Caveat emptor - let the buyer beware - has traditionally been the defining philosophy of
wholesale financial markets, but the phrase took on a new meaning when it was revealed that traders at many leading investment banks had been manipulating LIBOR and foreign markets for their own benefit, at the expense of their clients. It is, therefore, no surprise that the Financial Conduct Authority (FCA) is shifting away from a general reliance on wary buyers.
Shift work
Among the areas which could be affected by the shift away from reliance on caveat emptor are:
1. The relationship between principal and agent. Are the two roles sufficiently differentiated and clearly understood by both parties?
2. Differentiation in the treatment of customers depending on their level of sophistication and professionalism.
3. Swap arrangements between banks and small- and medium-sized enterprises (SMEs). In 2012, the regulator required banks to compensate SMEs for mis-sold interest rate swaps.
4. Client assets, and when it is appropriate for a wholesale firm to take ownership of collateral.
5. Unbundling brokers' research so that it is clear when clients are paying for research, and when they are paying for other services.David Lawton, Director of Markets at the FCA, signalled the change in
a landmark speech in November 2013. "We certainly cannot assume that the cumulative result of
caveat emptor adds up to appropriate standards of wholesale conduct," says Lawton. He promised a renewed focus on wholesale regulation that, while it would still recognise that wholesale and retail markets are different, "makes the links more explicitly between market integrity, conduct and consumer protection".
Simon Orton, Partner in the Financial Institutes Disputes group at law firm Freshfields Bruckhaus Deringer, thinks the change in attitude has actually been emerging since the start of the financial crisis, but has been given a sharper focus by LIBOR and other scandals.
Over the six years or so since the crisis erupted, the FCA and its predecessor, the Financial Services Authority, have conducted a number of thematic reviews on areas such as conflicts of interest. "But they have not stood back and asked, how should we regulate wholesale markets?" points out Orton. Now, he adds, the FCA is questioning whether it is right to assume that, in complex markets, involving sophisticated people, the market will impose its own discipline.
Chain reaction
Underlying the reduced emphasis on
caveat emptor is the realisation that, while much of the business in wholesale markets is carried out between professionals, retail investors can still be affected further down the chain: LIBOR manipulation, for example, could have influenced mortgage rates as well as undermining the public's trust in financial markets.
The shift away from
caveat emptor is part of a more general focus on the need to change the culture of the wholesale markets - a focus that underpins other regulatory action such as the FCA's review of competition in the wholesale markets and the Bank of England's Fair and Effective Markets Review. Both of these reviews are still works in progress and are expected to bring in major changes in the way markets operate, some of which could require primary legislation.
"In future, wholesale markets will be more closely analysed"
The new FCA philosophy is also being closely watched by regulators elsewhere: in the US, William Dudley, President of the Federal Reserve of New York, made a trenchant speech in October in which he talked about the "shift in the prevailing business model away from traditional commercial and investment banking activities to trading; that is, from client-oriented to transaction-oriented activities".
Duty calls
The Markets in Financial Instruments Directive II (MiFID II) contains new high-level duties between professional counterparties which will apply in the future - go to the FCA and EC website sections on MiFID II to find out more.
Another interesting point affecting professional counterparties is the wider definition of 'customer' in the FCA rules, notes the CISI's Christopher Bond. This definition, he points out, includes professional customers, thus giving the FCA powers to expand the duties owed to professional coutnterparties easily.
Professional transactions most at risk of losing caveat emptor, he adds, are those where the effect on retail customers is the clearest - for example, sell-side transactions with fund managers or pension funds."Clients," continued Dudley, "became counterparties - the other side of a trade - rather than partners in a long-term business relationship. In general, interactions became more depersonalised, making it easier to rationalise away bad behaviour, and more difficult to identify who would be harmed by any unethical actions."
Regulatory intervention
Firms operating in the wholesale market are likely to become increasingly aware of the change in emphasis in their dealings with the regulator.
Christopher Bond, Chartered MCSI, Senior Adviser at the CISI, says: "In future, wholesale markets will be more closely analysed and can expect regulatory intervention if there is any doubt that they will damage the public interest." But he adds: "One unfortunate consequence of this could be to restrict their dynamism and flexibility."
Details of some of the probable changes can be found in resources on the Fair and Effective Markets Review at
the Government and
Bank of England websites, as well as in
a speech made by Minouche Shafik, Deputy Governor, Markets and Banking at the Bank of England, to the London School of Economics in October this year.
Freshfields Bruckhaus Deringer's Orton believes that firms should already be reviewing their operations and questioning the validity of established practices to ensure that they are robust enough to cope with more intense regulatory scrutiny. He emphasises: "Firms can now start to identify practices which could be vulnerable and assess what they can do to improve their position."