In our recent article " How might the proposed new senior managers and certification regime for individuals have affected accountability for foreign exchange manipulation?" we considered how the proposed new regulatory regime in relation to individual accountability would have affected those responsible (both directly and indirectly) for the manipulation of spot foreign exchange rates which was the subject of recent enforcement action by the FCA.
In this further article, we consider the possible effects on the behaviour identified by the FCA of changes to the regulation of the foreign exchange market and of benchmark setting.
Regulation of the foreign exchange market
The Fair and Effective Markets Review (FEMR) is currently consulting as to what further action (by the industry and by regulators, domestically and internationally) is desirable in order to improve the fairness and effectiveness of Fixed Income, Currency and Commodities (FICC) markets. FEMR is due to deliver its final recommendations in June 2015, but its Consultation Document of October 2014 provides some useful indications as to FEMR's methodology and some of its assumptions.
In particular, the Consultation Document emphasises the range of new measures already making their way into the regulatory canon, and FEMR's wish to avoid unnecessary additional regulation. It points in particular to the introduction of MiFID 2 which will cover most currency derivatives. It will not, however, apply to spot FX which, according to the statistics quoted by FEMR, accounts for 38 % of foreign exchange instruments traded. The activity in relation to which the recent fines were levied was, of course, manipulation of FX spot rates. FEMR also refers to the introduction of the Market Abuse Directive and Market Abuse Regulation, which will extend the application of market abuse provisions to manipulation of FX benchmarks in July 2016.
Nonetheless, FEMR is consulting as to whether there are still regulatory "gaps" which should be filled.
Regulation of benchmark setting
The recent scandal in relation to manipulation of some FX spot rates had a particular resonance because of the findings two years earlier that another benchmark, LIBOR, had been the subject of artificial submissions. The FCA was particularly critical of firms' failure to address FX manipulation in part because it felt that the LIBOR controversy should have caused the banks to take action in respect of similar risks of abuse, rather than allowing it to continue for a further year.
There were suggestions in the wake of LIBOR that the banks were not the only ones who needed to put their house in order, and the Wheatley Review was set up to recommend a framework of regulation for financial benchmarks.
Various legislative changes followed, including the amendment of the Regulated Activities Order to include the regulated activities of providing information in relation to a specified benchmark, and administering a specified benchmark. The FCA introduced provisions in its Handbook at MAR 8 to provide further rules and guidance in relation to these activities.
The only benchmark specified by these arrangements was LIBOR, but it was intended that others be added. FEMR published initial recommendations in August 2014 that seven additional benchmarks be added to the list of prescribed benchmarks, including the WM Reuters 4 p.m. fix which was one of the two spot rates which the FCA went on to find, in November 2014, had been manipulated. The other rate referred to by the FCA, published by the ECB, is not a UK-based benchmark and therefore cannot be subject to this regime. However, FEMR notes that new EU legislation is proposed, which will regulate benchmarks at a Community-wide level and replace the UK measures taken, but such is the importance of benchmarks to the financial system that it has been decided not to wait for this new legislation.
It therefore follows that once the relevant legislation has been implemented, the WM Reuters rate previously manipulated by traders will come within the same category as LIBOR for regulatory purposes. However, the fact remains that it is not the same as LIBOR in one key respect. LIBOR relies on submissions from those whom MAR terms "benchmark submitters", whereas WM Reuters does not. Its benchmark is determined by reference to trading on a platform over a specific period. FEMR therefore acknowledges that the regulatory provisions in MAR 8 relating to "benchmark submitters", and the regulated activity of providing information in relation to a specified benchmark, do not apply to the WM Reuters 4 p.m. fix.
Market abuse
There have been suggestions that the market abuse regime may be struggling to deal with cases such as FX manipulation, having been designed initially to deal with equities trading.
Its difficulty as presently drafted is that it relates only to qualifying investments admitted to trading on a prescribed market, and the transactions that are tainted by abuse in this case fulfil neither criterion.
It may be that future changes to EU regulation will go some way to addressing this issue. The Market Abuse Regulation introduces at Article 12 a concept of market manipulation (including by trading), which is prohibited at Article 15. Both these Articles will apply to benchmarks, and it seems likely that they will serve to catch the type of abuses which have taken place in the FX market.
