Moloney, Niamh --- "Regulation of the Market and Intermediaries: Global Comparison and Contrast - What is Best Practice" [2008] MqJlBLaw 1; (2008) 5 Macquarie Journal of Business Law 1
Regulation of the Market and Intermediaries: Global Comparison and Contrast – What is Best Practice?
Recent Developments in UK and European Union Market and Intermediary Regulation
NIAMH MOLONEY[*]
I The Regulatory Environment
A Introduction – the Reform Movement
One of the most striking features of capital market regulation worldwide at present is the extent to which it is characterised by large-scale reform and innovation, from regulatory, supervisory, and institutional perspectives.[†]
While the US Sarbanes Oxley Act 2002 remains the classic example of controversial and swingeing regulatory, supervisory, and institutional reform, the International Organisation of Securities Commissions continues to extend its reach and influence,[1] and markets worldwide are experiencing major reform initiatives.[2] This movement reflects an international momentum, and what might be termed a ‘copy cat approach’ to reform,[3] following the series of disclosure and corporate governance scandals of which Enron is now the paradigm example. It also reflects recent innovations in law and finance scholarship, which suggest that there is a correlation, if a controversial one, between regulation and market conditions and financial development.[4]
The prejudicial effects of over-regulation and liability risk have also recently come under sharp political focus following concerns in the US as to a weakening in the competitive position of the US as the world’s leading financial market which may, although this is contested, reflect the stringent requirements of the Sarbanes Oxley Act 2002 and the US liability and enforcement regime, and as markets worldwide adopt more sophisticated regulatory regimes and compete in attracting capital.[5] In the UK, the 2006 bid by NASDAQ for the London Stock Exchange prompted concern that any risk of change in regulatory oversight (in particular US SEC oversight) over the London Stock Exchange could threaten the Exchange’s competitive position.[6] International regulatory developments and regulatory burdens, and particularly EU requirements, now form part of the UK Financial Services Authority’s (hereafter FSA) Annual Risk Outlook and are the subject of specific discussion in its Annual International Regulatory Outlook. For example, the FSA noted in 2006 that one of the priority risks to its achieving its aim of efficient, orderly, and fair markets was the substantial volume of international regulatory change affecting UK financial institutions. At the very least, the risks of law are becoming apparent.
The form, design, and quality of regulation are therefore increasingly policy priorities. This overview of recent developments considers the new focus on the quality of regulatory design in the regulation of intermediaries and markets in the UK and the EU which is currently a major feature of regulatory and policy discussion. But the UK and the EU are also experiencing large-scale substantive regulatory reform. The discussion therefore also considers the major themes of the recent reforms to markets and intermediaries in the UK and the EU and whether they can be regarded as best practice and a template for reform internationally.
B The European Union as a Driver for Reform – the Context
Since 1999, the EU (currently composed of 27 Member States) has been engaged in a massive and wide-ranging reform project to upgrade its financial markets architecture and its regulatory framework. Dramatic reforms to the regulation of markets and intermediaries have been taking place under the Financial Services Action Plan (the FSAP), an ambitious reform agenda adopted in 1999 and completed in 2005. The FSAP extends from the issuing of securities and issuer disclosure (initial, periodic and ongoing), through to trading in securities (including trade execution and transparency rules) and the supply of investment services, gatekeeper reform (including credit rating agencies and investment analysts), and on to market infrastructure, in particular clearing and settlement systems. It demands a radical reform of financial market regulation across all 27 Member States. Under the EU’s constitutional arrangement, rules adopted by the EU’s “quasi-federal” institutions - the Council (which represents the Member States and their national political interests), the Commission (the EU’s independent executive and bureaucracy which represents the EU interest), and the Parliament, (composed of directly elected representatives) - must be implemented by the Member States in their national systems. EU rules take precedence over national rules.
The key FSAP measure for markets and intermediaries is the groundbreaking Markets in Financial Instruments Directive 2004 (MiFID)[7] which was applied across all EU financial markets from November 1 2007 and which is projected to transform the regulatory landscape for markets, intermediaries, and the trading of securities. MiFID is designed to apply a single European rulebook to wholesale and retail transactions in financial instruments and to the full range of investment services. It has two core regulatory elements:
(i) authorisation and regulation of investment services; and
(ii) the support and regulation of a competitive and transparent order execution market.
MiFID is considered by many to be the most significant reform ever to affect the European financial services industry and it will “significantly alter how firms operate their businesses and how they interact with customers.”[8] In the UK, for example, the Financial Services Authority’s major policy priority for some time has been the massive and resource-intensive exercise to implement the MiFID reforms in the UK national rulebook for markets and intermediaries. Market participants are also undergoing large-scale and costly systems change to reflect the new rulebook. The projected upfront costs of MiFID in terms of IT, compliance, and risk management systems are immense.[9] This paper reviews some of the most significant MiFID reforms for intermediaries and markets.
C The UK and the UK Financial Services Authority – the Context
From a regulatory reform perspective, the EU is now the context within which almost all financial market policy development, regulatory reform, and market engagement takes place across the 27 Member States, including the UK. The UK retains control over supervision and enforcement, however, and has also recently engaged in very considerable reform to its overall approach to regulatory design, including in the implementation of EU rules, under its More Principles-Based Regulation (MPBR) initiative (see section II below).
UK financial markets are overseen by the UK Financial Services Authority, an independent single financial market supervisor of almost 2,600 regulators, funded by a levy on market participants,[10] which regulates approximately 25,000 banks, investment firms, insurance companies, brokers, and financial advisers.[11] It operates under the Financial Services and Markets Acts 2000 (FSMA), 11 High Level Principles for Business (which have the status of rules), and some 5,000 rules, both adopted by the FSA under FSMA.[12]
The FSA has four statutory objectives under FSMA:
(i) to maintain confidence in the UK financial system;
(ii) to promote public understanding of the financial system;
(iii) to secure the appropriate degree of protection for consumers;
(iv) the reduction of financial crime.
Although the adoption of these principles was controversial, a clear statement of objectives provides, at least, support for effective and coherent supervision across different sectors and the efficient allocation of supervisory resources. It should also facilitate cost benefit analysis of the application of the regime.[13]
Regulation of intermediaries is based on the authorisation of “regulated activities,” a very wide range of activities which include accepting deposits, insurance, dealing in investments as a principal, dealing in investments as an agent, arranging deals in investments, managing investments, safeguarding and administering investments, and advising on investments. In the investment services sphere, once a firm is authorised, regulation is primarily based on the twin pillars of conduct of business regulation and conflict of interest management.
Regulation of markets is based on FSMA’s provisions concerning recognised investment exchanges and recognised clearing houses. These provisions reflect a long tradition of self regulation. In principle, a recognised investment exchange is exempt from FSMA, but recognition depends on compliance with FSMA requirements.[14] The FSA may also issue directions to an exchange and veto rule changes - its residual powers remain considerable. The admission to listing process and the approval of listing particulars also rests with the FSA and with its Listing Authority division, not with the London Stock Exchange. This separation of functions was required under EU law and reflects the LSE’s status as a listed public company. RIEs remain responsible for admission to trading, however, and monitor and enforce trading rules. Exchange participants are regulated under the FSA’s regime for investment activities. The influence of the EU has also resulted in ever-increasing prescription on the regulation of markets.
All UK regulation is, however, closely based on EU rules and, in particular, on the Markets in Financial Instruments Directive 2004 (MiFID). The key substantive reforms for markets and intermediaries introduced by this measure are considered in sections III (markets) and (more briefly for intermediaries) section IV.
II
Markets And Intermediaries (1): Regulatory Design And Supervision
This section considers the emerging importance of better regulation and effective regulatory design in the recent reform movement.
A Better Regulation
Although its approach to supervision faced considerable criticism in the wake of the Northern Rock collapse,[15] the FSA has for some time faced criticism that it over-regulates the UK market.[16] A 2007 Report from the National Audit Office, for example, reported that the FSA was “rich in process” and needed to streamline its bureaucracy and focus on results.[17] One of its responses has been the adoption and close application of the Better Regulation Agenda. The Better Regulation agenda (December 2005) is based on four principles:
(i) increased use of principles, and an outcomes-based, incentive-driven approach, to drive the operation and behaviour of firms;
(ii) the removal of rules where the costs cannot be justified by the benefits;
(iii) a more robust application of risk-based regulation; and
(iv) supporting firms in complying with FSA requirements.[18]
Risk-based and outcome-focused regulation is now a key objective for the FSA.
Better regulation is also entrenched in the background statutory regime. FSMA 2000 requires the FSA to follow principles of good regulation in carrying out its activities.[19] In seeking to meet these objectives, the FSA follows three strategic aims:
(i) promoting efficient, orderly and fair markets;
(ii) helping retail consumers achieve a fair deal; and
(iii) improving its business capability and effectiveness.
Effective cost benefit analysis is of particular concern to the FSA as it has a statutory responsibility to assess the costs and benefits of each measure it adopts. The FSA has deployed considerable resources to developing appropriate performance review measures, given the difficulties in quantifying the effects of financial market regulation.[20] It has, for example, in an attempt to improve its cost-benefit assessment of measures, recently engaged in a major ‘Costs of Regulation’ exercise in the corporate finance, institutional asset management, and investment and pension advice sectors,[21] which enjoyed considerable market support.
The concern to promote Better Regulation also reflects a general and intensifying concern in the UK financial markets (and internationally[22]) with the risks and quality of regulation. For example, the Financial Markets Law Committee, an independent committee of the Bank of England, considers issues of legal uncertainty which give rise to material risks in the wholesale financial markets. Major market actors concerned with the quality of regulation include trade associations such as the London Investment Banking Association (LIBA), an influential City trade association which has addressed effective policy formation and regulatory impact analysis.[23] Internationally, the International Council of Securities Associations (ICSA), which represents a wide range of financial market self-regulatory and trade associations, regularly addresses the effectiveness of the regulatory process.[24]
A focus on more effective regulation is now a major theme of the current policy dialogue on financial markets in the EU generally. Overall, there is an increasing concern across UK and EU financial market policy, to promote:
(i) more effective regulatory design, particularly with respect to costly investment services disclosure;
(ii) less prescriptive regulation and more incentive-driven, principles-based regulation based on self-assessment by market participants; and
(iii) the use of “softer” ancillary measures, such as investor education and market discipline/industry solutions, which may reduce the need for prescriptive regulation.
B Principles-Based Regulation
1 More Principles-Based Regulation
One of the most important themes of UK financial market policy at present, and a major current preoccupation of the markets, is the move away from detailed prescriptive regulation to principles-based, outcome-driven intervention. Principles-based regulation is designed to change firm behaviour and culture, encourage self-assessment of the application of regulatory principles, and provide incentives for compliance. It is particularly important in providing flexibility in dealing with the risks inherent in the different business models for markets and investment services.
Although principles-based regulation is not new in the UK market, the UK FSA has recently formally committed to a movement towards ‘more principles-based regulation’ (MPBR) as part of its 2005 Better Regulation agenda.[25] This agenda may yet deliver to a ‘potentially revolutionary shift in the nature of the regulatory process’.[26] The current FSA Handbook contains 11 Principles but over 5,000 rules and related guidelines. The FSA is concerned that this imbalance between principles and rules can dilute the clarity of its objectives and, in particular, reduce senior management’s sense of responsibility. Under the Better Regulation agenda, the FSA believes that “better outcomes can be achieved by encouraging a focus on the best actions to take in a particular situation rather than following a mechanistic process.”[27] It has also, however, warned of the complexities in changing the balance of regulation. Under MPBR, the FSA is likely to rely more heavily on principles alone, to strip out detailed prescriptive rules where appropriate, to enforce on the basis of high level principles and to focus on outcomes, leaving firms greater freedom to determine how outcomes are achieved. Greater reliance is likely to occur on industry guidance and codes.[28] Senior management is expected to engage with the desired regulatory outcomes, ensure that any necessary changes to deliver an outcome-based approach are embedded in the organisation, and to satisfy themselves that the minimum standards set by the Principles are met.[29] More enforcement on the basis of the 11 High Level Principles, which have the status of enforceable rules, rather than on the basis of the detailed rules in the FSA Handbook, is expected. Overall, MPBR is designed to deliver a stronger focus on outcomes and a more principles-based approach to delivering outcomes, based in particular on highlighting the responsibility of senior management to engage with the Principles and ensure firms deliver outcomes that meet the Principles.[30] It reflects in part a concern that detailed rules have not been successful in preventing a series of recent financial mis-selling scandals, including with respect to personal pensions, endowment mortgages, and split capital investment trusts.[31]
2 The Application of
MPBR
While progress is likely to be slow, as it involves a significant cultural shift in the marketplace, the new approach is increasingly being relied on. The ‘Treating Customers Fairly’ initiative for investment services, for example, has seen the FSA adopt a principles-based rather than a rules-based approach in order to achieve greater flexibility. Treating Customers Fairly (TCF) is now a major business priority for the FSA. It is based on the General Principle 6 of the FSA’s High Level Principles for Business: that a firm must pay due regard to the interests of its customers and treat them fairly. It is designed to address the FSA’s finding of repeated failures in the retail sector to treat customers fairly and to ensure that firms treat customers fairly through all stages of the product life cycle, from product design, to marketing, to sales and advice, and to after sales information and complaints handling. Rather than defining the ‘treating customers fairly’ obligation through specific rules, or definitions of ‘fairness’, however, the FSA has asked senior management to consider this question, taking into account their particular business models, and to ensure a TCF culture is implemented throughout the firm.[32] It has also provided guidance materials on its TCF website, including hypothetical case studies and reports giving examples of good and bad practice. Self assessment tools are also being made available, while direct engagement with the FSA is possible through the FSA’s Firms Contact Centre, FSA roadshows and individualised “surgeries”, and FSA TCF workshops.
