Fairer and More Effective Fixed-Income, Currency and Commodity Markets?

June 15, 2015

At the annual Mansion House speech to the City on Wednesday, 10 June, Bank of England (BoE) Governor Mark Carney announced an end to “the age of irresponsibility.

Shortly before the Mansion House speeches began, the Treasury, the BoE and the Financial Conduct Authority (FCA) jointly published the Final Report of the Fair and Effective Financial Markets Review (FEMR), which is the result of a 12 month exercise focusing on those wholesale markets, both regulated and unregulated, where the majority of recent concerns about misconduct have arisen: fixed-income, currency and commodity (FICC) markets, including associated derivatives and benchmarks. This Review comes in the wake of the major multijurisdictional investigations and enforcement actions in respect of the manipulation of LIBOR and foreign exchange markets, resulting in record fines being imposed on banks and public outcry at some of the misconduct uncovered.

The FEMR terms of reference, published in June 2014, set out the objectives as: 

  • to reinforce confidence in the fairness and effectiveness of wholesale FICC market activity conducted in the United Kingdom; and 
  • to influence the international debate on trading practices, including highlighting issues that can only be addressed through co-ordinated international action. 

The FEMR is intended to be collaborative and forward-looking, having considered the input of public officials, market participants, end users of wholesale financial services and commentators. 

The Report considers where fairness and effectiveness were deficient in the FICC markets, and notes a number of factors (including a culture of impunity) which led to a process of “ethical drift” where improper conduct went unchecked and, as result, became gradually more prevalent until it was an industry norm. 

Chancellor George Osborne in his Mansion House speech said that “Implementing the reforms set out in this Review will ensure trust in our markets and strengthen London’s global leadership position.” 

Recommendations of the FEMR to strengthen regulation of FICC markets in the United Kingdom 

The Report sets out 21 recommendations, including near-terms actions to improve conduct in FICC markets and principles to guide a more forward-looking approach to FICC markets. 

Five of these recommendations are aimed at strengthening the regulation of FICC markets in the United Kingdom, and these are considered in more detail below. A defining feature of the FICC markets is that, for the most part, they involve professional counterparties who do not require the same level of regulatory protection as retail customers. However, the Report recognises that despite this, it is still important that these markets operate in a fair and effective way and consequently the following recommendations are made: 

a. Extend the UK regulatory framework for benchmarks to cover seven additional major UK FICC benchmarks 

Following the Wheatley Report, a new regime was introduced in the UK in 2013 regulating the design and administration of LIBOR. In August 2014, as its first act, the FEMR recommended to HM Treasury that this regime should be extended to cover a further seven major UK-based benchmarks: Sterling Overnight Index Average (SONIA), the Repurchase Overnight Index Average (RONIA), the WM/Reuters 4pm London Fix, ISDAFix, the London Gold Fixing, the LBMA Silver Price and the ICE Brent futures contract. 

This recommendation was accepted and it was implemented by HM Treasury. As of 1 April 2015 these benchmarks became regulated by the FCA. 

b. A new statutory civil and criminal market abuse regime should be created for spot foreign exchange, drawing on, among other things, work of the international project to draw up a global foreign exchange code 

The FEMR welcomed the announcement by Central Banks that they are working towards creating a single global FX code, the programme for which will run until May 2017 (following the agreement on a ‘Global Preamble: Codes of Best Market Practice and Shared Global Principles’ in March 2015, setting out shared high level principles for personal conduct, the handling of confidential information, and execution practices). 

Due to the global nature of spot FX markets, the Report notes that it is important that the principles governing good conduct should be agreed internationally, therefore it is recommended that the globally agreed principles should be used to shape a new statutory market regime for spot FX in the UK, to maximise the protections against market abuse (as this asset class is not directly covered by the new European Market Abuse Regulation). 

