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Introduction
Good morning ladies and gentlemen. First may I say thank you to the London Metal Exchange for inviting me to speak at this conference. It is clearly timely for me to be here this year as the commodities markets have come closer to centre stage and the LME is considering its options for the future. What I want to do today is to make some remarks about the role the FSA and financial services regulation has to play in this market.
The commodities markets have been the subject of much press interest over the past year with stories of rogue traders, rocketing prices and increasing investment from hedge and pension funds, and I am grateful to the LME for allowing me this opportunity to talk through how we regulate these complex and diverse markets, where our interest lies and where our regulatory remit ends.
FSA Background
A good starting point is to look at our objectives. These are set out in the Financial Services and Markets Act which sets out four statutory objectives. It requires us to: maintain confidence in the UK financial system; promote public understanding of the financial system; secure the appropriate degree of protection for consumers; and help to reduce financial crime.
FSA Markets
I should make clear however that in the wholesale space, FSA takes the view that there are no true consumers, and that all participants active in this space are market counterparties – informed participants working to a presumption of caveat emptor. We do not perceive the same asymmetry of information to be present in wholesale as we perceive in retail. Furthermore, critically we do not operate a zero failure regime. This differentiation of approach between wholesale and retail is a key part of what we have sought to develop since I became the first Wholesale Managing Director in 2004.
As such, a key underlying point is that our approach to policy is to intervene only when we can demonstrate market failure or an opportunity to improve market efficiency, and the proposed solution passes a cost benefit analysis. There are, however, also times when we are required to regulate by Europe. When intervention is justified our preferred approach is via stimulating market solutions. At the end of the day underpinning good quality markets are good quality participants demonstrating good judgement.
Regulation of Investment Exchanges
Recognised Investment Exchanges in the UK, of which the LME is one, are regulated by us via a principles based regime. This is distinct from the authorised firms' regime under which members firms are regulated. The application and recognition process is more onerous one than firm authorisation. But once recognised exchanges are supervised against the requirement to continue to meet the various recognition criteria. These are pitched at a high level and provide the necessary flexibility for a variety of markets and trading arrangements whilst aiming to provide protection for investors and orderly transparent market conditions in which they can operate. It is not up to the FSA to determine how each exchange meets these requirements. But each exchange must be able to demonstrate that they are able to meet each requirement imposed on them.
In short the regime underpins one of our key beliefs, namely we should facilitate competition through a framework which allows differentiated regulatory platforms.
Thus exchange regulation will focus on the requirements set out in the FSA handbook, with the examples set out on the slide. The monitoring of market activities by exchange staff is of particular importance in exchanges where, such as LME, more than one trading mechanism is available.
It is worth stressing here that the recognised exchange has responsibility for the front line regulation of activity carried out under its rules and through the facilities it provides. Arrangements for market abuse referrals to FSA are in place but the exchange must have its own rules, enforcement and appeals procedures.
FSA will maintain close and continuous regulation of the exchange and its structure, trading activity and monitoring. This involves regular contacts with staff at all levels and is based on a periodic risk assessment, the intention of which is to encourage proportionality and consistency in our regulatory approach.
The exchange world might be clearer if I briefly contrast the OTC markets, which of course are also a key arena for metals trading.
Whilst the participants may be regulated, the market is not. The structure and protections provided by the recognised exchange regime do not apply. There is not the same requirement for market transparency. Nor is the market monitored in any meaningful sense.
Key Regulatory Issues for Market Participants
Key issues for market participants to consider:
FSA vision 2010
Our "2010" vision is, we believe, quite simple and quite achievable. It is entirely consistent with the Government's Better Regulation initiative. Realising the vision will, we believe, further enhance the UK's ability to attract and sustain globally competitive financial services business.
2010 is based upon the concept of principles based regulation. It is a more mature, more confident and less mechanistic approach to regulation. Alongside this will come differences in emphasis, and different types of responsibilities for the FSA. We will need to be better able to make the flexible and informed judgments required for principles based regulation. Firms want this flexibility, and we believe they are ready for that kind of relationship with the regulator.