TCF is designed to become embedded in a firm’s culture and is subject to FSA enforcement. Six consumer outcomes under TCF have also been established to guide firms.[33] Although there is some market concern as to the lack of firm guidelines on TCF, the FSA has argued that “additional regulation in this area could create defensive and less competitive markets, reduce flexibility, and increase costs.”
Similarly in the hedge fund area, the FSA has resolved not to adopt detailed prescriptive rules but to rely on better dialogue with the industry and on the application of generic rules to particular risks. For example, the giving of preferential “side letters” to particular hedge fund investors, which give investors more information and preferential redemption terms, has been stated by the FSA as a breach of Principle 1 which requires firms to carry our their business with integrity.
The 2007 revision of the FSA’s conduct of business rules for intermediaries (the NEWCOB element of the FSA Handbook) is the flagship for MPBR. The Markets in Financial Instruments Directive 2004 required major reforms to the FSA’s conduct of business regime for intermediaries, but these reforms have reflected the MPBR strategy, albeit within the confines of the limits posed by the EU rules.[34] The principles-based approach has, according to the FSA, resulted in a new sourcebook on conduct of business regulation (NEWCOB) which is simpler and shorter and “allows firms more discretion to achieve outcomes that are appropriate for their particular business”.[35] As part of this strategy, guidance on the new regime has been limited and only included where it was believed to be benefit to firms, notwithstanding some market demand that more guidance be provided (the FSA, has however, highlighted the role of industry guidance).[36] Other examples include the FSA not defining how, for the purpose of applying the suitability test, a client’s knowledge and experience is to be taken into account,[37] but instead committing to providing case studies as the regime develops.[38] The FSA has also removed the rule that firms advise the “most suitable” packaged product from the range on which they advise, given that the objective of this requirement would be covered by a combination of conduct of business rules including disclosure, best interest of client obligations, suitability requirements, and the over-arching TCF principle.[39]
3 The Risks
While there is generally strong market support for the more principles-based regulation initiative, there is also a concern to ensure that principles are supported by guidance which provides intermediaries and markets with certainty but which also has some degree of endorsement by a regulatory authority.[40] There is a difficult balance to be achieved between the clarity, cost, and flexibility benefits of a principles-based regime and the needs of market participants for certainty and for safe harbours. The sources of MPBR remain unclear – major speeches from FSA executives, Dear CEO standard letters, press releases, industry guidance, FAQ documents, case studies and other soft sources all form a matrix from which MPBR derives and which is developing outside the formal Handbook.
This can be highly unsatisfactory for intermediaries seeking clarity and to reduce regulatory risk. Concerns have been raised as to the uncertain status of “softer” information, and as to the risks that a proliferation in this material could bring back detailed regulation by the “back door”. Consumer groups have also expressed concern that careful supervision and enforcement is required to mitigate the risk of detriment to consumers in practice, particularly as firms may not, initially at least, fully understand what is required of them in an MPBR environment.
The FSA has responded by confirming that once a firm complies with the FSA’s High Level Principles, it is irrelevant whether it has complied with any other material, but that firms which reasonably rely on FSA material will also have a defence in any subsequent regulatory action.[41] The FSA has also highlighted that, in addition to developing the capabilities of its staff with respect to MPBR, its regulatory approach will be directed away from detailed procedural issues and towards regulatory outcomes and that there will be increased emphasis on high level rules and outcomes in enforcement.[42]
Considerable controversy surrounds the role of industry guidance, with the FSA adopting an approach based on ‘confirming’ guidance which, where complied with, protects regulated actors from subsequent enforcement action by the FSA.[43]
Industry guidance looks set to be critical for MiFID implementation, with the FSA acknowledging the role of industry and MiFID Connect, a groundbreaking association of the major market associations impacted by MiFID,[44] already providing guidance on the implementation of MiFID.[45] While this reliance on guidance to support regulation chimes with outcomes-driven, culture-based regulation, and also fits with the wider move towards the capturing of market discipline as a market management technique (section III below), MPBR may generate a more opaque regulatory environment, with proliferating guidance and governance risks in terms of consumer input, unless these risks are carefully managed.
C The EU and Principles-Based Regulation
Similar efforts are underway at the EU level, with principles-based regulation a core commitment of the 2005-2010 financial services agenda which sets regulation for all 27 Member States.
More specifically, although the new MiFID regime imposes detailed rules for intermediaries and markets, it is, in principle, designed to be generic and to be applied by investment firms to their particular business models and situations. The legislative guidance to the MiFID regime, for example, notes that “investment firms vary widely in their size, their structure, and the nature of their business. A regulatory regime should be adapted to that diversity while imposing certain fundamental regulatory requirements which are appropriate for all firms. Regulated entities should comply with their high level obligations and design and adopt measures that are best suited to their particular nature and circumstances.”
D Case Study: Conflicts of Interest and Principles-Based Regulation
1 Approach
Conflict of interest management and prevention is a major theme of the recent EU (and therefore UK) reforms to intermediary regulation. MiFID’s new conflict of interest regime, which will be applied in the UK, also provides a useful case study for principles-based regulation.
The MiFID regime imposes an upgraded, but generic, conflict of interest regime on the supply of investment services generally and, in particular, to address the risks of multi-service investment firms. It is designed to operate as a principles-based template against which firms self-assess and manage their potential exposure to conflicts of interests.
The new regime is designed to be applied by firms to identify, assess, and manage the particular conflicts they face under their particular business model. It is stated to provide ‘flexible principles of general application across the whole range of business models’. As such, it reflects a concern to ensure that conflict rules are sufficiently flexible to reflect changing business activities and structures. Although the regime contains a number of detailed rules, it is, in essence, based on self-assessment by firms and on the application of core principles. The strong underlying theme is of application by firms of the core rules to the specific businesses and risks they face. In effect, the regime attempts to bring about cultural change instead of a box-ticking mentality. The formalities of disclosure-based controls are replaced by policy and procedural requirements, designed to ensure that investment firms focus on the management of specific risks. Overall, the legislative guidance note states that the regime is designed to “ensure that investment firms take a holistic approach to conflicts management, regularly reviewing their business lines to ensure that at all times their policies reflect the full scope of their activities and the possible conflicts that may emerge.” The new regime was, however, strongly resisted by the market during the consultation process given what was regarded as a more prescriptive and structural approach to the management of conflicts of interest, concerns as to the administrative burdens and the failure to assess the costs and benefits of the new regime.
2 Elements
The conflicts of interest regime is unusual within MiFID’s otherwise calibrated structure as it is a fundamental obligation. It applies regardless of whether the client is a retail investor, professional investor, or counterparty engaged in arms-length own-account trading with the firm, despite the market hostility to the extension of conflicts obligations to counterparties (the previous UK regime, for example, did not apply to market counterparties). This extensive application reflects the centrality of conflict of interest management to the new regime and its high political profile – although it cuts against the traditional characterisation of sophisticated market actors as entities capable of bargaining for their own protections. There is also a striking movement away from the disclosure techniques which dominate in the conduct of business sphere, and towards more interventionist procedural and structural requirements which ensure the independence of the investment firm. There are two strands to the core conflict of interest obligation imposed on investment firms, whatever their activities.
The first core obligation is an identification requirement. Investment firms must take “all reasonable steps” to identify conflicts of interests that arise in the course of providing investment services.[46] These are broadly defined as conflicts arising between themselves (including their managers, employees and tied agents, or any person directly or indirectly linked to them by control) and their clients, or between one client and other. The conflict regime is not therefore dependent on an existing fiduciary obligation but it is triggered by the firm/client relationship.
The second core obligation is an organisational requirement. All firms must maintain and operate “effective organisational and administrative arrangements” with a view to taking “all reasonable steps” designed to prevent conflicts of interest from “adversely affecting” the interests of their clients.[47] These two obligations are linked by a default disclosure requirement. Where the organisational and administrative arrangements adopted are not sufficient to ensure “with reasonable confidence” that risk of damage to client interests will be prevented, the firm must clearly disclose the general nature and/or the sources of the conflicts of interest to client, before undertaking business on its behalf.[48]
Central to the new regime for managing conflicts of interest is the requirement placed on firms to establish, implement and maintain an effective, written conflicts of interest policy. Reflecting the emphasis in the conflicts regime on calibration and self-assessment, the policy must be appropriate ‘to the size and organisation of the firm and the nature, scale and complexity of its business’. The conflicts policy must contain certain minimum requirements. It must first identify the ‘circumstances’ which constitute or may give rise to a conflict of interest entailing a material risk of damage to the interests of one or more clients with reference to the specific investment services and activities carried out by, or on behalf of the firm. Reflecting the generic nature of this requirement but the special risks posed by multi-service firm, firms must pay “special attention” to the activities of investment research and advice, proprietary trading, portfolio management, and corporate finance, where the firm, or persons directly or indirectly linked by control to the firm, performs a combination of two or more of these activities.
The detailed rules which implement the conflicts regime make clear that simple disclosure of conflict of interests is not sufficient to meet the conflicts obligation:
the disclosure of conflicts of interest by an investment firm should not exempt it from the obligation to maintain and operate the effective organisational and administrative arrangements requirement…..while disclosure of specific conflicts of interests is required….an over-reliance on disclosure without adequate consideration as to how conflicts may appropriately be managed is not permitted.
Disclosure is not, therefore, a panacea, but a last resort: ‘disclosure of a conflict of interest to a client is a last resort and should only be used in specific cases where measures adopted…may not prevent risk of damage to the client in the case of that specific conflict.’
While the roll-back of disclosure places more responsibility on firms to address conflicts, a responsibility which disclosure can reduce or disable altogether, and reflects well-established weaknesses in investor decision-making generally,[49] it does not reflect the overall emphasis on disclosure across the investment services regulation generally and particularly in the new MiFID regime. Neither is it entirely consistent. Unlike the pre-MiFID UK FSA regime, the regime does not recognise that refraining from acting can be a remedy where a prejudicial conflict exists. If conflicts are of such severity that they cannot be managed by internal procedures, it seems unlikely that retail investors will be able to assess the degree of risk through disclosure - unless particular attention is given by supervisory authorities to the format in which this disclosure is presented, and the detail it contains. The current EU policy emphasis on testing disclosure[50] may predict close supervisory attention to how firms provide this disclosure – but it remains to be seen.
3 Best Practice?
It remains to be seen whether the new conflict of interest regime will be successful and whether the EU’s approach, based on self-assessment and flexible application of core principles, in parallel with a move away from disclosure, has potentially wider application.
Although disclosure of conflicts can be of doubtful effectiveness, particularly for retail investors, there is some uncertainty as to whether procedural requirements will be any more effective than disclosure in preventing prejudice to clients.[51] Prescriptive regimes exacerbate the general risk of obsolescence to which financial market rules are subject, given the speed at which business models develop and the increasing use of conflict of interest tools to manage emerging risks. But considerable risks attach to reliance on self-assessment of risks by firms, based on flexible principles. Until now, conflict of interest breaches have tended only to attract enforcement attention following high-profile, large-scale, and systemic failures.[52] Successful application of the new conflicts identification and management regime is, therefore, likely to reflect current attitudes towards general risk-management of an investment firm and, in particular, the priorities of senior management. The new regime will, therefore, test the market’s and individual firms’ culture with respect to conflict of interest management, and the strength of reputation risk as a control on firms.[53] Effective cost-benefit analysis and review of the new regime will be essential.[54]
Ultimately, however, successful management of conflicts of interest, certainly in the EU context where there are limits on the ability of investors to take private actions,[55] depends on strong enforcement by supervisory authorities which will support the development of an effective market culture in dealing with conflicts of interests. The framework nature of the regime, and the emphasis on flexibility, suggests that supervision, not regulation, will determine the effectiveness of the new regime.[56] It success rests to a large degree, therefore, on supervisory resources and on the effectiveness of supervisory monitoring and enforcement tools in building a compliance culture.
