Wholesale market policy – a year in review

Speech by David Lawton, Director of Markets Policy and International, FCA, delivered at the ICI Global Trading and Market Structure Conference in London on 8 December 2015. This is the text of the speech as drafted, which may differ from the delivered version.

Good afternoon. 

Today is 8 December, which means just 12 working days until Christmas and just over three weeks until the end of 2015.

I thought I would take the time today to reflect on what 2015 has meant for the regulation of wholesale markets, and the funds sector.

Because it goes without saying that this year has been one of change. Change coming from new technology (eg blockchain). Change coming from new market players (our authorisations of wholesale firms up 50% this year). Change coming from continued innovation (eg robo advice, on which there was a discussion paper from the European Supervisory Authorities published last week). And there is also undoubtedly change coming from new regulation.

I suppose many of you think that regulation is always changing and never stands still. Perhaps true. But I would argue that there is a core of timeless, immutable goals which policymakers and regulators are pursuing. Those goals for wholesale markets could be summed up as 'fair and effective' markets, which work well for those who use them.

'Fair and effective' was one of the phrases of the year, thanks to the conclusion of the Fair and Effective Markets Review, conducted by the Treasury, the Bank of England and the FCA. That review sought to define the terms 'fair' and 'effective' (at least in relation to FICC markets).

I would argue that there is a core of timeless, immutable goals which policymakers and regulators are pursuing. Those goals for wholesale markets could be summed up as 'fair and effective' markets, which work well for those who use them

So 'fair' markets are ones that demonstrate clear, proportionate and consistently applied standards of market practice, sufficient transparency, open access, competition on the basis of merits, and integrity. 

'Effective' markets are ones which: allow end-users to undertake investment, funding, risk transfer and other transactions in a predictable way, have robust infrastructure enabling the sourcing of liquidity, aides the discovery of competitive prices, and ensures the proper allocation of capital and risk.

The 'fair and effective' phrase, I’m sure, is not the only way to express the goals which regulators like the FCA are aiming for, but it is a pretty good one. Short, clear and hopefully understandable by all market users.

So, this morning I would like to review some of the more important market policy developments in 2015 and look at how they might contribute to the goal of fair and effective markets.

What has happened in 2015?

MiFID II

So, what has happened in 2015? Let’s start with MiFID II. 

This, as I am sure you will know, will herald major change for investment firms and for markets.

From mandated changes to market microstructure, a requirement for equity trades to take place on trading venues, and a framework for mandating on-venue trading of derivatives, new requirements for trading venues, plus the creation of the new types of venue called ‘organised trading facilities’ or OTFs, through to a new regime for non-equity pre- and post-trade transparency, and a cap on dark trading in equities. There are new requirements for HFT firms and users of trading algorithms, new transaction reporting requirements, and commodity derivatives position limits and position reporting, plus substantive enhancements to organisational and conduct of business requirements.

While the foundation rules written over the last few years run to over 200 pages, many more pages have been needed to fill out the detail of the large number of 'level two' requirements, and to transpose certain requirements into national handbooks. To this end, both FCA and HM Treasury published discussion papers in the summer of 2015, seeking industry views. The FCA also conducted a larg- scale cost benefit analysis survey with around 5,000 firms in the autumn to better understand the impact of change.

And of course, at the end of September, ESMA submitted to the European Commission a swathe of draft regulatory technical standards – running to over 400 pages – for approval by the EU co-legislators. This was a big focus for regulators in their work this year.

I’m sure you can see how MiFID II contributes to the fair and effective goals, with its substantive provisions to make markets more resilient, transparent and competitive. MiFID II will enhance open access, strengthen integrity of markets taking into account new technology and help to improve market users’ ability to source liquidity through better consolidation of data.

Dealing commission

We are still awaiting the final delegated acts from the Commission, following ESMA’s advice provided this time last year. That means we are still waiting to see how the Commission has taken on board ESMA’s advice which impacts on dealing commissions. A topic which I’m sure everyone here has followed closely.

Dealing commission – the charges paid by consumers when investment managers execute trades and acquire external research on their behalf – is worth around £3 billion a year.  However, regulators have long worried about the potential unmanaged conflicts of interest these commissions create. And late last year, we published a discussion paper gathering further views on what the future of our rules could look like in light of these concerns, earlier thematic review findings and the likely new MiFID II rules.

In February this year we published a feedback statement, in which we noted the comments we had received from  a range of different stakeholders, which provided a mixed view on what they thought the likely outcomes of a move towards further unbundling of research provision and payments for execution services and transaction costs would be. We provided commentary on a number of these points, but were clear that we felt further unbundling would provide better value for investors, be more transparent and enable a more effective market in research. Thinking back to the fair and effective market goals, here we are seeking a market in research and execution that is transparent, appropriately priced and ensures confidence of investors through removal of unnecessary conflicts of interest that may disadvantage them.

