U.K. FICC Review to Impact U.S. Markets

Terry Flanagan

The US is likely to transplant recommendations form the UK review of fixed-income, currency, and commodity markets according to a governor of the Federal Reserve System.

The Fair and Effective Markets Review was set up by the UK government and Bank of England last June to address the lack of confidence in FICC markets following the successive scandals over rigging rates in interest rate, foreign exchange, gold and other markets.

Martin Wheatley, chief executive of the UK’s Financial Conduct Authority presented on the review last month at the Brookings Institution in Washington D.C. Governor Jerome Powell of the Federal Reserve System provided a US perspective on the review which were reported by the CLS Blue Sky Blog, Columbia Law School’s blog on corporations and capital markets, today.

Powell said: “All of the big US firms are involved in the review and are involved in global markets, so it doesn’t really make sense for us to be running a parallel process and perhaps coming to different conclusions. I think we’re eager to hear what the review comes up with in June and then think about how to transplant that to our markets rather than run some sort of a parallel process.”

The areas covered by the review include market microstructure – such as whether corporate bond issuance cab be more standardised and of there are structural vulnerabilities in the foreign exchange market – and competition and market discipline including whether technological innovation can improve competitiveness.

Wheatley said : ”We can’t simply keep stumbling across another asset class where we find out that things are not working as they should be. You can’t pretend somehow, okay, yeah the Libor guys they got it wrong, they did something bad, but actually what we’re doing over here, well nobody is looking so we’ll carry on with it.”

Powell said there is a perception that FICC markets and their participants are highly sophisticated and do not need protection but this perspective is too narrow because they affect the borrowing costs of households, companies and governments.

Many have blamed pre-crisis compensation practices at the largest financial firms for creating misaligned incentives and Powell said many firms have enhanced deferral of incentive compensation and the possibility of more robust clawbacks.

“In my view, the reforms are both essential and generally on target,” Powell added. “The US financial regulators, including the Federal Reserve, are also preparing for public comment a proposed new rule on incentive compensation that will codify and strengthen these initiatives.”

The review stated that greater transparency can also help curb market abuses and strengthen competition.

“In the United States, we have had over a decade of experience with the Trade Reporting and Compliance Engine (Trace) in over-the-counter corporate bond, MBS and ABS markets,” said Powell. “The Municipal Securities Rulemaking Board provides similar data for municipal bonds.”

In Europe there is no equivalent to the Trace system for reporting bond trades. Europe is also lagging behind the US in introduction legislation such as the Dodd-Frank Act for using central clearing, trade repositories, and swap execution facilities in over-the-counter derivatives markets.

“But despite significant progress, there are still a number of impediments to sharing trade report data across regulatory agencies and jurisdictions, leaving us with only a piecemeal picture of the overall market rather than the full transparency that we desire,” added Powell.

He said the issues around foreign exchange benchmarks, when users want to guarantee trade execution at the daily WM Reuters fixing at 4pm in London, highlights the difficulty of managing the potential conflicts of interest associated with the traditional market-maker model across FICC.

“It may be that these challenges can be addressed through coordinated private efforts; for example, through such bodies as the Foreign Exchange Committee and the Treasury Market Practices Group, sponsored by the Federal Reserve Bank of New York. It may also be that further supervisory or regulatory action is needed,” said Powell.

He noted that the submission and administration of Libor is now regulated and monitored by the new administrator, ICE Benchmark Administration.

“With surveillance and penalties in place, and a new administrator, one might be excused for thinking that there is nothing more to be done,” added Powell. “That is emphatically not the view of the FSB Official Sector Steering Group that I now co-chair with Martin, which concluded that it is essential to develop one or more risk free (or near risk free) alternatives to LIBOR for use in financial contracts such as interest rate derivatives.”

He explained that as there there are approximately $300 trillion in gross notional contracts that reference Libor, there are still incentives for manipulation.

“For these reasons, the Federal Reserve has convened a group of the largest global dealers to form the Alternative Reference Rates Committee. We have asked them to work with us in promoting alternatives to US dollar LIBOR that better reflect the current structure of funding markets,” he said.

Powell said issues that a few years ago concerned equity markets – such as mutual funds, exchange traded funds, algorithmic and high-frequency traders, and electronic exchanges taking more prominent roles – are now arising in FICC. At the same time broker-dealers are curtailing some market-making activities and their appetite for providing liquidity.

“These changes will affect market liquidity and functioning in ways that are difficult to foresee,” said Powell. “It is possible that some of these factors played a role in the sharp swing in Treasury yields last October 15, and we are working with other regulators to understand exactly what happened that day and to determine whether there are implications for regulatory or supervisory policy.”

The UK review is jointly chaired by Nemat Shafik, the Bank of England’s deputy governor for markets and banking, Wheatley and Charles Roxburgh, director general, financial services, HM Treasury. It includes an independent market practitioner panel, led by Elizabeth Corley, chief executive of Allianz Global Investors. It will make its final recommendations in June 2015 after the consultation period ended last month.

“The Review raises the right questions in considering the troubling patterns of market abuse, and also in considering the structural changes that we are now seeing,” said Powell.

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