The UK FSA is committed to tough enforcement of conflict of interest breaches, given the centrality of its conflicts of interest policy to investment services regulation (see section IV on the role of conflict of interest management in addressing hedge fund and private equity risk), and has a range of weapons at its disposal. Of particular importance, and reflecting the move towards “softer”, outcome-driven measures, is its use of “Dear CEO” letters, addressed to senior management and designed to outline the FSA’s view of best practice in a particular area. In 2004 and 2005 the FSA issued “Dear CEO” letters to the investment services sector which outlined the principles which a well-managed firm would follow with respect to conflict of interest management and how non-standard transactions, which might carry particular conflict of interest risks, should be managed.[57] While these principles are not regulatory requirements, they were developed in consultation with the industry and the FSA recommended their adoption as best practice. Softer technique such as these carry the benefits of allowing close dialogue with the industry and also flexibility and are increasingly appearing as a supervisory tool across the EU.
E Supervision
While regulation of markets and intermediaries is largely dictated by the EU, supervision remains the province of the Member States.
While the role played by law and regulatory design in supporting market development remains controversial, it as least clear that a complex interplay of different factors, and different aspects of financial market intervention beyond the adoption of rules, particularly the effectiveness of public and private enforcement and the quality of supervision, drives financial market development.[58] In the UK, there have been significant innovations in monitoring and supervision, reflecting the FSA’s integrated approach to supervision.
The FSA operates under a “risk-based model” of regulation and supervision across all markets, actors, and sectors under its supervision under the “ARROW”[59] review. The ARROW system is designed to allow the FSA to: identify the main risks to its objectives; measure the importance of the risks; mitigate those risks where required; and monitor and report on risk management. A whole-firm approach is adopted whereby risk assessment is designed to capture the “regulatory footprint” of the firm and the potential risk it poses to the FSA’s objectives. ARROW is based on an assessment of the different risks posed by a firm and aligns the management of these risks with the firm’s own risk management systems. The business risk posed by a firm is assessed along with the quality of controls in place. Low impact firms (typically small firms) are rarely subject to firm-specific risk assessment. Other firms are subject to regular risk assessments.[60] The model reflects the FSA’s position that not all risks can be removed from the markets and that a “zero-failure” approach would be prohibitively costly. Supervisory resources are, therefore, concentrated in areas which represent the most serious risks to the FSA’s statutory objectives. The FSA also appoints a nominated FSA manager to larger firms to ensure effective communication and monitoring.
F Best Practice?
While most recent policy attention has been closely focused on the substantive reforms to intermediary and market regulation dictated by MiFID (sections III and IV below), a wider concern to promote more effective regulatory design generally has also emerged as a strong trend of UK and EU financial market policy.
Although considerable risks attach to the MPBR initiative in particular, the risks of flawed regulation and the intensifying sophistication of markets, suggest that traditional rule-based “command and control” regulation[61] will become increasingly ineffective in dealing with new challenges. The FSA’s move to MPBR remains highly controversial and potentially costly[62] and is still being worked out. New staff, for example, are being recruited to deal with a more outcome-driven regime.[63] Initial signs are promising. The FSA’s May 2007 review of the TCF project reported good progress, with many firms already investing substantially in changing the way in which they conducted business.[64] The FSA also reported, however, that further progress was needed to “reach the embedding phase and ensure the consistent delivery of fair consumer outcomes. This is, and will continue to be, a significant challenge for most firms, and requires sustained focus from senior management.”[65]
It is at least a brave attempt to pull back from direct regulatory intervention and to rethink how regulators intervene on the markets, given the complexity of financial markets and the limitations of prescriptive regulation, and to deliver more effective market discipline by focusing on general standards, the delivery of outcomes, and the engagement of senior management in the development of effective firm processes and procedures.[66] It should allow firms more freedom to innovate in designing their response to delivering regulatory outcomes. It may yet act as a template for more effective regulation internationally and is being closely followed in the US.[67] At the very least, the new focus on regulatory design has led to greater engagement by the markets with the law-making process and closer attention to the fundamentals of market regulation.
III Markets and Intermediaries (2): Reforms to the Regulation of Trading Markets
This section considers recent developments with respect to the regulation of trading markets.
A Restructuring EU Equity Trading Markets – Competitive Order Execution Markets and the Role of Regulation
1 Competitive Order Execution
Notwithstanding the uncertain relationship between law and financial market characteristics and development,[68] and the wider uncertainties as to the relationship between the financial markets and wider economic growth,[69] the EU (and therefore UK) policy commitment to the financial markets as agents of economic growth and, in particular, to law and regulation as a means of driving market development appears unshakeable.[70] One of the best illustrations of this policy commitment (and of the risks of large-scale regulatory design) comes from the recent dramatic reforms to securities market trading across the EU under MiFID – these reforms came into force in November 2007.
MiFID is designed in part to address order execution and trading markets and to “establish a comprehensive regulatory regime governing the execution of transactions in financial instruments irrespective of the trading methods used to conclude those transactions” (MiFID, recital 5). A major objective of MiFID is the liberalisation of the pan-EU trading market for order execution and to level the playing field for competing execution venues. MiFID supports a competitive pan-EU market in order execution by abolishing the “concentration rule,” which previously allowed Member States to route retail equity orders to central stock exchanges, and by enhancing transparency and effective price formation. France, Spain and Italy, for example, required all retail trades to be executed centrally on a stock market. Across Europe, trading in equities has traditionally been centred on the main national stock exchanges.[71] MiFID’s adoption followed a fiercely contested debate as to the merits of competition in order execution and the risks of fragmentation in trading as order interaction becomes more diffuse in a competitive environment. The EU’s policy institutions strongly supported a competitive order execution market as a means of delivering competition (by supporting the growth of alternative venues), greater choice in trading venue, and better responses to investors’ trading needs – reflecting the proposition that no single venue can meet all investors’ trading requirements. Opponents pointed to risks from market fragmentation, poorer liquidity, weaker price formation, and investor protection risks linked to conflicts of interests. After bitter negotiations, a controversial regulatory regime has been imposed in support of the competitive order execution policy which is designed to be neutral as to trading models but to reflect the sensitivities of different trading functionalities.
Pan-EU trading in securities has the potential to become highly competitive as traditional stock exchanges, alternative trading systems, and internalisers (investment firms which execute client orders against their proprietary order book) all compete to provide execution services, following technological innovation, the liberalisation of securities trading, and a loosening of the grip of the major stock exchanges.[72] From a regulatory perspective, competitive order execution raises difficult questions as to whether to characterise trading venues as investment firms (with the major focus on investor protection) or trading markets (with a concern for wider market stability, integrity, and liquidity risks).
MiFiD’s new trading market regime was subject to fraught negotiations as traditional stock exchanges fought to protect their position from emerging competitors, notably internalisers.[73] Their primary argument was that the quality of trading and of price formation would be damaged unless trades, and particularly retail trades, were routed to a regulated market, but that if investment firms were permitted to execute trades, they should be subject to the same regulation as all trading markets, particularly with respect to transparency rules. Transparency rules are, of course, highly sensitive to the particular business model adopted by a trading venue, can carry significant costs, and, given that they require venues to disclose their trading position, can pose significant risks for internalising investment firms who trade bilaterally with investors and do not supply liquidity in the same manner as stock exchanges and alternative trading systems.[74] Internalising firms argued that pre-trade transparency, which requires firms, in effect, to act as liquidity providers, commit capital, and stand ready to buy and sell at the disclosed prices, even though investment firms to do not carry the liquidity and trading capacity of exchanges, would increase costs, severely prejudice internalisation, and dilute the benefits of competitive order execution. They argued that investor protection was more appropriately delivered under the investment firm model and through conflict of interest rules, best execution requirements, and post trade transparency requirements.
2 The New Regulatory Regime for Equity Trading
MiFiD’s new trading markets and order execution regime is based on elements of investment firm and trading market regulation. It distinguishes between three actors: (i) systematic internalises or investment firms who execute client orders bilaterally on their own trading book of securities rather than sending them for execution elsewhere; (ii) multilateral trading facilities (alternative trading systems); and (iii) regulated markets. Regulation of these actors becomes progressively more sophisticated, with “regulated markets” (essentially traditional stock markets) subject to extensive regulation and their distinguishing feature, the admission of securities to trading, subject to admission requirements (the “regulated market” concept is in effect a proxy for regulated, liquid, securities trading markets).
The new trading market and order execution regime adopts an approach based on the characterisation of the venue either as an investment firm (internalising firms and multilateral trading facilities (although the latter are subject to particular rules)) or a regulated market. The generic MiFID investment services regime (see section III – it applied to all investment services across the EU from November 2007), including its authorisation, prudential, and operational conduct of business requirements, applies to internalisers[75] and to market operators that operate multilateral trading facilities (MTFs).[76]
Given the particular investor protection, conflict of interest, and market stability risks involved in securities trading, particularly where it is carried out on a large scale as in an MTF, MiFID imposes three sets of distinct rules, additional to the generic investment services regime, on systematic internalisers and MTFs: (i) pre- and post-trade transparency requirements; (ii) trading requirements for MTFs, including a requirement for transparent and non-discretionary trading rules and basic securities admission criteria; and (iii) compliance requirements for MTFs, including a requirement to report conduct which may involve market abuse.
The new transparency regime, which is designed to counter fragmentation and price discovery risks in a competitive order execution context, was particularly problematic. A lighter, if complex, pre-trade transparency regime applies to systematic internalisers. The major reform concerns the introduction of a new and controversial quoting obligation for internalisers. The key element is the requirement is that internalisers publish firm quotes in respect of shares admitted to trading on a regulated market for which there is a liquid market. Firms must therefore provide continuous quotes for liquid shares. Where the market is not liquid (increasing the risks to the internaliser), quotes are to be provided to clients on request. This pre-trade transparency requirement only applies when the internaliser is dealing in sizes up to “standard market size.” Particular and contentious rules apply to price improvement, or the ability of the internaliser to improve on published quotes. Price improvement is prohibited for retail investors whose trades must be executed at the published quotes (for retail trades up to the standard market size). Price improvement is permitted for professional investors, subject to conditions. For the first time, post-trade transparency requirements concerning the time, volume, and price of completed trades are also imposed on internalising investment firms. This information must be published in as close to real time as possible, although deferred publication is possible for large trades.
MTFs and regulated markets are subject to a very similar pre- and post-trade transparency regime, given their similar functionality with respect to trading. In effect, current bid and offer prices and the depth of trading interest at those prices must be published, although exceptions apply to accommodate particular market models which are sensitive to pre-trade transparency (such as dealer markets) and may require time delays and to large transactions. The post-trade transparency regime requires publication of the price, volume, and time of transactions executed in the relevant system, subject to deferred publication for particular sizes and types of trade.
While the transparency regime therefore attempts to address different trading functionalities, while at the same time seeking to level the trading playing field and ensure efficient price formation and effective transparency, the new trading regime also provides an example of an attempt to integrate different regulatory techniques. One of the most acute risks in the multi-service firm context, currently of concern to EU policy makers, is the potential conflict which arises where an investment firm acting as broker internalises a client trading order. Investors face conflict of interest risks in this new competitive order execution environment, as well as the benefits of choice and competition. MiFID’s new, principles-based conflict of interest regime (section II above), however, is designed to support competition in order execution and deliver investor protection.
In addition, a new and controversial best execution regime[77] is designed to address the conflicts which may arise and to promote strong price discovery. Investment firms must take all reasonable steps when executing orders to obtain the “best possible result” for their clients, taking into account price, costs, speed, likelihood of execution and settlement, size, nature, and other relevant considerations. In a new approach (certainly for the UK), firms are now required, as a result, to take into account a range of factors, other than price, in achieving best execution (a total consideration benchmark applies for retail trades). These factors must be assessed according to the nature of the investor and the transaction. Investment firms must also establish and implement effective arrangements, including establishing and implementing an order execution policy for each asset class, to allow them to obtain the best possible result. They must also monitor the effectiveness of their execution arrangements and policy and identify and correct any deficiencies. At the request of a client, firms are also required to demonstrate that orders were executed in line with the execution policy. All investors must be provided with “appropriate information” on the policy and retail investors must be provided with specified disclosure on the firm’s execution policy, including the key venues on which the firm places significant reliance in meeting its best execution obligations and the relative importance the firm places on the different factors feeding into best execution. Client consent to the policy must be provided, and, where the policy provides for execution against the firm’s proprietary trading book, the firm must inform the investor of this possibility and obtain prior express consent before proceeding to execute. Some attempt is made to manage the costs of this system in that consent can be obtained in a general agreement.
A multi-layered approach, therefore, applies to the management of emerging conflict of interest risk in the new trading environment, based on the generic conflict of interest regime and an upgraded best execution requirement. Transparency requirements, the best execution rule and conflict of interest rules (together with new trade reporting requirements and order handling rules)[78] are designed to work together to minimize the investor protection and market efficiency and liquidity risks attendant on greater competition in order execution.
3 Impact?
The impact of MiFID’s new order execution model and the robustness of the trade transparency regime is uncertain and will remain so for some time until evidence emerges from the new trading environment.[79] It is widely accepted, however, that major structural change will follow. Some markets which have traditionally operated a concentration model (Spain, Italy and France) will face more competition, while other markets (including the UK) will be required to increase transparency requirements for internalisers.