Additionally, we gave a view and interpretation on ESMA’s final advice to the Commission for the delegated acts that will define the new EU regime, expressing strong support for the proposals made. 

Of course, it was just advice and over the year the European Commission has been considering ESMA’s suggestions on this and other delegated acts to decide whether to accept it, reject it or propose amendments. We are still waiting for this clarity, and even then the delegated acts must pass the scrutiny of both the European Council and Parliament. Only then will the FCA be in a position to publish a consultation to consider how these rules get implemented into the FCA Handbook.

MiFID II timing

In the past couple of weeks, the big discussion on MiFID II has been around the timing. When will it come into effect? Following input from ESMA, the Commission has said that it is contemplating a one-year delay in MiFID II’s implementation date, and the European Parliament’s MiFID II negotiating team has signalled that it would support that. 

MAR

And in a similar vein to MiFID II, we have the new Market Abuse Regulation.

Likewise, this legislation was passed at level one some time ago, and the focus over the last year has been on getting the detailed level two measures finished.

The regulation – MAR as we call it – is the significant extension of the civil market abuse regime under the existing Market Abuse Directive. It takes into account the new instruments brought into regulation by MiFID II. It defines new abusive market practices. It takes better account of new technology being used in the market, and it provides new tools for regulators to address market abuse risks.

Again, we had final technical standards from ESMA in September and are expecting delegated acts from the Commission, based on ESMA advice, to be published very soon. This will provide the final detail, ahead of the regime going live next July. And likewise, consultation, education and calibration of rules have been key strands of our work during the course of this year.

MAR is really important for fair and effective markets, in that it enables us to better tackle abusive market practices. Market abuse, in all its forms, damages confidence in the market through the perception of users that another party may be taking unfair advantage of privileged information at their expense. This discourages participation. It further damages the price discovery mechanism, pushing prices away from the real interaction of supply and demand. MAR provides some important new tools to help us to deter and detect such practices.

CMU

A further important development in Europe this year was the launch of the European Commission initiative to create a ‘Capital Markets Union’.

In the Commission’s words, the CMU agenda has a mission to 'ensure that financial markets are properly regulated and supervised so that they are stable, competitive and transparent, (and) at the service of jobs and growth'.

In the first half of this year we saw a consultation paper on the specific measures that could be introduced to fulfil Lord Hill’s pro-growth mission.

The FCA submitted its views. Our response noted in particular that:

  • action is needed along investment chains
  • greater participation in capital markets must be matched with appropriate levels of investor protection
  • regulatory measures already in place, and the reforms in train, have made significant strides to the CMU agenda
  • further gains can come through more consistent supervisory application of these measures across the EU
  • competition is an important and powerful driver of reforms

In the second half of the year, the Commission produced its Action Plan.

It is fair to say that the Action Plan is rightly ambitious. Two specific legislative proposals have been published: one to update the existing rules in the Prospectus Directive, and a new proposal to facilitate simple, transparent and standardised Securitisation.

The Commission’s mission is very much about realising the potential of EU capital markets, and to do that requires a focus on making those markets as effective as possible.

FEMR

Closer to home was the UK’s Fair and Effective Markets Review (FEMR), which published its final report and recommendations in June this year. 

Launched in the wake of the significant fines, from regulators around the world, related to the identified misconduct in FX market trading, and earlier in relation to LIBOR. This review, conducted by staff from the FCA, Bank of England and HM Treasury, looked at the primary causes of misconduct, considered what new regulation and industry initiatives existed to address those causes and how effective they might be, and finally to consider what more needed to be done.

On this last point, the final report made 21 recommendations to the authorities, to the Government, to international standard setters like IOSCO and the FSB, and finally to industry itself.

I won’t go into details about all of the recommendations, but three major ones I would pull out:

  • first, a proposed extension of the senior managers and certification accountability regime from banks, now to a much wider group of firms, including fund managers and others involved in wholesale FICC markets. A bill was laid before Parliament in the last couple of months to bring this into being – the details and scope are still debating points in the Parliamentary chambers. The purpose being to ensure that firms have clear lines of accountability and senior managers are held answerable if they fail to take reasonable steps to prevent breaches of regulatory rules in areas for which they are responsible. It also sets a clear standard for more junior staff
  • second, new criminal offences for market abuse – essentially, to mirror those in MAR, to provide an extra deterrence via criminal penalties. But also, in a second part, the recommended creation of a criminal market abuse regime for spot foreign exchange markets, applicable to all market participants. Thinking has been at the earliest stages during 2015, considering questions of scope and coverage, but much more is likely to be done in 2016
  • third, the establishment of a new FICC Market Standards Board – an industry body with a mission to help identify trends and risks, produce guidance and market standards and share good practice within firms active in FICC markets. The body has been established and has made good progress during 2015 in gathering members, and starting work on some difficult issues in their market, such as the appropriate use of spot loss orders in FX markets. We’re already seeing a broad range of firms, including fund managers, joining this body, ensuring it provides a more complete perspective in FICC markets

Wholesale competition studies

And moving on now to come of the FCA’s own work. In February, the FCA concluded its exercise of calling for evidence regarding competition issues in the wholesale market. We received a great deal of feedback, both positive and negative about how competition was working in different wholesale market sectors. A large number of respondents pointed out their perception of longstanding issues – many of which are being separately addressed through legislation like MiFID II. Others pointed out that, generally, business is done, markets work efficiently and that there is plenty of competition between firms.