Firms need to accept that it requires judgment from them too – judgments that are consistent with the spirit not just the letter of what our rules say. We believe this will achieve better quality regulation and a more appropriate focus on senior management responsibility. Consistency will need to be judged more in terms of outcomes rather than inputs or outputs. It will be inherent in a more principles based system that different firms may adopt different approaches to an issue. But because a common outcome is secured some inconsistency in approach does not ultimately matter.
MiFID
On the specifics of MiFID, for the firms represented here today I would highlight two key issues.
First and foremost, how you categorise your clients, will determine the choices you make within your business strategy. It is therefore vital that senior management make the decisions now as to how to treat the new retail and professional clients and eligible counterparties. Many existing ‘intermediate’ customers are likely to be classed as retail clients. Firms will need to consider the implications of such a shift on their business model and the costs involved.
The second is best execution. How can firms reasonably provide a client with best execution, considering not only price but cost, likelihood of settlement and other factors. We are aware of the concerns with this requirement amongst firms and our Discussion Paper – and it was just that - outlined some ideas, intended to be as pragmatic as possible, for practical ways forward in terms of non binding guidance to help firms comply in a pragmatic manner.
We must be clear in that context that there is room here for firms to make a judgment as to how they meet their obligations – there is no 'one size fits all' in terms of best execution. Firms and indeed their senior people will need to form a policy and put arrangements in place that meet the MiFID obligations whilst bearing in mind their individual firm's situation and type of business.
Market Abuse
One of the overarching objectives of the FSA is to maintain efficient, orderly and clean financial markets. The Wholesale Business Unit takes the lead in the FSA in pursuing this objective.
Let me say at the outset that we don't think that our markets are rife with insider trading or market abuse. We consider the majority of individuals and institutions participating in the UK's financial markets do adhere to high standards. However, a small minority do not and are prepared to engage in unacceptable behaviour. This raises costs for all market participants: unfair markets are inefficient ones.
There have been a number of cases over the years which have demonstrated the adverse impact of poor market standards. For example, the Sumitomo case during the 1990s undermined confidence in the global copper market and particularly the LME. The impact was felt directly by consumers of copper across the globe as the price of copper soared following the manipulation of the market. I should add that markets can soar – or indeed fall - for reasons other than manipulation and that speculation is not coterminous with market abuse.
Institutional abuse is particularly insidious as the opportunities for the unscrupulous are more frequent and the potential for damage to market confidence greater. So while we will continue to take enforcement action against individuals who commit market abuse – and the majority of our completed cases so far have been against individuals from outside the financial sector - we are now targeting our resources primarily at institutional cases.
The FSA's Code of Market Conduct – which was published just over four years ago – sets out in detail the standards that should be observed by everyone who uses the UK's key financial markets, whether they are trading in the UK or from overseas. In particular it makes clear the standards we expect to see maintained through its descriptions of what is and is not market abuse. The Code brings transparency to all market users and lets everyone know what standards can be expected when dealing on UK markets.
The LME's lending rules as enshrined in the exchange's Market Aberrations regime is a key tool in this context. Trading activity conducted strictly in accordance with the lending rules is "safe harboured" for the purposes of the Code. Traders with long positions approaching delivery can act safe in the knowledge that as long as they meet the LME's lending requirements in a timely and orderly fashion they will not have difficult questions to answer from my enforcement colleagues at the FSA.
My key message to you is that as well as the FSA taking steps to combat market abuse, it is incumbent on the senior management of City firms to guard against the risk that their staff will commit, or facilitate, market abuse. I would hope that our common desire to promote the UK as an efficient, orderly and fair market will ensure they do so.
The FSA would much prefer to deter than to enforce: it is more cost effective and better for market confidence. We know market abuse happens and, when we find it, we will take it very seriously. But I would emphasise that this does not mean a confrontational relationship with firms. We cannot deter on our own. Our objective is to work with the industry to counter abuse and ensure proper market standards are maintained, and this will be to the benefit of all.
FSA Remit
It is important to note that whilst we do keep a very close eye on investment markets and the authorised participants active on these markets, our regulatory remit only stretches so far.
