Since it succeeded the Financial Services Authority on April 1, 2013, the Financial Conduct Authority has been focussing increasingly closely on conduct in the wholesale markets. Although the FSA in recent years took a renewed interest in this area, the FCA has made it a priority. The main influence behind this change in the regulatory approach to wholesale conduct has been the recognition that poor conduct in wholesale markets can reverberate throughout the UK financial system, passing on risks and detriment to retail consumers and eroding trust and confidence in the integrity of UK markets.
In this, the second of six articles on investigations and enforcement topics by Freshfields Bruckhaus Deringer, the authors consider the source and development of the FCA's focus on wholesale conduct, the likely targets of future scrutiny as a consequence and implications for firms as a result.
The new approach to wholesale markets
The prior approach to wholesale conduct was, broadly, to assume that professional counterparties were sufficiently sophisticated to be able to safeguard their own interests – the principle of caveat emptor. As a result, the FSA's general practice was to focus in the wholesale markets on market abuse and significant breakdowns of systems and controls (for example, mis-marking cases) and to use its more direct intervention techniques primarily in retail rather than wholesale markets.
The FCA is now adopting a more interventionist and assertive approach to identifying and addressing risks arising from wholesale conduct, and scrutinising these markets more broadly than before. So, in 2014/2015 the FCA is conducting a review of the wholesale sector, which will include an assessment of competition issues encountered by market participants. This could lead to the FCA conducting a full market study in some parts of the wholesale markets.
Rationale for the FCA's new focus on wholesale conduct
There are two key factors driving this new focus: the interconnectedness of retail and wholesale markets, and the potential impact of poor wholesale conduct on market integrity. The FCA's approach seeks to address these drivers, consistently with the FCA's operational objectives of securing an appropriate degree of protection for consumers, enhancing the integrity of the UK financial system and promoting effective competition in the interests of consumers (including wholesale consumers).
The concept of treating customers fairly (TCF) has historically been relevant principally to retail rather than wholesale markets. The FCA has however made clear that it expects TCF to be central to all firms' conduct. It wants firms to put customers at the heart of their business, and in some wholesale markets that could lead to different expectations about how firms should conduct themselves.
The FCA recognises that there is no "bright line" between retail and wholesale markets. Risks caused by poor practices in wholesale markets may feed through to retail consumers who rely on products and services originating or sold in wholesale markets. For example, the way a bank deals with a professional investor in the wholesale market, such as a pension fund or an investment management firm, could ultimately impact on the retail consumers whose funds and savings comprise the investment funds of those professional clients.
The FCA's approach reflects this connection. Where poor wholesale conduct causes detriment to retail consumers, whether directly or indirectly, the FCA is more likely to intervene and if it does, it will take the impact upon retail consumers into account when pursuing any enforcement action.
The FCA's consumer protection objective is not limited to retail consumers though. Under the legislation, "consumers" is defined to include wholesale consumers, such as regulated firms buying products or making investments, or issuers looking to raise capital. Recently, the FCA has spoken of the need to intervene where there is a risk to consumers, whether wholesale or retail.
The FCA recognises that a wide diversity of firms fall within the broad categorisation of wholesale firms. At one end of the spectrum are non-financial services firms hedging risk, which might include public authorities or charities, and at the opposite end of the spectrum are large, sophisticated financial services firms. The FCA has said that sophisticated wholesale investors do not require the same level of protection and degree of intervention as retail consumers. The FCA is therefore most likely to focus on standards of wholesale conduct where retail consumers or less sophisticated wholesale firms are at risk. A critical question will be where the FCA sees institutional investors as falling in that spectrum.
One reason why the FCA needs to be cautious about how far it goes to protect sophisticated wholesale firms is that if the FCA were to afford greater protections to wholesale counterparties than firms will be obliged to provide under Markets in Financial Instruments Directive 2, it might be viewed as extending the UK regulatory regime beyond the parameters of MiFID 2.
The FCA will intervene in wholesale markets not just where risks are transferred to consumers, but also if there is conduct which could undermine trust and confidence in the integrity of markets. The FCA considers that reliance on the principle of caveat emptor has not been conducive to establishing appropriate standards of wholesale conduct and that increased scrutiny of wholesale markets is necessary.
The FCA views good conduct in wholesale markets as underpinning the integrity of the wider UK financial system. It is concerned that misconduct in wholesale markets can have a far-reaching impact on confidence in market integrity (as shown by the investigations into London Interbank Offered Rate rigging).
The Libor-setting process has limited direct impact on retail consumers. So, the FCA is prepared to intervene in respect of a broader range of conduct than that affecting consumers.
What is not clear is how far this will go beyond cases of alleged manipulation, drawing the FCA into debates about whether particular wholesale markets (which are not the subject of clear abuse) are operating effectively in the interests of the consumers of those markets. In principle, the FCA's statutory objectives draw it into that territory. And the upcoming wholesale strategic review will be an illustration of this broader focus. But how far and in what circumstances the FCA will want to intervene remains to be seen.
Likely targets for regulatory scrutiny
One area of focus for the FCA in respect of the impact of wholesale conduct on retail consumers is the general insurance market. In its Business Plan, the FCA announced that, to further its consumer protection objective, it will conduct a thematic review of distribution chains relating to insurance firms operating in wholesale markets, which will specifically look at the impact on retail and small commercial customers.
On its market integrity objective, benchmark manipulation will continue to be a major area of focus for the FCA: the investigations into Libor and FX markets are stated in the FCA's Business Plan to be an enforcement priority for 2014/2015 and the FCA has announced a thematic review of control and governance of traders around inputs to benchmarks.
Aside from benchmarks, the FCA has indicated that another area of focus is conflicts of interest in the use of information in investment banks, specifically, the risks that information received by one part of a firm might be used improperly by another part of the firm. The FCA has announced in its Business Plan that it is conducting a thematic review of investment banks' controls over information flows.
The FCA is also conducting, or plans to conduct, further thematic reviews relevant to wholesale markets, on: the responsibilities of asset managers as agents; conflicts of interest in investment banks; and market abuse controls.
Implications for firms
Looking ahead, firms can expect the FCA to scrutinise a wider range of wholesale conduct than previously. Firms operating in wholesale markets should consider how they conduct business with all counterparties, focussing in particular on the areas where the FCA has identified that risks to consumers and market integrity might arise: for example, benchmark-setting, conduct with an (even indirect) impact on retail consumers, relative sophistication among market participants (leading to a risk of abuse), and the potential for conflicts of interest in the use of information.