UK: Wholesale Conduct – Wholesale Review?

Traditionally, conduct supervision has focused on two issues – consumer protection and market integrity – with financial crime (relevant to both) sometimes identified separately. While market integrity is mainly a 'wholesale' issue, the consumer protection agenda has understandably been dominated by retail issues, not least because this is where the imbalance in information on, and understanding of, financial products is potentially greatest.

This, however, is now changing. When coupled with the generally more assertive and pre-emptive supervisory approach being shown to conduct issues in the UK, it has the potential to transform the approach to the supervision of wholesale market players here.

The Journey to the FCA: a new destination?

In its launch document issued in October, the FCA made clear that change was on the way. The new twin peaks regime provided the opportunity to "adjust our approach" to wholesale conduct. This appeared to reflect a variety of factors:

  • A lack of a clear divide between retail and wholesale markets. Such issues have arguably been surfaced by the ways in which interest rate hedging products were sold to relatively unsophisticated smaller businesses.
  • A recognition that retail and wholesale markets are connected, with risks transmitted between them.
  • A view that such links are important even if the linkage is indirect; e.g. structured products originated in investment banks and then packaged and sold in the retail market.
  • A belief that trust in wider financial services can be undermined by incidents such as the LIBOR-setting saga, even if these have limited direct impact on retail relationships – in the FCA's words "misconduct in wholesale markets can have a much wider impact on the integrity of, and trust in, markets than a narrow interpretation of the principle of 'caveat emptor' may suggest".

The paper stated that "Poor wholesale conduct is not a victimless act simply because it takes place between sophisticated market participants, and it is not limited to criminal behaviour such as fraud or market abuse. It also captures a wide range of activities that exploit differences in expertise or market power to undermine trust in the integrity of markets or cause harm to retail consumers".

So while the document said that the FCA would "continue to recognise the differing degrees of experience and expertise that different consumers may have" it would nevertheless "intervene more assertively to supervise existing rules governing the conduct of wholesale participants dealing with each other" and would "no longer accept that there are some categories of relationship in which we should not be interested because the sophistication of the parties enables them to look after their own interests". This was particularly so where poor behaviour had a wider impact on trust in the integrity of markets, or where charges and fees were passed on to retail consumers.

What might this mean in practice?

The above vision of the interconnectedness of retail and wholesale markets was re-emphasised in the FCA's 'Risk Outlook 2013', published at the beginning of April. It leads to a view from the regulator that wholesale markets have natural in-built conflicts that can adversely affect the interests of retail consumers and that need to be transparently and effectively managed. There is "asymmetry of information" in wholesale markets which can lead to market abuse and insider dealing risks.

There could be an increased incentive for traders to pursue transactions that could be seen as manipulative or there could be a heightened need for surveillance of trade executions. Information provided to retail consumers could be incomplete or insufficiently tailored to the investor's experience and understanding, or to the maintenance of their best interests.

Transactions may be undertaken in a highly intermediated way and so the underlying transactions may not be visible to the end consumer, nor may any instances of market abuse, conflicts of interest or failure to maintain appropriate conduct of business rule protections. Regulatory pressures for more stringent local regulation, which could well lead to a continuing fragmentation of global regulatory initiatives, may also turn the clock back on the ability of firms and regulators to maintain the transparency and effectiveness of cross-border regulatory protections provided to the end-consumer.

As is also likely to be the case from a commercial perspective, pressure on business models may lead firms to take on new types of transactions which are designed to create higher margins, given the lower transaction volumes in the market place. There is, of course, a tension in the regulators' mind between the need for business models that can sustain the financial solvency of firms but at the same time should not create detriment to consumers, and there is an innate wariness of any retail focused products which are of more than average profitability. In the FCA's view, the risk of consumer detriment begins in the lack of detailed oversight and transparency in the wholesale markets.

All of the above factors lead the FCA to expect compliance teams to oversee wholesale conduct risk closely and transparently. Areas like LIBOR and other benchmarks will require specifically designated individuals to oversee the price formation and reporting processes, but across the front office there will be an expectation that conduct of business issues will be more actively monitored at a detailed product and business line level. There is also an expectation that changes in staff behaviours to meet the new standards will be driven home by focused front office oversight and reporting. This will be supported by compliance training around specific positive and negative behaviours, and more active disciplinary measures and financial disincentives, if staff do not display appropriate improvements in conduct. The challenge will be how to achieve this at scale across the front office, where previously there has been less micro- oversight of conduct of business issues.

The wholesale conduct risk agenda puts even greater emphasis on the importance of achieving tangible outcomes from compliance monitoring and training, and the effective oversight by the three lines of defence. It is likely to be a tough agenda, where there is a track record of repeat issues, and it will drive even further the requirement that good compliance is judged by the actions of the many in a regulated firm, with a more equal balance between the retail and wholesale oversight rather than the compliance awareness of a limited number of senior management and compliance professionals.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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