural economics, can bring fresh insights into these problems, challenging us to consider, for example, the role of non-rational behaviour in price formation.
You will see work on maintaining the integrity of the price formation process throughout the FCA’s market agenda, and indeed international securities regulation. I will touch on some of this agenda in the rest of my remarks, which I want to organize under three broad themes:
- steps we are taking to continue to strengthen price formation in centralised public markets
- regulatory efforts to strengthen price formation in hitherto more decentralized and OTC markets
- finally, looking at areas where prices are set completely off market, and which traditionally have not been thought of as part of the price formation process
Strengthening public markets
Historically, markets regulation has focused on a number of core public markets, particularly in the equities space, due to their key role in capital raising and economic growth, and as an intersection between wholesale, retail and small business.
Equity markets have over the last decade experienced a revolution driven by two factors. Firstly, through regulation, via the Markets in Financial Instruments Directive (MiFID), changing fundamentally the shape of market structure, and secondly what seems like a Moore’s Law rate of change provided by technological innovation.
MiFID has radically changed the competitive landscape of markets, resulting in increased competition between trading venues, narrower bid-ask spreads and reduced transaction costs for participants.
Technology has revolutionized how equity markets work, providing a gateway to new participants, new offerings and new investment strategies. Coupled with market fragmentation, we have seen an increase in market structures competitive offers, with reduced transaction costs and new services.
Market participants have had to adapt to their new eco-system. We have seen growth in high frequency traders. Equity markets have been attractive to them because of the robust market infrastructure, liquidity, transparency and small tick sizes they typically offer. And while there are clearly some risks, we should not lose sight of the benefits of high frequency trading (HFT); They have helped the price formation process across venues by being able to rapidly assimilate and build in new information into their quotes and orders.
However, we are seeing that for some investors, the benefits of increased competition are counterbalanced by increased search costs and reduced liquidity. Some participants have been concerned that availability of post-trade transparency has affected their ability to compare prices across trading spaces and evaluate the market. Lit markets have become less attractive for large block orders. The rapid rise of HFT trading has also raised concerns around the quality of the liquidity provided by HFT and whether the short term nature of HFT investment strategies impairs the price discovery process.
So in order to achieve an optimal price formation process, we need to achieve a balance between what competition can offer, a reduction in transaction costs and a facilitation of best execution, and the associated risks of fragmentation, increased search costs and reduced liquidity.
Tuesday 14 January 2014 will be a memorable day for all of those involved in the political gestation of MiFID 2, political agreement finally being reached. The next stage of the process is establishing the finer detail at Level 2. MiFID II’s significance to market structure and price formation is hard to underestimate.
It revises the transparency regime for equities, making adjustments to increase lit trading and to improve market efficiency. It also introduces a principle of transparency for non-equity instruments, such as bonds and derivatives.
One of the key measures in MiFID is the improvement to the quality and consolidation of post trade data in the equity markets. This will improve, and at the very least protect, standards of price formation. The implementation of a consolidated tape and controls on those who publish trade reports will help address the concerns of industry in relation to post trade transparency in more fragmented markets. It should assist firms, particularly on the buyside, in assessing market developments and achieving best execution. Regulators will also be given access to a wider range of information about trading activity through an expanded scope of transaction reporting and a richer set of information to be included in reports.
There are also measures in MiFID to cap dark trading in individual shares both at a venue and overall level at 4% and 8% respectively which is intended to increase lit trading, although the prospective suspension of waivers could be potentially disruptive to trading.
For HFT firms, MiFID codifies European Securities and Markets Authority’s (ESMA) existing automated trading guidelines and introduces new microstructural requirements covering tick size, order to trade ratios and fee structures. These measures are seeking to improve the quality of liquidity that high frequency traders provide and ensure fair access to markets is maintained.
The Market Abuse Regulation moves in step with MiFID, modernising the regime to reflect changes in market structure. These measures, largely in keeping with the UK’s own super equivalent regime, recognise the importance of off-exchange activity, and instruments and assets that sit outside the core public markets. The extension of the market abuse regime to multilateral trading facilities (MTF) and organised trading facilities (OTF) and relevant over the counter instruments, and the widening of the provisions around market manipulation will help protect the price formation process by putting in place consistent standards of market conduct.