The FEMR concluded that due to the scale of misconduct which has been uncovered in relation to foreign exchange markets, “substantial further work is needed to raise standards in FX markets”. 

c. Ensure proper market conduct is managed in FICC markets through monitoring compliance with all standards, formal and voluntary, under the Senior Managers and Certification Regimes (“SM&CR”) 

Under the SM&CR (which begins to come into effect on 7 March 2016 for banks and other PRA regulated firms), individuals will be personally liable for any breach of a Conduct Rule, which will mean that individuals will be more incentivised to comply with the required standards. One of the proposed Conduct Rules (5) provides that “You must observe proper standards of market conduct”. The FCA’s proposed guidance indicates that compliance with the FCA Code of Market Conduct, or relevant market codes and exchange rules will tend to show compliance with this Conduct Rule. 

Consequently, the SM&CR can give ‘teeth’ to voluntary codes, such as the proposed global FX code discussed above. 

d. Extend elements of the SM&CR to a wider range of regulated firms active in FICC markets 

The Report recommends that HM Treasury should consult on legislation to extend elements of the SM&CR to a wider range of regulated firms, covering at least those active in FICC wholesale markets. FEMR noted that a significant group of regulated FICC market participants are currently outside the scope of the SM&CR, including hedge funds under the EU Alternative Investment Fund Managers Directive (AIFMD); MiFID investment firms, including asset managers and interdealer brokers; and fund managers under the EU Undertakings for the Collective Investment of Transferable Securities Directive (UCITS). 

The elements of the SM&CR which the FEMR recommends should be extended to a wider range of firms are: regulatory pre-approval and ‘Statements of Responsibility’ for senior managers; certification of individuals with the potential to pose ‘significant harm’ to a firm or its customers and enforceable Conduct Rules for individuals. 

The Report notes that some respondents to the consultation argued in favour of such an extension on the basis that it would bring a level playing field across all firms. A date for implementation of the new regime to the wider range of regulated firms is yet to be announced. 

e. Improve firms’ and traders’ awareness of the application of competition law to FICC markets, including through communication by the FCA of material presented in the FEMR 

Report to authorised firms active in FICC markets, through firms’ internal training programmes, and through the new guidance on FICC market qualifications and training to be developed by the FICC Market Standards Board The Report notes that collusion can have a significant detrimental effect on the integrity of FICC markets, and the results of the consultation suggested that for participants in these markets there are currently shortcomings in the understanding of the scope of the competition law regime. 

The 6 page Annex to the Report is a summary of competition law issues which arise in wholesale markets and is designed to be presented by the FCA to authorised firms in the FICC markets, to raise awareness and improve understanding of such matters. 

Given that there has recently been a number of competition cases successfully prosecuted involving FICC markets (including cartels related to interest rate derivatives and commodities and abuse of market power via discriminatory behaviour), it seems this recommendation should be welcomed by those in the FICC markets. 

International co-operation 

The FICC markets are global in scope and size. As noted in the Report, the turnover in the foreign exchange markets is some $5 trillion a day and the global stock of corporate, financial and government bonds amounts to nearly $100 trillion. 

One of the near-term actions recommended in the Report is to launch international action to raise standards in global FICC markets, including agreement on a single global FX code (as referred to above). 

Commenting on the publication of the Final Report, Martin Wheatley, Chief Executive of the FCA, emphasised the need for reform efforts on a global scale. He said the FICC markets “are central to our economy and today’s recommendations will be important in rebuilding public trust in their integrity. Domestic regulatory reform is only one piece of the puzzle. Driving up global standards needs international cooperation between regulators, but confidence is underpinned by the behaviour of the firms and individuals active in them. We will know the review has truly succeeded when we see these changes being embraced at every level in industry.” 

What should FICC market participants do next? 

It will be important for FICC market participants to closely monitor the implementation of these recommendations. Some of the recommendations have already been implemented (for example, the extended regulatory regime in respect of benchmarks). As for oversight of the implementation of the remainder of the recommendations, Table C of the Report sets out proposals of which bodies (including HM Treasury, the Competition and Markets Authority and the FCA) might take which of the recommendations forward. 

In the autumn of 2015, an Open Forum event will be held at the BoE which is intended to provide an important opportunity for a broad range of stakeholders to discuss the recommendations of this Report, and the role that they can play in the reform programme. 

A full implementation update will be provided to the Chancellor of the Exchequer and the Governor of the BoE by June 2016.

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