One of the biggest open questions raised by MiFID is whether investment firms will change their business model and take the form of ‘systematic internalisers’.[80] They may, given the risks and costs of the new regime, reduce their internalisation activities, potentially decreasing market liquidity, increasing the costs of trading, and defeating one of MiFID’s major objectives.[81] But initial signs suggest that the market is reacting to the opportunities created by the regulatory reforms, with November 2006 seeing the dramatic announcement of ‘Project Turquoise’, under which a group of the world’s largest investment banks announced plans to build a major equity trading platform, using MiFID’s new regulatory structures, to challenge the major exchanges in share trading.[82] Legal reform therefore appears to be driving market innovation or, less dramatically, at least responding to market demands.
Whether policy and regulatory support of competitive order execution represents best practice will depend on the extent to which the new regime has successfully reflected the different functionalities in trading model and supported effective price formation and liquidity – careful ex-post monitoring and review will be required. But it also depends on whether investor protection has been delivered under the new regime – particularly at a time when there is a strong push to develop a European equity culture.
In one respect, however, the new regime reflects very poor legislative practice, albeit in a context which is peculiarly European. Initial orientations on the MiFID regime suggested only limited transparency requirements for internalisers and no pre-trade requirements. The complex and controversial pre-trade transparency regime for internalisers was inserted by the President of the European Commission at the last moment before final political negotiations, a move which was widely interpreted as supporting the continental stock exchange lobby. The substantive merits of this approach remains to be seen. But the MiFID negotiations are also a warning as to the difficulties in achieving radical regulatory reform in the face of fierce political and market debate.[83]
B The Debt Trading Markets: Transparency Reform and Regulatory Design
While it remains to be seen whether competitive and efficiency benefits will follow from the new competitive trading market environment which MiFID promotes, and whether investor protection and pricing efficiency will be supported, this significant reform of securities trading has generated considerable momentum and spill-over risks in the debt markets, which may provide a wider lesson in the risks of regulatory design.
MiFID’s controversial transparency regime is currently restricted to the equity markets: Member States had the option to extend the regime to other financial instruments, but have not done so. But Article 65(1) MiFID is something of a hostage to fortune in that it requires the Commission (the EU’s independent executive arm and bureaucracy) to report to the EU’s key political institutions, the European Parliament and the Council, on the possible extension of the regime to non-equity markets across the EU. The question of debt market transparency (and particularly in cash government and investment-grade/high yield corporate bonds markets) has accordingly come to the top of the regulatory, policy, and market agenda across the EU and has become the subject of intense debate.[84] Although the market is largely hostile to the imposition of transparency requirements (particularly pre-trade requirements)[85] and with little appetite across all stakeholders for major change,[86] the debate raises a number of important themes of wider importance for regulatory design and may have some lessons for the management of controversial regulatory change.
1 Spill-Over Risks
Debt markets operate under very different transparency and price formation mechanisms to the equity markets. A wider range of issuers are active in these markets (including special purpose vehicles and governments), issuers make repeat issues, and debt instruments can be considerably more complex and structured than equities. Debt markets can be less liquid than the equity markets and experience much thinner trading patterns, with trading typically concentrated at the time of issue. Debt instruments are also traded on a much wider range of venues, with dealer structures dominant[87] and trading often decentralised and concentrated in the OTC markets.[88] Investors tend to be institutional and block traders, with much less significant participation by retail investors than in the equity markets. Pricing (linked to the rate of return of the security) is affected by a range of factors beyond trading information including macro economic conditions (particularly for government bonds) and credit risk – including credit agency ratings – (for corporate bonds). In the EU, the bond market represents approximately two-thirds of all securities outstanding and is dominated by government bonds and those issued by financial institutions.[89]
Across the EU, approaches to debt market transparency vary, but broadly reflect the particular features of debt markets. Transparency requirements are typically only imposed on transactions concluded on regulated markets or stock exchanges. In the UK, for example, transparency requirements for debt securities operate through the high-level recognition requirements for Recognised Investment Exchanges which are translated into transparency requirements by the exchanges.[90] These require that sufficient pre-trade transparency is delivered through trading arrangements and practices and that sufficient post-trade transparency (taking into account the nature and liquidity of the instruments, market conditions, and the scale of transactions) is ensured, given the needs of different market participants for timely information. OTC bond markets (in which cash corporate bonds are traded for the most part) are not subject to mandatory transparency requirements.
The debate on mandatory transparency requirements for debt markets is multi-faceted.[91] Any regulatory response needs to engage with the potential for fragmentation risk in the absence of transparency requirements, given the nature of bond trading across multiple venues, and address the strains imposed on investment firms (particularly smaller firms) seeking to meet best execution obligations in the absence of full transparency given the search costs. But it must also engage with the particular risks of dealer-driven markets and the danger that transparency requirements could lead to a withdrawal of liquidity as the risks of committing capital become higher. More limited transparency can lead to an increase in liquidity providers.
The risk always existed that the ever-present danger of regulatory creep would have pulled cash debt and other markets into MiFID’s already controversial transparency regime.[92] This risk was averted during the MiFID negotiations, but the current review process raises the risk that an inevitability of reform arises and a template which is inappropriately based in the equity regime is imposed on the debt markets.
So far, this risk seems to be receding, with initial indications suggesting that there is a policy realisation that cash bond markets have different dynamics and that any transparency regime must reflect those dynamics. The Committee of European Securities Regulators which advises the EU institutions on securities market policy (it is composed of the national financial market regulators from the 27 Member States), for example, has, in its initial orientations in 2007,[93] suggested that there is little evidence of market failure affecting wholesale market participants in the EU debt markets with respect to transparency levels, with the market having developed an appropriate level of transparency which suits major market participants.[94] It has warned that any increase in transparency requirements would need to be carefully managed and tailored to ensure that liquidity provision and competition were not damaged by dealers withdrawing from the markets or reducing their level of commitment. Initial stakeholder feedback to the EU Commission also suggests that the markets for non-equity instruments are functioning well with an adequate level of transparency and that mandatory transparency obligations could undermine liquidity in what are primarily OTC markets.[95] The UK FSA has also entered the policy debate with its 2005 policy paper suggesting that there was no material market failure in the UK bond markets, although some risks may exist in the retail markets, followed by its subsequent endorsement of this position in 2006 following evidence-gathering and market consultation.[96]
2 Momentum Risks
More generally, review clauses are, in principle, necessary for effective financial regulation, not least because financial markets are dynamic while rules are static, and can have unintended consequences.[97] But review and reporting clauses similar to MiFID Article 65 run the risk that controversial questions are disposed of by reporting/review clauses that may provoke institutional momentum building up behind inappropriate measures. Once a regulatory question is placed on the policy agenda, it becomes very difficult to remove it.
3 Industry Engagement
One of the striking features of the debt market debate has been the close engagement by industry, at a very early stage, in the policy debate. While the expertise and informational asymmetry between regulators/policy makers, and the market, with respect to technical and complex issues of market design is considerable, and while market expertise must be harnessed to ensure effective regulatory design, the challenge for effective law-making and policy formation is to how harness this market expertise appropriately and ensure all stakeholders are appropriately represented.[98]
The debt market transparency debate, for example, suggests that there are some signs of influential cost-benefit analysis being, in effect, outsourced to the market. A group of influential UK and European trade associations active in the bond trading markets combined to commission research into the European bond market to inform the industry’s contribution to the EU’s review,[99] which has been welcomed by the European Commission, although it has, nonetheless, pledged to keep an “open mind”. The Commission published a Call for Evidence on extending the transparency regime in June 2006 which makes clear that public consultations will also be undertaken, expert advice will be sought from the Committee of European Securities Regulators and the new European Securities Market Expert Group (a group of market-facing advisers) will be consulted.[100] The very strong market input should therefore be counterbalanced and distilled into the final policy response.
4 Policy Formation
The debt markets discussion is also notable for the extent to which the EU’s institutions are engaging in close examination of the rationale for regulatory intervention. As noted in section II above, the EU has only very recently committed to a Better Regulation agenda. Much of the new regulation imposed under the FSAP has been adopted without reference to cost benefit analysis, impact assessment, or market failure analysis.
The 2006 Call for Evidence on Transparency, however, sets out the Commission’s methodology, how impact assessments will be used, the proposed scope of the Commission’s analysis, and the possible rationales for intervention.[101] It establishes the extent of a market failure as the key policy question – an approach which has been supported by the industry.[102] The 2007 policy paper recently prepared by the Committee of European Securities Regulators also engages closely with market failure analysis, considering whether failures arise as to externalities, information asymmetry, market power, or under-supply of a public good in the form of pricing information in the debt markets and concluding that there is no significant evidence of a market failure.[103]
As a recent example of how to build a response to a sensitive and complex area where market interests are likely to be organised, vocal, and expert, the Commission’s approach augurs well for interventions in other controversial areas currently on the EU agenda, including private equity and hedge funds.
5 Market Discipline
Finally, the trend towards principles-based, outcome-driven regulation discussed in section II above reflects a related trend in financial market regulation towards reliance on internal control mechanisms, as the financial markets become increasingly complex and difficult to police. This is best exemplified internationally in the Basel II reforms to capital adequacy, which are applied in the EU to banks and investment firms under the 2006 Capital Requirements Directive.[104] In a related development, market discipline, supported to varying degrees by regulatory structures, is increasingly appearing as a tool to manage the markets in the UK and across the EU. This development can also be observed in the debt market transparency debate.
There is considerable market support for a transparency model based on the development by the market, in an evolutionary manner, of transparency systems. Considerable trading information, and particularly pre-trade transparency, is currently made available under market-developed systems. [105] Industry-led solutions have been supported, with the Committee of European Securities Regulators acknowledging that the practical reality that transparency is delivered by the market through a variety of channels might suggest that transparency initiatives be industry-led, particularly in a cross-border and multi-jurisdictional context, as long as regulators remained confident that the market could deliver an appropriate solution and that appropriate governance structures are adopted. It is heartening that a central question in the reform debate is who is best placed to deliver the right solution.[106] Evidence to the European Commission similarly suggests that market innovation is contributing to increases in transparency levels across non-equity markets, but that this could be prejudiced by regulatory intervention.
C Internationalisation and Financial Markets – Regulatory Impact
It is now axiomatic in financial market regulation that international financial markets are interconnected – the recent swathe of reports and initiatives in the US[107] addressing concerns that the US market is viewed as unattractive to issuers globally and as imposing burdensome regulatory and liability costs is a testament to this.[108] The corporate sector increasingly looks to international financial markets as a major source of new capital, while institutional investors are seeking to diversify their portfolios through the acquisition of securities outside their home markets. Financial firms are responding by strengthening their presence in the international marketplace. Regulators are responding by developing techniques for managing this marketplace, whether through acceptance of international best practice standards through institutions such as IOSCO, the Financial Stability Forum, the Basel Committee, and the International Accounting Standards Board, or through the consideration of new techniques for recognising or endorsing host regulatory regimes.[109] In the EU, the impact of internationalisation can be seen particularly clearly with respect to trading markets, with regulatory policy development closely connected to international, and specifically transatlantic, developments.
One clearly emerging lesson for EU and UK policy makers, and reflecting the Better Regulation theme which undercuts recent reforms, is the critical importance of transatlantic regulatory dialogue, both upstream on new policy challenges[110] and downstream as issues develop or unforeseen consequences emerge.[111] The US and the EU are now engaged in regular, high-level dialogue on financial regulation through the Financial Markets Regulatory Dialogue. While much of the engagement concerns financial reporting and the difficult question of IFRS and US GAAP convergence,[112] one of the Dialogue’s biggest recent successes concerns market regulation and de-listing from US markets. Reflecting the risk that regulation can have unforeseen outcomes, one of the consequences in the EU of Sarbanes-Oxley was that EU issuers sought to exit the US market, and its regulatory burdens, by de-listing from the New York Stock Exchange. But delisting does not terminate an issuer’s reporting requirements as long as the issuer has at least three hundred US shareholders and remains subject to SEC registration.[113] The resulting problem for EU issuers was memorably described as reminiscent of the Hotel California – you can check out any time you want, but you can never leave.”[114]
The deregistration problem and the difficulties faced by EU issues in leaving the US market provoked very substantial market concern and close contact and lengthy negotiations between EU and US regulators. A solution was finally reached in March 2007 which makes it easier for EU companies listed on US markets to terminate SEC reporting and which is regarded in the EU “as a milestone of the Financial Markets Regulatory Dialogue.[115]
The importance of international markets and developments, and the impact of costly regulation on international market competitiveness, is also clearly reflected in the recent efforts in the UK to protect the City’s international status as a principles-based, risk-based, light-touch regulation centre.[116] The proposed takeover by US exchange NASDAQ of the London Stock Exchange in 2006,[117] which came in the wake of the politically controversial merger between Euronext and the New York Stock Exchange,[118] raised concerns that the LSE could be brought within the reach of the SEC. In principle, the question of oversight over trades on an international stock exchange is a difficult one.[119] But concern that NASDAQ ownership could trigger SEC oversight, and make the LSE less attractive to issuers and the trading community, prompted the highly unusual and accelerated adoption of the Investment Exchanges and Clearing Houses Act 2006 towards the end of 2006. This very short Act gives the UK FSA a veto over any regulation proposed by a UK exchange or clearing house which is “excessive” – a requirement is excessive if it is not justified as pursuing a reasonable regulatory objective or is disproportionate to the end to be achieved. In considering whether a requirement is excessive, the FSA is to consider all relevant circumstances, including the effectiveness of existing legal and other requirements, the global character of financial services and markets and the international mobility of activity, the desirability of facilitating innovation, and the impact of the proposed provision on market confidence. The Act is designed, in effect, to allow the FSA to reject any rule changes proposed by a foreign-owned UK exchange, promoted or required by a foreign regulator, which are seen as disproportionate.[120] In effect, it ringfences the LSE’s regulatory position from foreign regulatory control.
