Adapting competition law rules and procedures developed in real economy markets to financial and investment markets is still work in progress

Until the financial crisis it was widely assumed that the financial services industry was highly competitive, and, in fact, the epitome of efficiency (hence the "efficient market hypothesis"). High profile financial scandals, from Libor to the current spotlight on the huge foreign exchange market, have cast doubt on such assumptions, and from 2015 the Financial Conduct Authority will have the power to enforce competition law like other regulators in the UK.

What are the underlying problems?

Although it might seem that financial prices are formed in the same way as prices for real economy goods and services in a competitive market (as the "efficient market hypothesis" suggests) the reality is subtly different. Macroeconomic theory indicates there are in fact two different price systems in the market economy: one set for current output by firms; and another set for capital assets (that is, investment, leading to the production of more goods and services in future).

Compared with trade in goods and services (or current output) in normal product markets, markets involving savings, finance and investment in capital assets tend to be based more on expectations of the future, over relatively longer time periods. Given the longer term uncertainty, firms in some financial markets may have a tendency to base their expected valuations on the opinions of others, or the expectations of other market participants. This can lead to herding around an average, or consensus, financial market price, which is not necessarily rooted in economic reality. Such prices can be subject to erratic fluctuations, and at times asset price bubbles can be created (if, for example, too much bank credit is extended to similar types of property, or real estate). Collusion to fix financial prices can arise where competitors try to replace uncertainty in the market with knowledge of one another's intentions.

Competition law is used to dealing with the behaviour of firms in normal real economy markets, but there is no reason in law or theory for it not to apply in financial markets, and indeed under Article 101 TFEU anti-competitive behaviour affecting "production, markets, technical development or investment" is expressly prohibited.

The challenge for competition policy is to adapt rules and procedures mostly developed in real economy markets to financial and investment markets. The principle in real economy markets is that competing firms must exercise decision-taking independence, and not co-ordinate with one another to remove the uncertainties present in the market. The application of this same principle to competing firms in markets for finance and investment appears necessary, but it is still work in progress.

Why is all this so important?

Firms in financial services are essentially intermediaries, ensuring that the savings of others are channelled into productive investment in the economy, so creating more goods and services in future. If horizontal relations between intermediaries displace the vertical relations between savers, intermediaries and investment this then can distort the efficient allocation of resources to the economy. That, in a nutshell, is what happened during the financial crisis.