On this I would like to make three points:
- We are not a price regulator. I believe transparency gives the marketplace the opportunity to act rationally and thus more efficiently to the benefit of the community as a whole, although to be clear we do understand the interplay with liquidity;
- We therefore also do not managing volatility in the market: LME has seen periods of volatile markets over the past year, and that although market participants may have gained or lost as a result of this volatility, it is not within our power to intervene with price movement caps on the market. Through close and continuous supervision of investment exchanges and the participants on them we can ensure a fair and orderly market;
- The past year has seen increased 'speculative' investment in the commodities space, with many varieties of investment funds buying into commodities both for reasons of diversification and capital gains. Firms trading directly on exchange will be authorised and regulated by the FSA, and have a duty to ensure that they comply with existing FSA rules as they apply. The reality is that users of all investment markets (not just commodities) are becoming ever more diverse and that if you want efficient capital markets you need to embrace diversity whilst seeking to ensure good behaviour by market participants.
Changing Nature of Market Participants
Commodity markets have historically been the domain for producers and consumers to come together to hedge production/consumption. During the recent commodity bull market these markets have seen an influx of investors that can be seen as speculative in nature, for the most part with little interest in ever owning the physical underlying commodity.
There are several good reasons for this influx, and one of the most readily quoted is that of portfolio diversification. Whilst this has been known for some time, it has taken the a combination of the current commodities bull- and recent equity bear markets to highlight to investors and fund managers the potential benefits of the long-recognised negative correlation of many commodities to most other asset classes. Fund managers are now espousing the benefits of portfolio diversification through commodities and this is driving the increased investment.
Amongst these investors, it is the pension funds that are in the vanguard, and although involvement is still limited, investment is expected to grow. There are reported to be a reasonable and growing number of US based pension funds with commodities forming part of their portfolio. However, in Europe only a handful have taken this step, led by the Dutch, with two or three UK funds close behind. Whilst UK pension funds tend to be exposed only through index products, the two largest Dutch funds have their own teams of asset managers actively managing their commodities exposure. Of those who do invest, typical current pension fund exposure to commodities is 3% of a portfolio.
Derivatives exchanges have benefited from an overall increase in investor sophistication over recent years, and another new source of inflow is coming from Hedge Funds. Not only do these investors prefer the efficiency of electronic trading, they are also seeking profit generating investment strategies that are facilitated by derivatives. Media comment can sometimes imply that such investors can be harmful to markets. This is a view we do not subscribe to. We recognise that hedge funds create new risks to market efficiency, but overall believe that the benefits they bring through increased liquidity and risk dispersion are significant.
Another area of potential growth is within the retail market. It is clear that high net worth individuals are increasingly investing in commodities through funds and through private banks. However, there is little suggestion of significant current retail involvement but has the potential to be a huge area of future growth. Most growth in the retail market is expected through exchange traded funds and through the adaptation by banks of equity investment products for commodities.
Changes such as these are testament to the way in which the market is being run and regulated, and underlines the importance of the LME's market monitoring and supervision to ensure that a fair and orderly market is maintained for all participants, and that as the exchange's customer base evolves, the exchange must be flexible enough to evolve with it.
LME: the Last 'Mutual'?
With the demutualization of exchanges that began in the nineties, we have seen a divergence first of identity and then of interest between the membership and the users.
The route followed has been a well trodden path. The membership realises value by selling to a new owner, either a single purchaser as or by going direct to market. Further value is derived by taking an axe to the cost base or – more rarely – by the successful development of new products. But this tends to lead to a cycle we have yet to see unwind, with increasing pressure on bottom line to justify the share price multiples. It gets increasingly difficult to justify these multiples through organic growth, hence the drive to do the big deal.
At times in the last few years, it seems that every exchange has been associated by rumour at least with every other exchange. Some of these rumours even have a basis in fact. In short, as we all know is often the case addressing one challenge creates another. In this case the divergence of interests between users and owners.