This approach does, however, carry considerable risks. The speed and timing of the intervention raises the perception, at least, of protectionism – albeit that steering Minister Ed Balls has stated that it is not intended to make the overseas ownership of UK exchanges any easier or more difficult than at present.[121] The Act also places the FSA, as an independent supervisor, in the centre of potentially politically and economic sensitive judgements.[122] More generally, crisis-led regulation[123] of this kind rarely generates optimum results.[124] But the Act certainly serves as a testament of the extent to which international developments are impacting on regulatory design and to the importance of the link between regulation and international competitiveness.
IV Markets and Intermediaries (3): Intermediaries
This section considers, more briefly, recent developments with respect to the regulation of intermediaries and key themes.
A The Impact of MiFID on Intermediary Regulation
1 The MiFID Regime
As noted above, the regulation of investment firms in the EU (and in the UK) is currently undergoing large-scale reform under the MiFID regime which applies to the supply of investment services as well as to trading markets.
The investment services regime covers the authorisation and regulation of investment services, which include broking, own account dealing, underwriting, portfolio management, operating multi-lateral trading facilities or MTFs (see section III), and providing investment advice, in relation to a range of financial instruments including commodities and derivatives. Investment banks, stock brokers and broker-dealers, corporate finance firms, portfolio managers, private banks, future and options firms, and commodities firms are all covered.
The regime is functional rather than institutional in application. Authorisation is required once an entity provides “investment services,” as defined. Credit institutions, for example, must be authorised where they carry out investment services such as selling securities or packaged products which contain securities. The regime is also designed to reflect multi-service investment firms carrying out a range of investment services from investment advice, to corporate finance, to asset management within the same firm. Conflict of interest rules are, therefore, pivotal to the application of the regime (see section II). But the regime is also designed to reflect the particular business models adopted by investment firms by relying on principles-based rules which can used flexibly across different business models.
There are two main sets of reforms: (i) conflict of interest management (section II) and (ii) conduct of business regulation, discussed below.
2 Conduct of Business Regulation
There are three elements to the new conduct of business regime. MiFID Article 19 addresses conduct of business in the investor/investment firm relationship. Article 21 introduces a best execution obligation (see also section II). Article 22 imposes new order allocation and handling rules.
Article 19 contains a number of elements which together form a classic conduct of business regime:
• an obligation to act fairly, honestly, and in the best interests of investors (Article 19(1));
• information and marketing disclosure to be fair, clear, and not misleading (Article 19(2));
• firm, service, and product disclosure to be provided prior to contract conclusion (Article 19(3));
• suitability rules (Article 19(4)-(6)); the customer agreement (Article 19(7)), and
• ongoing investor reporting requirements (Article 19(8)).
The Article 19 regime therefore covers the life cycle of the investor/investment firm relationship from initial marketing and disclosure through to suitability assessment and the customer agreement and on to ongoing record-keeping requirements.
All of these high level rules are subject to detailed rules, particularly with respect to the content of investor marketing and disclosure and with respect to the nature of the suitability and know your client rules (a graduated regime applies with full suitability applied to investment advice and asset management, no advice required for execution-only transactions in specified non-complex instruments, and an intermediate appropriateness test for all other services and products).
In terms of regulatory design, of particular note (and reflecting the increasing reliance on high level principles) is the emerging importance of the umbrella Article 19(1) obligation to act in the best interests of clients. It is, for example, being used to deliver investor protection to the professional sector. While the nature of marketing and investment firm/service/product disclosure is prescribed by MiFID for retail investors, it is not for professional investors who are regarded as protected by the Article 19(1) high level obligation. Article 19(1) has also been used as the basis for an extensive investment firm inducements regime under MiFID which also reflects the importance of conflicts of interest management under MiFID. Although the market strongly resisted rules on inducements where there was no evidence of a conflict of interest, an extensive inducement regime has been adopted based on the generic obligation to act in the best interests of the client, even in the absence of a traditional conflict of interest. An investment firm will be not regarded as acting honestly, fairly, and professionally in accordance with the best interests of a client if that firm accepts a fee, commission, or non-monetary benefit in relation to the service provided to the client, unless
(i) that payment is clearly disclosed to the client in a comprehensive, understandable, and accurate manner, and
(ii) unless the payment is designed to enhance the quality of the service to the client and does not impair compliance with the firm’s duty to act in the best interests of the client.[125]
A separate requirement provides that when a firm is identifying conflicts of interests which may damage the interest of clients as part of the core conflicts of interest obligation (see section II) imposed on firms, the minimum criteria applied by the firm must include whether the firm receives inducements in relation to a service provided by a client other than the standard commission or fee for that service.[126] The conflict of interest rule and the best interest rule therefore both engage with respect to inducements – with respect to investor protection and more specifically with respect to conflict identification and management.[127]
As noted in section II above, Article 21 introduces a best execution obligation for the first time in EU investment services law. Article 22 addresses the processing of investor orders and the management of conflicts of interest, requiring investment firms to implement procedures and arrangements which provide for prompt, fair, and expeditious execution of client orders, relative to other client orders and the trading interests of the investment firm.
The conduct of business regime generally is risk-based and calibrated to reflect the different needs of retail and sophisticated investors. All detailed technical rules on the conduct of business regime must take into account the retail or professional nature of investors. The Article 21 best execution regime also reflects the different needs of retail and professional investors by adopting a total consideration benchmark for retail trades and particular disclosure requirements for retail investors. Article 24 disapplies Articles 19, 21, and 22 from eligible counterparties or sophisticated market participants who enter into transactions with investment firms. MiFID also contains detailed guidance on how to classify an investor as professional for the purposes of the Directive. Authorised institutions such as investment firms, collective investment schemes and credit institutions and sophisticated investors such as governments and regional authorities are classified as professional (although they may request non-professional status), while private actors may opt to be classified as professional on request, based on their meeting competence and asset-based tests.
B Emerging Regulatory Risks
1 Regulatory Arbitrage
Appropriate regulatory differentiation and segmentation is key to effective capital market regulation. Investor protection regulation traditionally segments investors into retail and sophisticated sectors for the purposes of applying protective rules and ensuring regulatory burdens fall appropriately. In the trading markets, as examined in section III above, market regulation must reflect market structures, the instruments traded, and market participants to manage liquidity, investor protection, and efficiency risks. But segmentation also raises the risk of regulatory arbitrage, a risk which is now emerging from the recent reforms and which may provide some lessons for best practice. Although MiFID is designed to operate functionally, it is limited to investment services and to nominated financial instruments – excluding, in particular, insurance-related products.[128]
One of the classic occasions for arbitrage concerns product regulation, with markets moving to design products which fall outside particular regulatory regimes. The UK FSA has recently committed to removing product-driven regulation, to the greatest extent possible, from its Handbook – this has been particularly evident in the recent redesign of the conduct of business regime.[129]
The new inducement regime (outlined above) has proved particularly controversial with the markets. One particular concern was whether it would apply where inducements passed within group structures, where a firm adopted a business model based on intra-group activity – a vertical model. In designing the legislation, care was taken to ensure that payments made between distinct legal entities within the same group offering group products were treated in the same way as other inducements. Similar concerns arose with respect to the sale of products which fall outside the MiFID investment services regime, such as insurance-wrapped products. The risk of potential arbitrage in designing products, and of a distortion in the playing field, have been put on the policy agenda for possible future action.
2 Hedge Funds and Private Equity
The new, generic conflict of interest regime (outlined in section II) is likely to be critical in ensuring investors are protected against conflict of interests in the EU’s fast-growing alternative investment market. In particular, hedge funds are currently a preoccupation of EU regulators, particularly with respect to the conflict of interest risks they pose.[130] Hedge fund activity generates multiple conflict of interest risks. Prime brokers which provide credit and trading services to hedge funds may be conflicted with respect to best execution and robust risk management. There is also an increased risk of asset managers feeding riskier investments into investor portfolios, particularly managers of multi-service investment firms which also hold own account portfolios of hedge fund investments and other riskier investments, and where the firm provides the hedge fund product. Concerns are also growing that investors may be exposed to conflict of interest in the design of structured products designed and sold by investment firms to allow investors exposure to riskier alternative investments, including hedge funds. Although the EU’s approach to hedge fund risk and alternative investment (see below) is evolving, it appears that the preferred policy approach towards retail risk, in any event, is the application of generic conduct of business (particularly suitability) and conflict of interest rules to the distribution and advice chain, rather than direct product regulation. On the wholesale side, the UK FSA, for example, has isolated conflict of interest as a particular risk of the hedge fund chain, particularly with respect to valuations, and has relied on general conflict of interest principles to proceed against hedge fund managers in its recent thematic review of hedge fund risk.[131] General conflict of interest rules are also increasingly being used by the FSA to address growing concerns as to the more widespread use of credit derivatives and the potential for conflicts of interest related to the use of confidential information.[132]
More generally, the emerging approach to hedge fund risk (and private equity) sheds some light on how new challenges are being addressed in a principles-based/Better Regulation environment. While considerable political heat and light is being generated by these sectors, the regulatory response across Europe has been more sanguine.
The hedge fund sector, which has raised concerns internationally with respect to “retailisation” (or the risk of growing retail exposure through funds of hedge funds in particular[133] – indirect exposure is also increasing through pension fund investments)[134] and with respect to market stability,[135] might be expected to attract considerable regulatory attention. Similarly, following the explosive growth in private equity funding[136] and with concern growing as to the role the industry now plays in the EU economy following a series of high profile buyouts of public companies, the private equity industry has drawn high-level political attention, with concerns raised by labour and other stakeholder constituencies.[137]
But a low-key, facilitative approach has been emerging from the EU institutions, if not always at domestic Member State level.[138] The EU Commission has focussed on supporting cross-border transactions in these sectors and supporting industry efforts to build a common consensus as to the definition of a “private placement” which would facilitate the cross-border operation of hedge and private equity funds. An earlier era would probably have seen efforts, at least, to harmonise regulation in these controversial sectors. This light-touch strategy reflects the pan-EU industry view (in advising the EU) in the 2006 Report of the Alternative Investment Expert Group on private equity which also highlighted the dangers of regulation, given the role of private equity in allocating resources, re-energising companies and supporting wider economic growth and job creation, and called for any strategy to incorporate industry practice and standards.[139] Information-gathering exercises appear to be the primary concern at present, with the establishment of a Task Force on Private Equity which brings together EU regulators and central bank supervisors. Support for a non-legislative strategy also came from the Expert Group’s Report on hedge funds.[140] EU Commissioner McCreevy, who holds the financial services portfolio, has recently been robust in response to critics demanding EU action on hedge funds and private equity, arguing that they are good for the market, support liquidity, drive innovation, and increase shareholder value.[141] This approach to two sectors which are under unprecedented political and regulatory scrutiny domestically and internationally suggests that the EU is now willing to allow certain sectors to develop free of targeted regulation, notwithstanding the potential political attractions of intervention.
The UK response, domestically, has been similarly low-key, albeit that the UK is the centre for hedge fund management in Europe. The FSA produced a number of important reports in the last two years on the retail and wholesale market aspects of hedge fund risk.[142] On the wholesale side, the FSA clearly recognises the liquidity and efficiency benefits of hedge fund activity and has adopted an information-based strategy which is designed to enhance understanding of the hedge fund management industry and establish greater contact with the industry. It has decided not to impose specific requirements, whether linked to specific authorisation requirements or stress testing, on the prime brokers who provide credit facilities to funds and hedge fund managers (both of which, as investment firms and credit institutions are in the FSA’s regulatory net - hedge funds rarely are as they are typically domiciled offshore), but to intensify the application of pre-existing generic rules. The FSA is to continue its six-monthly survey of prime broker exposure which, so far, suggests that levels of exposure to hedge funds do not raise concern. It has also decided to ask additional questions of all fund managers (in their Integrated Regulatory Report) concerning the nature of their asset management activities and whether it includes hedge-fund-related activities including managing unregulated collective investment schemes, using derivatives for investment and shorting techniques, and undertaking venture capital management. It is also clear, however, that the FSA is aware of the costs of additional reporting and is concerned to minimise these requirements. The FSA is also to enhance its supervision of hedge fund managers identified as posing particular risks to the FSA’s objectives. More specifically, the FSA is also addressing valuation as an aspect of conflict of interest management given the incentives for hedge fund managers to overstate valuations given the link between fund values and remuneration. Overall, a strong theme of the hedge fund strategy is a reluctance to impose new prescriptive rules but to maximise information-gathering and the effective risk-based application of the current generic rules on investment services.