The remainder of the Regulation will (in broad terms) apply to those transactions which will be covered by MiFID2, and should therefore bite in relation to currency derivatives.
Part 7 of the Financial Services Act 2012
Market abuse should in future provide a civil regime to deal with problematic behaviour, but Part 7 of the Financial Services Act 2012 has already introduced a new offence which may be used in future in respect of manipulation of benchmarks. The regime currently applies only to LIBOR, but FEMR has recommended its extension to the WM Reuters 4 p.m. fix as well.
The Act repeals the offence of making misleading statements contained at section 397 of FSMA. Instead, it creates various new offences. These include, at section 91(2), an offence of misleading statements in relation to benchmarks, where:
"A person ("C") who does any act or engages in any course of conduct which creates a false or misleading impression as to the price or value of any investment or as to the interest rate appropriate to any transaction commits an offence if—
- C intends to create the impression,
- the impression may affect the setting of a relevant benchmark,
- C knows that the impression is false or misleading or is reckless as to whether it is, and
- C knows that the impression may affect the setting of a relevant benchmark."
Section 91 came into force on 1 April 2013.
The definition of "benchmark" for these purposes is contained at section 22(6) of FSMA1, and it is different to that used in the Market Abuse Regulation2. It will be interesting to see whether they are harmonised in due course, or whether this distinction will mean that the market abuse regime and criminal regime are not always both available options in relation to the same potential benchmark.
Interaction with the new individual accountability regime
In our article " How might the proposed new senior managers and certification regime for individuals have affected accountability for foreign exchange manipulation?", we referred to the fact that the designation of Senior Management Functions under the proposed new regime for individual accountability is linked to regulated activities. There is at present no proposal to make the specific type of FX trading that was until recently subject to abuse a regulated activity. That said, as currency derivatives increasingly fall within the regulated sphere, it may be difficult to maintain a different line of accountability for currency spot trading.
FEMR is also consulting on the possibility of imposing (or suggesting) qualifications for FICC traders. If that is the case, then it is likely that such traders will need some form of FCA approval to undertake those activities, which would bring them within the scope of the proposed new Certification Regime. This would mean that firms had to certify their currency traders annually as fit and proper to undertake their roles.
Conclusions
The authorities are undoubtedly taking steps which will have an impact on the sort of behaviour that was the subject of recent criticism, but two (related) gaps remain.
One is that there is no current plan to regulate spot currency trading (unlike trading in currency derivatives). That means that abuses in currency trading do not fit easily into the current market abuse regime, although this is likely to be rectified in relation to benchmark manipulation with the implementation of the Market Abuse Directive. In addition (as explained in our earlier article), the new Senior Manager Functions proposed may not catch spot currency trading as a business area, although it may well be that, as a matter of practice, the same individual will have ultimate responsibility both for unregulated and regulated currency trading activity.
Another is that the post-LIBOR drafting of regulation surrounding benchmark setting did not factor in benchmarks that were determined by reference to trading rather than submissions. As matters stand, therefore, it appears that while such benchmarks are eminently susceptible to manipulation, half the regulatory regime designed to deal with such abuses does not apply. It seems likely that this may need to be the subject of further change, but it is hard to see how this can be achieved without some regulation of the trading that underlies the setting of the benchmark.
Footnotes
1The FSMA definition of a benchmark is "an index, rate or price that—(a) is determined from time to time by reference to the state of the market; (b) is made available to the public (whether free of charge or on payment), and; (c) is used for reference for purposes that include one or more of the following—(i) determining the interest payable, or other sums due, under loan agreements or under other contracts relating to investments; (ii) determining the price at which investments may be bought or sold or the value of investments; (iii) measuring the performance of investments."
2The definition of a benchmark in the Regulation is "any rate, index or figure, made available to the public or published that is periodically or regularly determined by the application of a formula to, or on the basis of the value of one or more underlying assets or prices, including estimated prices, actual or estimated interest rates or other values, or surveys, and by reference to which the amount payable under a financial instrument or the value of a financial instrument is determined".
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