These measures support our own on the ground surveillance and supervision. We have long had a strong credible deterrence agenda. Credible deterrence is not only about the use of our enforcement powers but is also making sure that we have a strong first line of defence against abusive practices in the integrity of participants in our markets. That has motivated our recent work at re-energising the suspicious transaction reporting regime and educational work with industry, and our work with the industry surveillance forum to facilitate increased monitoring of cross platform activity. Our supervision of trading venues focuses on the operational resilience and ensuring that venues reflect the increasing technical dependencies of trading but also systemic risks posed in the growth in cybercrime.
We have seen in response to these challenges to price formation, a general impetus from policy makers that Transparency is King. There is throughout asset classes, instruments and markets, a drive, in keeping with G20 Pittsburgh commitments, to push trading that can be done on organised venues, on to organised venues. For asset classes and instruments traditionally not captured under pre and post transparency regime, the net is growing and pulling them in. This must be done in the right way, recognising the idiosyncrasies of instruments and asset classes and acting without stymying liquidity. Doing this will ensure that we have an overview of the systemic risk building up and stronger risk management and controls in place around that risk. In the EU, we have met the G20 commitment through two key pieces of legislation, EMIR and MiFID. EMIR requires standardised derivatives to be cleared through CCPs and puts in place mandatory derivative trade reporting to trade repositories. MiFID implements the final leg of the G20 pledge, bringing standardised OTC derivative contracts that are sufficiently liquid on to organised venues. MiFID will also put in place position limits for commodities with the aim of supporting orderly pricing and settlement conditions.
One significant example of markets that have stood just outside the core public markets are the commodity markets. Over the last decade we have seen these markets experience a radical change in their participants and in the relationship between the commodity spot and future markets. Significant investor inflow into commodity futures has resulted in a change in those who participate in the price discovery process, and a change in the relationship between the physical and derivatives commodity markets.
A lot of work is going into understanding how this affects the price discovery process in the commodity markets and the signalling which future prices provide of commodity fundamentals.
One particular example of where we are interested in the impact on the price formation process in the commodity market is the role of warehouses, where these are part of the delivery and settlement process for exchange-traded contracts. Part of our role is ensuring that exchanges’ derivative contracts which incorporate warehouse arrangements are adequately anchored to the price of the underlying product, and because of the central function warehouses play in ensuring orderly settlements more generally. Last year there was a lot of commentary over whether the current arrangements were appropriate, and we have seen recently some exchanges change their warehouse policy in response. We will seek to ensure that the impact on market integrity and orderliness is fully coordinated.
Pricing mechanisms outside markets
When we step back from public markets, we see that there are a range of mechanisms used off market used to generate prices which are typically not recognised as part of the price formation process, but nonetheless can set or influence key prices which impact on financial markets.
One example of this where work has recently been done is price reporting agencies (PRA). PRAs, who report prices transacted in the physical commodity and some derivative markets, provide increased transparency in markets for physical oil. Recent IOSCO guidelines for oil price reporting agencies aim to improve the functioning and oversight of oil price reporting mechanisms by encouraging behaviours of best practice to improve internal controls, increase transparency, ensure the integrity of information and therefore promote the reliability of price assessment.
Beyond this there is of course broader work on benchmarks, which has been one of the key areas of international regulatory work since 2012 Libor has highlighted the importance of good governance and systems and controls in benchmarks more broadly. The measures put in place by the Wheatley Review will strengthen both the submission and administration of Libor, and help bring accountability to the process, returning confidence to the benchmark. And the FCA has been at the forefront of international coordination through IOSCO and the FSB to raise standards in benchmarks so that they are a robust part of the price formation process. We support the proposed EU regulation which will develop further the IOSCO principles.
In other mechanisms, such as mark to market and mark to model valuations, there has been work to improve independence and governance around these processes.
We should look at work in these various strands - PRAs, benchmarks, mark to market valuations- as the next stage in bringing further transparency to the price formation process. While price formation in centralised markets will always be a prime focus for market regulators, we can expect continued and perhaps growing interest in mechanisms where prices and valuations are set outside such markets.
- getting an optimal price formation process is vital if the UK is to continue to offer deep, liquid markets to investors
- traditionally we have focused on a tight set of core public markets
- we are, increasingly, recognising the importance of off exchange activity to this process and there is a trend to push for transparency in the markets. Instruments that have traditionally stood outside the core public markets are now being pulled into transparency
While we may all breathe a sign of relief that MiFID II has reached political agreement, MiFID and MAR are not the end of the story. We will continue to need to adapt to market behaviour, actors and structures. Benchmarks and off exchange mechanisms are one example of where future improvements to the price formation process may be found.