In its 2007 Annual Risk Outlook, the FSA noted that hedge fund performance remained broadly positive, while querying whether investors were receiving returns which justified the very high fees paid to hedge fund managers. It did, however, note an increase in the number of hedge funds and in assets under management, along with fierce competition among investment banks to provide services, and a related risk that competition could influence robust risk management and weaken credit assessment procedures.[143] The 2007 Outlook also reported “generally reassuring results” on prime broker exposure and, in particular, that the high profile winding-down of the Amaranth hedge fund in 2006 had minimal systemic impact[144] and showed that investment banks had managed counterparty credit exposures appropriately.[145]
On private equity, the FSA appears to be keeping a watching brief[146] – although politically speaking the industry is coming under very considerable pressure, with private equity leaders summoned to a select committee of the House of Commons earlier in June.[147] The FSA’s 2007 Risk Outlook noted a rapid increase in leveraged lending, associated with private equity, and greater concentration of exposures in private equity lending, although it also reported that banks were succeeding in distributing underwritten debt.[148] It also noted the widely-reported erosion in loan covenants “with less robust triggers” that reduce protection for lenders.
The hedge fund discussion also reflects the importance of internationalisation and transatlantic dialogue in policy development. Valuation, a particular concern for the FSA, is being addressed by IOSCO, collaboration in hedge fund supervision is being discussed by the EU/US Financial Markets Regulatory Dialogue) (and in FSA/SEC bilaterals), while the EU was heavily (albeit unsuccessfully) involved in negotiating an exemption for EU investment firms from the 2005 SEC registration requirement for hedge fund managers,[149] which has since been struck down as invalid.
In terms of best practice, it remains to be seen whether the light touch approach being adopted to hedge fund risk, in particular, will be robust against a major crisis, although the FSA’s industry reports are encouraging while the recent reluctance among G8 Member States to impose a code of conduct on the industry also suggest confidence in the regulatory supports which already apply to entities in the hedge fund risk chain. More generally, the care being taken in the UK and at EU-level to develop a nuanced regulatory response to hedge funds and private equity in the teeth of often considerable political pressure is reassuring for the development of regulatory policy.
[*] Professor of Capital Markets Law, University of Nottingham and Fellow, Department of Business Law and Taxation, Monash University.
[†] This analysis of recent developments was presented at the Monash University and Macquarie University Conference on Financial Services Reform Third Anniversary – Where to Next? Sydney, 13 July 2007. It reflects major developments and trends as at May 2007 and does not reflect later events, including the worldwide credit crunch and the subsequent policy response.
[1] Influential IOSCO standards include the 2004 Code of Conduct for Rating Agencies, which was adopted as a self-regulatory standard for rating agencies in the EU in early 2006.
[2] Korea, for example, is in the process of reforming its financial market regime.
[3] G Hertig, On-Going Board Reforms: One Size Fits All and Regulatory Capture (2005), available on http://ssrn.com/abstractid=676417.
[4] This scholarship is spearheaded by the influential and controversial work of economists La Porta, Lopez de Silanes, Shleifer, and Vishny. See R, La Porta, F Lopez de Silanes, A Shleifer and R Vishny, ‘Investor Protection and Corporate Governance’ 58 Journal of Finance (2000) 3. For a recent application in the insider dealing sphere see L Beny, ‘Do Insider Trading Laws Matter? Some Preliminary Comparative Evidence’ 7 American Law and Economics Review (2005) 144 and for a recent critique see John Coffee, ‘Law and the Market: the Impact of Enforcement’ (2007), available on http://ssrn.com/abstract=967482.
[5] See, eg, the high-profile report of the Committee on Capital Market Regulation, Interim Report of the Committee on Capital Market Regulation (November 2006) which made a series of recommendations for increasing the attractiveness of US capital markets for domestic and international investors. It highlighted the regulatory and litigation burden (including class action law suits), restrictions on open capital markets (the difficulties in exiting the US), and multiple enforcement agencies, among the causes for the decline in the competitiveness of the US capital market.
US Treasury Secretary Paulson also called for a fundamental re-examination of how the US regulates its capital markets, “mark[ing] a fundamental break with a regulatory approach rooted in the securities markets of the 1930s” (J Grant and K Guhna, ‘Paulson seeks more flexible market rules’ Financial Times, 21 November 2006, 7).
2006 saw, for the first time, more finance raised on the London Stock Exchange than on the New York Stock Exchange and Nasdaq (D Wrighton, ‘Threat to New York as centre of finance’ Financial Times, 22 November, 1).
Former New York Governor Eliot Spitzer also convened a top-level panel to consider modernisation of New York’s financial services regulation in order to ensure New York’s competitiveness with London in particular. B Masters, ‘Spitzer convenes top level panel to update Wall Street Regulation’, Financial Times, 27 May 2007, 1.
[6] See section III below.
[7] Directive 2004/39/EC OJ (2004) L145/1. It has been described as a “sprawling directive with far-reaching implications for any firm involved in buying and selling securities in Europe.” Editorial, Financial Times, 23 August 2005, 14.
[8] FSA, Business Plan 2006-2007.
[9] One-off costs to the UK investment services industry have been estimated at £877 million - £1.17 billion and ongoing costs at £80 million. FSA, The Overall Impact of MiFID (November 2006).
[10] Its budget for 2006-2007 is £276 million.
[11] It authorises and regulates deposit taking, insurance, mortgage lending, general insurance advice, mortgage advice, and investment business. It has four business units: wholesale and institutional markets; retail markets; regulatory services; and corporate services and board.
[12] The FSA regime is contained in the extensive FSA Handbook, which is composed of a series of individual Sourcebooks organised in particular Blocks. They are being reformed under the move to more principles-based regulation (section II).
The High Level Standards Block, eg, includes individual Sourcebooks on: the Principles for Business (the 11 High Level Principles); the Senior Management Arrangements, Systems and Controls (which addresses the responsibilities of directors and senior management); and the Fit and Proper Test for Approved Persons.
The Business Standards Block includes Sourcebooks on: Conduct of Business (for firms with investment business customers) (now called NEWCOB following recent extensive reforms); Client Assets; and Market Conduct.
The Specialist Sourcebooks Block includes the Sourcebook on Collective Investment Schemes and on Recognised Investment Exchanges.
The Listing, Prospectus and Disclosure Block includes the Listing Rules.
[13] H Jackson, Variations in the Intensity of Financial Regulation: Preliminary Evidence and Potential Implications, Discussion Paper 521, 08/2005 (2005), John M Olin Center for Law, Economics and Business, Harvard University, available on
http://www.harvard.edu/programs/olin_center, 5-6.
[14] These include that the RIE have adequate financial resources, be a fit and proper person to perform the functions of a RIE, ensure its business is conducted in an orderly manner, take effective measures against issuers who do not comply with disclosure obligations, and have effective arrangements for monitoring and enforcing compliance with its rules.
[15] The FSA’s targeted and risk-based approach to supervision, which is informed by its principles-based approach (discussed in this section), came under severe criticism in the wake of the autumn 2007 run on Northern Rock. The FSA was criticised as having ‘systematically failed in its duty as a regulator to ensure that Northern Rock would not pose a systemic risk’ and the run was ‘regarded as a substantial failure of regulation’ given the FSA’s failure to tackle the fundamental weakness posed by the bank’s funding model and to respond to the warning signals as to the scale of liquidity risks being carried by the bank: House of Commons, Treasury Committee, The Run on the Rock. Fifth Report of Session 2007-2008 (2008), 34, 37. In its initial reaction, the FSA was robust in response, acknowledging failures in supervision but arguing that its principles-based approach was not flawed: C Briault, ‘Regulatory Developments and the Challenges Ahead’, Speech to the Compliance Institute, 20 January 2008, available on http://www.fsa.gov.uk/pages/library/Communication/Speeches.
[16] Former Prime Minister Tony Blair warned that the FSA is “hugely inhibiting of efficient business.” D Lascelles and J Fuller, ‘Opening Up the Debate, Financial World, February 2006, 15. Similarly a major survey of businesses in 2006 by the FSA’s Practitioner Panel reported considerable unhappiness with the FSA. Particular concerns included the cost and burden of compliance and a lack of clarity with respect to certain principles-based initiatives.
[17] B Jopson, ‘FSA told streamlining needed’, Financial Times, 1 May 2007, 18.
[18] FSA, Annual Report 2005-2006, 8.
[19] These include: the need to use its resources in the most efficient and economic way; that burdens should be proportionate to benefits; that innovation in regulated activities should be supported; and the need to support competition.
[20] For an example of the FSA’s approach, see its analysis of the new investment research regime: FSA, Ex Post Analysis of FSA’s Conduct of Business Rules on Conflicts of Interest in Investment Research (2005).
[21] The survey was designed to deliver a broad picture of costs in the wholesale and retail markets by establishing the costs of complying with FSA rules and to demonstrate the validity of the methodology used. It does not, however, address the indirect costs of regulation (such as opportunity costs).
[22] See above, n 5, for recent US developments.
[23] LIBA, Annual Report (2005), 20-21, 22-23.
[24] Initiatives include the ICSA Statement on Regulatory and Self Regulatory Consultation Practices (October 2004), and the ICSA Statement on Rule Making and Regulation in Financial Markets, Principles for Better Regulation (October 2006), both available on http://www.icsa.bz. The London Investment Banking Association publicly supported the 2006 statement in advance of the November 2006 IOSCO meeting in London, noting that “over regulation of the financial sector is a real threat…too often regulatory initiatives have been introduced without clearly establishing evidence of a problem, or evidence that the regulation proposed is a proportionate response to a problem…Many regulators are aware of the dangers of over regulation and some...have adopted new disciplines…the best of these make it clear that the burden of proof is on regulators to show that the regulation is necessary and proportionate, and not on the industry to show that it is not”.
[25] MPBR is the FSA’s main strategic priority for 2007-2008. FSA, Business Plan 2007/2008. For a recent discussion see FSA, Principles-based regulation – focusing on the outcomes that matter (April 2007).
[26] Herbert Smith, ‘Principles-Based Regulation: the Challenge for Stakeholders’, Financial Regulation E-Bulletin, April 2007.
[27] FSA, Better Regulation Action Plan.
[28] M Hopper and J Stainsby, ‘Pause for Thought’, International Financial Law Review, January 2007, 2.
[29] The FSA has noted that under MPBR key regulatory decisions will move to a more senior level of the company and the Board of Directors will be required to engage with the regulatory environment: “managing regulatory risk will become much more akin to managing commercial risk.” FSA (April 2007), above n 25, 17.
[30] The benefits of MBPR have been identified as increased flexibility for firms to decide on their business and operating processes, consumer benefits deriving from firms being more attuned to their needs, and a strengthening of the ability of the FSA to have “business-like conversations” with firms and to make risk-based judgements. FSA, Business Plan 2007/2008, 10.
[31] The FSA has noted that its response to mis-selling and mis-buying problems has typically been to make more detailed rules which have added to the costs of regulation but failed to address root causes – such as firms’ failure to consider the reasonable information needs of investors. The new approach is designed to break this cycle. FSA, Reforming Conduct of Business Regulation (October 2006), 13. It has also noted that the risks of prescriptive regulation include greater difficulties in responding to innovation and product development, inaccessibility to smaller regulated firms in particular, and attention becoming focused on the letter rather than the purpose of regulatory standards. FSA (April 2007, above n 25), 6.
[32] Firms were to be, at least, implementing TCF in a substantial part of their business by March 2007.
[33] They are:
(1) consumers can be confident that they are dealing with firms where the fair treatment of customers is central to the corporate culture;
(2) products and services marketed and sold in the retail sector are designed to meet the needs of identified consumer groups and targeted accordingly;
(3) consumers are provided with clear information and kept appropriately informed before, during, and after the point of sale;
(4) advice is suitable and takes account of consumer circumstances;
(5) consumers are provided with products that perform as firms have led them to expect and the associated service is of an acceptable standard and as consumers have been led to expect; and
(6) consumers do not face unreasonable post-sale barriers imposed by firms to change product, switch provider, submit a claim or make a complaint.
The FSA has recommended that firms adopt a structured approach to revising their business following 4 phases: awareness; strategy and planning; implementing; and embedding. FSA, Treating Customers Fairly – towards fair outcomes for consumers (July 2006).
[34] NEWCOB is about half the length of the earlier conduct of business regime.
[35] FSA, Reforming Conduct of Business, Feedback (May 2007), 2.
[36] Ibid.
[37] Following industry concern that investor education, qualifications and employment do not necessarily provide a reliable indicator of product understanding.
