Fair and effective financial markets are critically important to the broader economy because:
“They help determine the borrowing costs of households, companies and governments, set countries’ exchange rates, influence the cost of food and raw materials, and enable companies to manage the financial risks they incur through investment, production and trade. They also support employment for many around the world, not least in the United Kingdom, which hosts a substantial share of these markets. So it is vital that they work well, and in the best interests of everybody.”(Source: Bank of England, Fair and Effective Markets Review Final Report June 2015)
Financial Markets – theory and reality
Theoretically, markets are fundamentally rational and efficient, with price discovery reflecting new information as it becomes available and assessed by independently acting market participants. These market participants themselves are assumed to be rational actors and as a result, overall prices have a strong tendency towards equilibrium. Two key consequences follow from this theoretical position:
- Allocative efficiency benefits are achieved by efficient and liquid financial markets, allowing participants to effectively fulfil their preferences for risk, return and liquidity
- Rational markets do not require regulatory intervention
Unfortunately, reality does not match these theoretical expectations, as amply demonstrated by the global financial crisis of 2008-9. For example, assumptions of individual and collective rationality are being challenged by findings from behavioural economics and neuroscience and by events such as speculative bubbles. Asymmetries of information do exist between different types of market participants, particularly between retail customers and financial institutions and some market participants engage in collusive behaviour, such as price fixing (e.g. LIBOR). These are all examples of market failure, justifying the need for regulatory interventions to ensure financial markets remain competitive, transparent and efficient.
MiFID II and MIFIR (Markets In Financial Instruments Directive) and MAR (Market Abuse Regulation) are examples of regulatory standards from the EU that address market shortcomings.
Ensuring fair and efficient markets
Market Transparency and Structure
Transparency is central to the fairness and efficiency of a market, and is defined as the ability of market participants to obtain information about the trading process such as price, order size, trading volume, risk etc. Transparency is necessary both pre and post-trade, and regulations such as MiFID II require near real-time reporting of trades for regulated markets (such as stock exchanges), multi-lateral trading facilities (MTFs – commonly known as exchanges), and other types of trading facilities. The precise requirements will vary depending on the type of trading venue, and if an investment firm is executing trades outside of a trading venue, that firm will be required to report these trades.
One of the primary aims of the first MiFID was to improve competition in the EU financial markets, particularly in terms of the various types of trading venue. Whilst encouraging different business models for trading venues and types of trading (e.g. high frequency trading), MiFID 2 includes requirements for ensuring these various market structures to manage their operational risk and also to ensure that smaller market participants are not denied access to trading venues.
Regulatory authorities rely on data to monitor the integrity of the financial markets, and to detect and investigate suspected market abuse, insider trading and market manipulation. Supplying this data to regulators is mandatory for investment firms under MiFID 2 and all such firms must report ‘complete and accurate’ details of those transactions to their home competent authority as quickly as possible, and no later than the close of the following working day.
At the heart of all types of regulation focused on protecting investors is the fact that a fiduciary relationship exists whenever one party appoints another party to act on his or her behalf. In such relationships, the agent should act in the best interests of the principal but conflicts of interest may arise when incentives are misaligned. Information asymmetries also need to be rectified to ensure the investors are equipped with all the data they need to make decisions.
Measures such as best execution, the disclosure of all costs and charges, product governance and suitability requirements all aim to protect the integrity of fiduciary relationships and ultimately, the investor. Best execution, for example, ensures that firms execute trades on behalf of their clients so that they receive the best terms (which could be based on just price or on price and other factors such as lowest cost-per-trade and the speed to execute). Not only must firms perform best execution, they must also provide information to clients on their policy for best execution and publish data publicly on execution quality for each relevant trading venue.
Governance & Controls
Additional requirements relate to the governance and conduct of investment firms that underpin the other principles discussed above such as investor protection, fair conduct in the market and market transparency. These include the need to have suitable governance and risk management and control frameworks in place, processes for monitoring conflicts of interest, employing personnel with the appropriate levels of skills and knowledge and expertise and, in the case of the Board of Directors, be considered fit and proper for their role and level of responsibility. There are also specific requirements under MiFID 2 for firms to record telephone conversations and electronic communications that relate to the ‘reception, transmission and execution of orders, or dealing on own account’ – including on mobile phones, SMS messages and electronic communications, and store them for a minimum of five years.
A key component of product governance is establishing a complete product lifecycle – from initial business case through to product reviews and a process for orderly demise. The new product business case must outline the client needs being addressed alongside which target markets the product will serve. Regular review of products versus their business cases is essential to demonstrate products are meeting their objectives. Critical to the reviews is client feedback – including complaints – alongside mechanisms to demonstrate how the ‘voice of the client’ is listened to and acted upon.
Market integrity is defined by the International Organization of Securities Commissions (IOSCO) as:
‘the extent to which a market operates in a manner that is, and is perceived to be, fair and orderly and where effective rules are in place and enforced by regulators so that confidence and participation in the market is fostered’Source: IOSCO, Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency (2011)
Types of market abuse may include insider dealing / trading on inside information and the deliberate manipulation of the market with the aim of moving market prices artificially to make a profit or avoid a loss. As well as releasing false information, price fixing or benchmark rigging, the following mechanisms are used to move security prices:
- “Wash trades” – a trader simultaneously buys and sells the security meaning there is no change in the ownership of the security
- Improper matched orders – matching buying and selling orders are entered into simultaneously
- “Pools” – groups of investors trade amongst themselves to give the impression of an active market in a particular security
- “Painting the tape” colluding parties make trades in securities that are shown on a public display facility (ticker tape)
Whilst these types of behaviour are clearly prohibited under securities regulations (e.g. EU MAR), firms should have systems, processes and controls in place that both prevent and detect market abuse. These may include written policies or procedures, watch lists, restricted lists, ‘Chinese’ walls and automated trade surveillance to identify likely patterns of misconduct in trading data that can then be investigated further.
Hopefully, it is now clear why we need regulation to ensure fair, transparent and competitive financial markets.
In the second post next week, I will discuss how financial firms meet these regulatory obligations from a practical perspective, how RegTech can help and our view of the this sector of the RegTech market. Make sure you don’t miss out on our blog posts and forthcoming market map by signing up to our newsletter. Also take a look at our past newsletters.