The LME has looked increasingly unique in the way it has continued to prioritise the interests of the members. The FSA is not in the business of judging business models in terms of the success or failure they will bring to their owners. It is a matter for the exchange, not the regulator, how the LME will evolve. But it would be only natural for the LME members to be aware of the potential to take advantage of the current attractiveness of exchanges to seek to unlock value. And you need to be aware of the environment in which the LME's potential competitors – and suitors – are operating. I would however like to state the obvious, you are in an excellent position to learn lessons from the dramatic changes we have seen in the development of all types of exchanges worldwide.
Also although the regulator does not seek to determine exchange strategy, we are entitled to expect that there is one. We thus welcome the LME's focus on its future. A knee jerk reaction to this competitive market is in nobody's interest. We fully accept the commercial realities, but there are legitimate regulatory interests.
- We expect exchanges not to dilute unduly market standards in the attempt to compete.
- Nor can the exchange cut overhead so far that it compromises the adequacy of its regulatory resource or its systems and controls.
- As exchanges have tended to form part of wider groups, the pressure has been to integrate functions. Again, there are sound commercial reasons for doing so, but the regulatory obligation is on the UK entity, so we expect the RIE to maintain within itself the ability to meet its regulatory obligations.
- We are also seeing the start of a trend experienced in other industries, in which the exchanges are likely to want to return capital as a way of gearing up their financial performance. Where this is proposed, it is likely to be a key part of the regulatory dialogue Exchanges have a responsibility to maintain sufficient financial resources for the performance of their functions.
Modernisation of Commodity Exchanges
There is a current trend for exchanges to migrate transaction volumes from floor to screen. In Chicago, both the Merc and the Board of Trade are reaping the benefit of this move. The New York exchanges have been a step behind, but NYMEX is now showing good volumes in its electronically traded WTI while NYBOT is exploring potential partnerships as a route to electronic trading. In London, ICE Futures closed its floor eighteen months ago.
The result of this migration has invariably been volume growth, spurred on by the benefits of electronic trading — speed, anonymity, transparency, and efficiency. Electronic trading lowers friction costs, broadens product distribution to new customer segments, and increases the velocity of trading. It has also facilitated much longer trading hours at exchanges, and hence access to global markets, with several exchanges now open around the clock.
It is important to note at this point that the FSA has no preference over trading venue. We are satisfied as long as the exchange can demonstrate that they are able to meet their recognition requirements, particularly in terms of transparency, market monitoring, market orderliness and cleanliness. It has long been received wisdom that the FSA would like to see the closure of the Ring. This is untrue and the future of the Ring is a matter for the LME alone.
The regulatory implications of the growth seen by the exchange should be fairly obvious. The business model of exchanges, as anyone can see from the accounts of those that are public companies, is a shareholder's dream in these buoyant markets: revenue rises from increased volume with little commensurate rise in costs. But it is important for exchanges to continue to invest in systems and controls to match the challenges from these rising volumes – and these should be in terms of market monitoring and compliance systems as well as member facing systems.
Cross border business does impose challenges for the regulatory framework. One particular and relevant aspect is where there are competing contracts across two exchanges in two jurisdictions. The FSA continues to explore how to address these challenges and we have made progress recently with the CFTC on cooperation and information sharing.
And finally business continuity planning needs to develop hand in hand with the changing market. We have all put in a great deal of effort in this regard since 9/11, but this will continue to be an area of significant work going forward.
Why We Care About These Markets
- Risks to market confidence
- Continued evolution of commodity markets
- Increasing diversity of market participants
London has always been one of the major trading hubs of commodities which play a large role in the global economy. With the increase in investment seen over the past years in commodities, it is now more important than ever that the market is regulated in a way which can both facilitate further investment and maintain a level of confidence in the market for participants. We believe that our approach will further facilitate the evolution of these markets as they continue to grow and adapt to the environment in which they operate.
There are challenges that lie ahead for all commodity markets - not least impending European legislation - but with your collaboration and hard work, we believe that London markets can minimise the risks to market confidence and embrace the new and diverse entrants to this market in order to maintain London's enviable position at the forefront of commodity trading.
Thank you for your time.
Questions?