[38] FSA, Conduct of Business Paper (May 2007), above n 35, 50-51.
[39] Ibid, 49-50.
[40] See, eg, LIBA Annual Report (2004).
[41] FSA April 2007, above n 25.
[42] The FSA has taken the view that if firms “engage positively with their regulatory responsibilities and can demonstrate that they have taken all reasonable steps to achieve the right outcome”, the FSA will take that into account in regulatory action. FSA Conduct of Business (May 2007), above n 35, 13.
[43] FSA, Confirmation of Industry Guidance (November 2006) and FSA, Policy Statement on Confirmation of Industry Guidance (September 2007).
[44] MiFID Connect is an unusual and powerful grouping of the 11 major trade associations active in the UK financial markets which was formed in 2006 to support member firms in applying MiFID requirements and which has articulated a co-ordinated position on MiFID.
[45] It has produced industry guidance on a number of aspects of MiFID (the guidance is subject to FSA rules), available on http://www.mifidconnect.com.
[46] MiFID, A18(1).
[47] MiFID, A13(3).
[48] MiFID, A18(2).
[49] On the limitations of conflict of interest disclosure see D Cain, G, Loewenstein, and D Moore, ‘The Dirt on Coming Clean: Perverse Effects of Disclosing Conflicts of Interest’ 34 Journal of Legal Studies 1.
[50] Traditionally, the EU has not market-tested disclosure formats or requirements, notwithstanding well-documented failures in investor competence and understanding. But current indications suggest a move away from this approach and greater engagement with the realities of investor understanding of disclosure. Reforms are currently underway, eg, to the EU investment fund regime and particularly to the simplified, summary mutual fund prospectus supplied to retail investors. The new regime, which will be market-tested among investors, is likely to be based on a core obligation on fund managers to deliver ‘key investor information’ which reflects the investor profile, the product, and the sales channel used, and which ‘has far more chances to meet the real information needs of investors’. Commission, Exposure Draft, Initial orientations for discussion on possible adjustments to the UCITS Directive. The Simplified Prospectus – Investor Disclosure Regime (March 2007), 5.
[51] In the European investment research context and querying whether separation improves research, see A Lehan and O Randly, Chinese Walls in German Banks (2003), available on http:www.ssrn.com/abstracted=424010 (2003). The UK FSA, however, has reported positive results from its reforms to investment analysis. N 54 below.
[52] In the UK, eg, a wide-ranging investigation took place into the split capital investment trust sector following concerns, after a collapse in the value of these investments and significant losses in the retail sector, as to conflicts of interest where a single manager managed a series of funds. Although specific enforcement action was not taken, the investigation resulted in a settlement of £194 million by the industry. FSA/PN/114/2004.
[53] On reputation risk and conflict of interest management see J Santos, Commercial Banks in the Securities Business: A Review (Bank for International Settlements, 1998).
[54] See, eg, the UK FSA’s ex-post examination of the UK’s new investment research regime: FSA, Ex Post Analysis of FSA’s Conduct of Business Rules on Conflicts of Interest in Investment Research (2005). It found that conflict of interest management had improved and that research was less biased, although it was unclear to what extent this was driven by regulatory reform.
[55] Including limitations on class actions.
[56] G Ferrarini, ‘Contract Standards and the Markets in Financial Instruments Directive’ 1 European Review of Contract Law 19.
[57] The principles suggest that the firm: has an up-to-date view of the totality of the types of conflict of interest involved in its business activities; regularly reviews the types of mitigation it considers acceptable to address conflict risks; has a conflicts architecture able to deliver the mitigation resulting from the review process; involves senior management in the process; uses management information on the extent and mitigation of conflicts of interest; has a culture which supports effective management of conflicts of interest; and has a conflict architecture which results in a process capable of being subject to independent review. They also suggest that a well-run firm will have systems and controls in place to identify non-standard transactions and escalate them for review.
[58] On the relationship between financial market development and enforcement see Coffee, above n 4.
[59] Advanced Risk-Responsive Operating Framework. It has recently been reformed and a new, more transparent, and risk-sensitive model (ARROW 2) was implemented over 2006.
[60] The ARROW assessment by the FSA includes: management, governance and culture; control functions; capital and liquidity; customers, products, and markets; and client money. The process concludes with the FSA establishing a Risk Mitigation Plan for the firm which sets out the action which must be taken by the firm to achieve particular outcomes.
[61] See generally J Black, ‘Mapping the Contours of Contemporary Financial Services Regulation’ 2 Journal of Corporate Law Studies (2002) 253, 256.
[62] The FSA’s Business Plan for 2007-2008 reported a need for £50 million to improve the effectiveness of its staff with respect to delivering MPBR and to invest in IT. The cost will be spread over a 10 year fee increase plan.
[63] ‘We need a different type of people to make judgments, do business analysis, and have grown-up conversations with chief executives and boards, rather than people who can read a rule and tick a box.’ per John Tiner, FSA chief executive, quoted in B Jopson and S Goff, ‘FSA Regulation move set to cost City £50 m’, Financial Times, 7 February 2007, 4.
[64] FSA, Treating Customers Fairly Initiative: progress report (May 2007), 2. Ninety three per cent of major retail groups met the March deadline, although only 41% of directly authorised small firms met the deadline (87% of medium firms). Failure to meet the deadline has been related by the FSA to a lack of commitment from senior management and, accordingly, to an inability to rely on senior management to deliver the right outcomes and a consequent increase in the focus and intensity of supervision for these firms.
[65] Ibid, 3.
[66] See, eg, FSA Annual Report 2005-2006, 8-10.
[67] The move to more principles-based regulation is being closely followed in the US following fears that recent reforms have damaged the competitiveness of US financial markets (n5). Treasury Secretary Paulson has noted that the US could learn from a principles-based approach. B Jopson, ‘Business remains unhappy with the FSA’, Financial Times, 30 November 2006, 2. Similarly, a McKinsey Report commissioned by New Mayor Bloomberg and Senator Schumer noted that US business leaders saw the benefits of the UK’s single principle-based regulator model, while the Capital Markets Committee (above, n 5, 8) argued that regulation should be “risk-based and principles-based” and it was “particularly important that the regulators accompany principles-based rules with well-articulated guidance to firms and that regulators be mindful of this guidance in their enforcement activities.”
[68] Above, n 4.
[69] See, eg, R King and R Levine, ‘Finance and Growth: Schumpeter might be right’ 108 Quarterly Journal of Economics (1993) 681; R Rajan and L Zingales, ‘Financial Dependence and Growth’ 88 American Economic Review (1998) 559; R Levine, ‘Law, Finance and Economic Growth’ 8 Journal of Financial Intermediation (1999) 8; M Khan and A Senhadji, Financial Development and Economic Growth: An Overview, IMF Working Paper/00/209 (2000), available on http:www.imf.org/external/pubs.
[70] Commission, Financial Services White Paper 2005-2010, White Paper.
[71] Although there has been growth in alternative trading systems, they account for only 1% of equity trading volumes in the EU. G Ferrarini and F Recine, ‘The MiFID and Internalisation’ in Ferrarini and Wymeersch, Investor Protection in Europe. Corporate Law-making, the MiFID and Beyond (OUP, 2006), 235, 238.
[72] See generally R Davies, A Dufour, and B Scott-Quinn, ‘The MiFID: Competition in a New European Equity Market’, in Ferrarini and Wymeersch, Investor Protection in Europe. Corporate Law-making, the MiFID and Beyond (OUP, 2006), 163.
[73] See, eg, in support of competition, the position paper on Innovation, Competition, Diversity, and Choice, A European Capital Market for the 21st Century (2002) prepared by a group of 7 leading trade associations including the International Securities Market Association and the London Investment Banking Association.
[74] See generally Ferrarini and Recine, above n 71, 235.
[75] A systematic internaliser is defined as an investment firm which on an organised, frequent, and systematic basis deals on own account by executing client orders outside a regulated market or MTF.
[76] MTFs are defined as multilateral systems which bring together multiple third party buying and selling interests in financial instruments in the system and in accordance with non-discretionary rules in a way that results in a contract.
[77] MiFID, A21.
[78] MiFID As22 and 25.
[79] See, eg, the 24 April 2006 statement by a group of twelve leading trade associations which argues that any fragmentation in market transparency data under MiFID’s order execution model would not lead to a reduction in execution quality but could be controlled by market forces (available on http://www.isda.org/speeches).
[80] At the very least, MiFID demands serious strategic consideration of the new regulatory and trading environment, with a leading commentator predicting that “MiFID is nothing short of a revolution: it will see banks operating as exchanges for some activities, exchanges offering alternative execution services that more closely resemble the structure of OTC markets than traditional organised markets, and the decentralisation of order execution among a panoply of venues in markets previously governed by concentration rules….the shock to the status quo will represent a profitable opportunity for those who are a well-prepared – and a death sentence for those who cannot adapt to the new environment.” K Lannoo and JP Casey, The MiFID Revolution (European Capital Markets Institute, 2006).
[81] B Riley, ‘Goodbye to the club’, Financial World, June 2006, 22. Investment firms are being advised to consider carefully the business case for the systematic internaliser model, particularly with respect to IT costs related to transparency requirements. J Neasham, ‘Eyes on the IT horizon’, The Banker, Supplement on Countdown to MiFID, May 2006, 50, 50-51. One senior City figure has suggested that the additional regulatory burden means that only the largest institutions will exploit the strategic opportunities represented by the MiFID regime: A Belchambers, ‘No time like the present’, ibid, 54 at 55.
[82] N Cohen, ‘A clash of the titans: why big banks are wading into the stock exchange fray’, Financial Times, 24 November 13.
[83] The MiFID negotiations on the transparency regime for internalisers have been well-described as “one of the most intense political struggles that Europe ever experienced over a piece of financial regulation.” Ferraini and Racine, above n 71, 253.
[84] See, eg, FSA, Trading Transparency in UK Secondary Bond Markets (2005) which found against mandatory transparency requirements. The question is also being debated internationally (IOSCO, Transparency of Corporate Bond Markets (2004), calling for IOSCO members to assess the appropriate level of debt market transparency).
[85] For a major contribution to the debate, reflecting market sentiment, see Centre for European Policy Studies, European Corporate Bond Markets: transparency, liquidity and efficiency (2006).
[86] See, eg, Commission, Feedback Statement, Pre- and Post-Transparency Provisions of MiFID in relation to transactions in classes of financial instruments other than shares (November 2006), 3-4 and 5, noting that even positive responses tended only to be “open-minded” concerning reform.
[87] The UK equity market, by comparison is, for the most part, based on electronic order-book trading.
[88] In the UK, eg, most trading is bilateral, dealer-based, and OTC, although multi-dealer trading platforms are developing (such as the Gilt-Edged Market Makers platform which operates under LSE rules). Multilateral trading facilities have also developed for government bonds.
[89] CEPR Corporate Bonds Study, above n 85, 1.
[90] High level rules also apply to trades conducted on alternative trading systems.
[91] The academic literature on debt market transparency is not conclusive, not least given limited data on the debt markets and limited trading which leads to hypothetical models and proxies being relied on. See generally CEPR Corporate Bonds Study, above n 85.
[92] This has happened before in EU policy. The EU’s 2003 Prospectus Directive, which sets out an extensive pan-EU disclosure regime for public offers, can be analysed as an example of retail disclosure standards leaking across to the sophisticated wholesale markets. As a result, the exemption regime from the Directive for debt offerings, private placements and offers to sophisticated investors was fiercely negotiated.
[93] CESR, Non Equity Market Transparency, Consultation Paper (May 2007). See also FSA (2005), above n 84, 5.
[94] The evidence suggests that spreads in European corporate bonds are tighter than in their US equivalents, notwithstanding that a post trade reporting transparency system operates in the US under the TRACE (Trade Reporting and Compliance Engine) mechanism. CEPR Corporate Bonds Study n 85 and FSA, Trading Transparency in the UK Secondary Bond Markets (2006).
[95] Commission, Feedback Statement, Pre- and Post-Transparency Provisions of MiFID in relation to transactions in classes of financial instruments other than shares (November 2006).
[96] The FSA concluded in 2006 that there was no market failure to support regulatory intervention to mandate transparency, although it considered that more formal post-trade transparency could be beneficial in the corporate bond markets, although it suggested that this be industry-led.
[97] This concern is frequently raised by the markets internationally and in the context of the EU’s reform programme. See, eg, the International Council of Securities Associations Statement on Consultation Practices (2004).
[98] See C Scott, ‘Analysing Regulatory Space: Fragmented Resources and Institutional Design’ (2001) Public Law 329.
[99] The London Investment Banking Association, the Association of British Insurers, the Investment Management Association, the European High Yield Association, and the European Primary Dealers’ Association (LIBA Annual Report (2005), Chairman’s Statement, 3). The extensive CEPR reports were published in May 2006; above n 85 – the CEPR also produced a parallel report on government bond market transparency).
[100] Commission, Call for Evidence, Pre- and post-trade transparency provisions of the Markets in Financial Instruments Directive in relation to transactions in classes of financial instruments other than shares, 12 June 2006.