However, some specific points were raised about how competition has been operating in the investment banking and corporate banking sector and therefore this is the area FCA competition teams began focusing on with the next stage – a market study. Throughout the year, we’ve been gathering evidence, analysing market data and talking to stakeholders in this sector. This should result in some initial findings in early 2016 with a full report and recommendations in the summer.

Of course, this was just the first of the wholesale competition reviews, and the second was announced a matter of weeks ago – into the asset management industry. 

Asset management competition market study

Last month we launched the terms of reference for this new market study. As we explained, the FCA is seeking to understand things like how asset managers compete to deliver value to their investors, how cost and quality control is managed along value chains and the role of investment consultants in the market. 

What is noteworthy about FCA competition market studies is that we typically start these not when there is a crystallised risk that needs fixing, but when there might be features of important markets that might not be working in the most fair and effective way

Market studies tend to take about a year to conduct and this one is likely to run to this sort of schedule, with an interim report next summer and a final report in early 2017. The first milestone though is to get some initial views on the terms of reference for the study, and we are asking for your comments by next Friday, 18 December. I’m sure we’ll get no shortage of responses from a range of stakeholders.

What is noteworthy about FCA competition market studies is that we typically start these not when there is a crystallised risk that needs fixing, but when there might be features of important markets that might not be working in the most fair and effective way. This approach allows us to have a large impact and intervene early to address fundamental features in a market that could have more profound and negative consequences for consumers in future. We look forward to working with the likes of the ICI and their members on this important piece of work.

FSB systemic nature of funds debate and bond market liquidity

And finally, this year has also been one in which the debate around the systemic nature of funds are continued unabated.

Principally this has taken place in the Financial Stability Board and within the UK’s Financial Policy Committee. The FCA has stayed closely involved in both.

The key questions being asked are: if a fund were to face significant outflows, make significant losses or be unable to redeem investors of their investments should they wish to exit the fund, could the impact of these events cause damaging ripples, or even waves, in the market?

If the evidence shows this is possible, what could be the trigger for this and what can be done to either prevent this or mitigate the impacts?

The global consensus this year seems to be that, taken alone, the actions of individual funds would be highly unlikely to have such systemic impacts. And of course, fund managers control only a minority of the world’s investments. A full analysis needs to take proper account of other players.

However, that does not mean that there are no risks to be thought about further in the fund space. Systemic impacts are more likely than it first appears if you consider that many funds have similar investment mandates, make similar investment choices and are all impacted more or less equally by macroeconomic factors, ie there may be herding effects.

And it is this last point about the macroeconomic environment, which connects to a further significant debate that has continue this year - that of bond market liquidity.

So, the argument goes, bond markets have become increasingly illiquid, across all qualities of debt, resulting from market makers (mainly investment banks) stepping back and reducing inventories of bonds as the capital charges for doing so have made it less profitable. Market liquidity is an issue that obviously affects all parts of the market, particularly those who trade frequently or need constant prices for asset they hold (including bond funds).

Despite this particular issue being widely talked about in the financial press and claimed as a feature of today’s market, the evidence is far from clear that this is the case or that, if it is, the impact is a wholly negative one for markets. It is arguable that markets are less liquid today than 10 years ago, but it is then equally arguable that liquidity was underpriced compared to risk 10 years ago, and today, rather than the recent past, represents ‘normal’ market conditions. 

More work will certainly be done on both of these questions in a number of forums in 2016. These issues are obviously connected, when you consider that a tipping point for both issues could be an increase in central bank interest rates globally. The study of these sorts of issues forms part of our work to ensure markets continue to operate effectively, towards aiding the function of markets and meeting the needs of end users, in light of economic conditions.

Conclusion

So, at this point I will conclude my whistle-stop tour of some of 2015’s most important market policy developments.

I hope I’ve demonstrated that all of the regulation and change that is occurring is not just for its own sake. That it all aims, in varying ways, to improve the way markets work - because we all want markets that are fair and effective, which serve their users well

I hope I’ve succeeded in convincing you, if nothing else, that 2015 was a busy year for regulators and policymakers, as well as those who follow wholesale market policy issues. 2016 is looking to be no different, and many of the issues that are important this year will equally be important in the next.

But equally, I hope I’ve demonstrated that all of the regulation and change that is occurring is not just for its own sake. That it all aims, in varying ways, to improve the way markets work - because we all want markets that are fair and effective, which serve their users well.

I hope the ICI and its members will continue to support us in our efforts to develop policy which meet this goal.

Thank you.