[101] Unusually, the Call for Evidence refers to a review of the relevant academic and institutional literature. At 7.
[102] Response to Commission’s Call for Evidence by a group of 13 leading EU trade association (September 2006)
[103] For a similar example see the FSA’s 2005 and 2006 papers on Debt Market Transparency which contains extensive discussions designed to develop FSA policy, canvass market opinion, and influence the EU response.
[104] Comprised of Directive 2006/48 EC OJ (2006) L177/1 and Directive 2006/49/EC OJ (2006) L177/201.
[105] Key industry initiatives in the EU bond markets include the trading information provided through regulated markets and multilateral trading facilities (such as EuroMTS which supports intra-dealer trading in euro denominated government bonds) and by firms which provide quotes through channels such as Bloomberg (which supports quotes by a large numbers of dealers across Europe) and the development of bond market indices (including iBoxx (cash bonds) and iTraxx (derivatives)).
[106] The Committee of European Securities Regulators has noted that while a range of criteria (governance, reliability, depth and breadth of information provided, timeliness of the data, cost efficiency, and the delivery mechanism) need to be taken into account in assessing the effectiveness of an industry-led solution, these criteria also apply to the development of a regulatory solution, leading to the common question – who is best placed to deliver the best response? Above n 85, 20.
[107] Above n 5. SEC initiatives include postponing by one year the application of the controversial section 404 internal control requirements to foreign companies (the costs of which are estimated at $4.36 million for an average company, Committee on Capital Market Regulation above n5, 5), the movement on IFRS/US GAAP convergence, and the reforms (noted below) to the SEC deregistration regime.
[108] The headline statistics indicate that 24 of the 25 largest IPOs took place outside of the US in 2005. Committee on Capital Market Regulation, above n 5, 2. The Committee also noted that London has increased its share of the global IPO market from 5% to almost 25% and is beginning to attract a greater share of IPOs from US-domiciled companies. The Bloomberg/Schummer Report similarly reported that the US share of global IPOs has fallen from 57% in 2002 to 16% in 2006, while Europe’s share has increased from 33% to 63%. Also of concern is that newly privatised Chinese companies have listed in Hong Kong in preference to New York. H Scott, ‘The Need for a New Look at Capital Markets Regulation Post Enron’, Journal of International Banking Law Review (2006) 166.
[109] In one of the most significant developments, see the recent discussion by two senior SEC officials (speaking unofficially) of a potential model for SEC enforcement based on “substituted compliance” with SEC rules under which foreign stock exchanges and broker dealers would apply for an exemption from SEC registration based on their compliance with “substantively comparable” foreign regulation and supervision by a regulator with comparable powers to the SEC’s and with a comparable regulatory and enforcement philosophy – the challenge lies in the notion of comparability and how this is benchmarked. E Tafara and R Peterson, ‘A Blueprint for Cross-Border Access to U.S. Investors: A New International Framework’, 48 Harvard Journal of International Law (2006) 31.
[110] Dialogue on hedge funds forms part of the Dialogue (see, eg, EU Commissioner McCreevy’s support for the President’s Working Group Report on Hedge Funds (Principles and Guidelines regarding Private Pools of Capital) which advocated a light touch approach given the efficiency and liquidity benefits of hedge funds) – the EU has yet to finalise its approach to hedge funds, although all recent indications suggest a light-touch approach (section IV below).
[111] For a recent example see the 2005 report by a powerful coalition of US and UK market associations calling for greater convergence in EU and US regulation to support cross-border wholesale dealings in equities and equity derivatives. The extensive report (in two volumes) is designed to capture the costs of regulatory compliance in the transatlantic trading market and make the business case for a more coherent framework of regulation. EU-US Coalition on Financial Regulation, The Transatlantic Dialogue in Financial Services: The Case for Regulatory Simplification and Trading Efficiency (2005).
[112] The SEC and the EU have agreed a roadmap on IFRS/US GAAP convergence. Recent developments include the conclusion of information-sharing agreements between the SEC and EU Member States. In June 2007, the SEC proposed a rule allowing non-US companies to file financial rules according to IFRS by 2009
[113] Rule 12g3-2(a) under the Securities Exchange Act.
[114] Commission Director General Schaub, speaking at a September 2006 conference on TransAtlantic Financial Services Dialogue. See K, Alexander, E Ferran, N Moloney, and H Jackson, ‘TransAtlantic Financial Services Dialogue’ 7(4) European Business Organisation Law Review (2006) 647.
[115] EU Commissioner Charlie McCreevy, Press Release 32/07, Delegation of the European Commission to the USA.
[116] For a challenge to any characterisation of the UK regime as being weak as a result of these features see FSA Chairman McCarthy, speech on ‘Financial Regulation: Myth and Reality’, British American Business London Insight Series and Financial Services Forum, 13 February 2007, available on http://www.fsa.gov.uk/speeches.
[117] The offer lapsed in February 2007. NASDAQ currently holds approximately 30% of the LSE. The LSE is currently in merger talks with the Italian Stock Exchange. N Cohen, ‘LSE in merger talks with Borsa Italiana’, Financial Times, 21 June 2007, 1.
[118] NYSE Euronext started trading in April 2007. 2006 was a volatile year in the consolidation of Europe’s exchanges. It saw the NYSE and Deutsche Börse bidding for Euronext, the successful NYSE Euronext tie up, and the failed NASDAQ bid for the LSE.
[119] The Committee on Capital Market Regulation, eg, has noted that supervising trades on globally-merged exchanges will “ultimately require cooperation among international regulators to produce harmonized trading rules….The US regulator (or for that matter, any regulator) cannot impose its rules on others.”; above n 5, 10.
[120] The Notes are rather muted and simply provide that the Act is intended to meet concerns that UK recognised bodies might introduce regulatory provisions which impose an excessive regulatory burden on the issuers of securities admitted to trading on their markets, on their members, or on other users of those markets.
[121] E Balls, Speech, City of London Corporation Dinner, 25 October 2006.
[122] In its 2007 Risk Outlook the FSA appears to protect its position, noting that it “take[s] a neutral stance on the ultimate ownership of Recognised Bodies, provided they continue to meet their regulatory requirements”, at 48.
[123] The legislation has been described as having ‘the feel of emergency legislation, akin to wartime measures’: T Plews, ‘The “Balls Clauses [the legislation was steered by Treasury minister Ed Balls]” are a mixed blessing for the City’, Financial Times, 29 November 2006, 18.
[124] It is now almost standard in securities regulation literature to describe Sarbanes Oxley as an ill-considered crisis-led response to a market crisis, in a tradition of earlier crash-driven legislation (the Securities Act 1933 and Securities Exchange Act 1934 which followed the 1929 crash). See, eg, L Ribstein, ‘Bubble Laws’ 40 Houston Law Review (2003) 77.
[125] A26, MiFID Implementing Directive 2006/73.
[126] A21, MiFID Implementing Directive 200673.
[127] The conflicts regime is designed to deliver general organisational and disclosure strategies for dealing with divided loyalties, while the best interest regime is designed to address specific cases in which a firm might not act in the best interest of the client.
[128] MiFID covers a wide range of instruments including transferable securities, money market instruments, units in collective investment undertakings, financial derivatives, commodity derivatives, and credit derivatives.
[129] FSA, Reforming Conduct of Business Regulation (May 2007), 11. An example includes the move towards more generic risk disclosure requirements rather than instrument-specific requirements (the current FSA approach) – on the basis that a product-specific approach encourages the belief that risk identification is for the regulator rather than the firm. A notable general exception concerns the requirement to supply a point-of-sale Key Features Document (KFD) (on the product’s aims, the investor’s commitment and risk factors – format and content rules apply) when selling investment products which is a core feature of UK retail investor protection. The detail of the disclosure regime will, however, be replaced with high level principles which will ensure the document adequately describes the product, reflects its complexity, is reasonable and sufficient to support informed investor decision-making, and does not disguise or diminish key warnings.
[130] See, eg: FSA, Hedge Funds: A Discussion of Risk and Regulatory Engagement (March 2006), Netherlands Authority for Financial Markets, Hedge Funds: An Exploratory Study of Conduct-Related Issues (2005), and the Alternative Investment Expert Group (which advises the European Commission), Managing Servicing and Marketing Hedge Funds in Europe (July 2006).
[131] FSA, Hedge Funds: A Discussion of Risk and Regulatory Engagement (March 2006), 9 and 17, referring to the use of conflict of interest principles as a key element of the existing supervisory tools used by the Hedge Fund Managers Supervision Team.
[132] G Tett, ‘FSA tells derivatives market to tackle conflicts of interest’, Financial Times, 20 September 2006, 1.
[133] See IOSCO, Consultation Report – The Regulatory Environment for Hedge Funds. A Survey and Comparison (March 2006).
[134] In the UK, the number of pension funds allocating to hedge funds has increased from 5% in 205 to 7.5% in 2006: FSA Financial Risk Outlook 2007, 54.
[135] Most concern is directed to market stability rather than to retail investor protection. As noted above, the UK FSA intends to liberalise the rules applicable to collective investment to facilitate retail investor access to hedge fund investment techniques through funds of hedge funds (FSA, Funds of Alternative Investments (March 2007).
[136] 2007 saw the announcement of the largest ever leveraged buy out transactions in the US (the TXU utility group and KKR/Texas Pacific Group deal ($44.5 billion)) and the UK (the KKR led bid for Alliance Boots (£11.1 billion)). Over £60 billion was raised by private equity funds in the UK over 2005 and 2006.
[137] Eg, major trade unions have called on the G8 to address the perceived dangers of private equity. A Taylor, ‘Unions demand G8 action on private equity’, Financial Times, 16 March 2007, 1. Political criticism has been particularly strong in France and Germany, with then presidential candidate Sarkozy calling for a tax on speculative capital movements. M Arnold, ‘Sarkozy aims to push for European tax on hedge funds’, Financial Times, 14 February 2007, 8.
[138] There has been some concern in Germany as to hedge fund activity (one widely reported remark by German’s minister for labour in 2005 likened hedge funds to locusts) – related to the success of the highly activist The Children’s Fund in scuppering Deutsche Börse’s bid for the London Stock Exchange. Germany’s calls for code of conduct for the hedge fund industry failed at the May 2007 G8 meeting following US and UK opposition. But a plan to create new incentives for private equity investors was dropped in May 2007 following political tensions. B Benoit, ‘Berlin backtracks on private equity’, Financial Times, 16 May 2007, 10.
[139] Report of the Alternative Investment Expert Group, Developing Private Equity (July 2006).
[140] Report of the Alternative Investment Expert Group, Managing, Servicing and Marketing Hedge Funds in Europe (July 2006).
[141] T Buck, ‘Hedge funds and private equity “are good for the market”’, Financial Times, 9 February 2007, 6.
[142] FSA, Wider Range Retail Investment Products. Consumer protection in a rapidly changing world (June 2005) and Feedback Document (March 2006); Hedge Funds. A Discussion of Risk and Regulatory Engagement (June 2005) and Feedback Document (March 2006) Funds of Alternative Investment Funds (March 2007).
[143] Financial Risk Outlook 2007, 46.
[144] Amaranth sustained heavy losses (US$6.4 billion) in September 2006 from energy trading on natural gas swaps.
[145] Financial Risk Outlook 2007, 46-47.
[146] It addressed the risks from private equity in a 2006 paper (Private Equity: a discussion of risk and regulatory engagement (November 2006 – Feedback June 2007) and does so regularly in its regular Financial Risk Outlooks. Particular concern was raised with respect to increased levels of leverage, potential market abuse risks given flows of sensitive information and the risk of insider dealing (via the increasing number of external advisers in deals), conflicts of interests in private-equity fund management (between the fund and the companies owned by the fund), conflicts of interest in advisers and finance providers as between their proprietary and advisory functions, stability risk on the collapse of a large buy-out, and limited transparency to the wider market. Although the FSA highlighted that the study was not a precursor to regulation, and concluded that the existence of private equity did not raise systemic risks, it has committed to close supervision of the leveraged loan market and to address excessive leverage risk through semi-annual leveraged lending surveys and to carry out regular visits to the 14 largest private equity firms. In its June 2007 follow-up report it committed to carrying out thematic reviews of conflict of interest risk and highlighted conflict management as an area of supervisory focus for all FSA-authorised firms involved in the private equity markets and to maintaining its focus on market abuse in private equity transactions. Its conclusions in June 2007 on the risk posed by private equity were that while market abuse and conflict of interests were high, excessive leverage was of medium high risk, while market access and market opacity risks were medium low and the risk of an overall reduction in overall capital market activity was low.
[147] This generated very considerable print media and television interest. See, eg, J Eaglesham and M Arnold, ‘Ps to target buy-out tax’, Financial Times, 21 June 2007, 1.
[148] Financial Risk Outlook 2007, 42.
[149] SEC Rule on Registration Under the Investment Advisers Act of Certain Hedge Fund Advisers (2005).