Farewell to the FSA – will derivative firms mourn its passing?

Farewell to the FSA – will derivative firms mourn its passing?

Derivatives specialists in London were today digesting the news of a radically changed UK regulatory structure, due to be introduced by 2012.

The Financial Services Authority, not always loved or respected by market participants since its foundation in December 2001, will be abolished – but the reforms are likely to give derivatives firms at least two regulators to deal with, in its place.

Meanwhile, a commission of enquiry will examine whether banks need deeper structural reforms, such as break-ups or a split between commercial and investment banking.

“We’re now going to have to work within a new structure,” said Anthony Belchambers, chief executive of the Futures and Options Association. “The timing is not great – obviously the FSA along with the SEC is one of the more influential voices in the international arena. With all the regulatory upheaval in the EU and the US we do question whether now is the right time for a change of this nature. That said, it is stated policy,” he added, indicating that the industry would have to concentrate on working well with the new regime.

George Osborne, chancellor of the exchequer, announced the measures on Wednesday night in his speech at the Mansion House, where he said: “At the heart of the crisis was a rapid and unsustainable increase in debt that our macroeconomic and regulatory system utterly failed to identify let alone prevent. Inflation targeting succeeded in anchoring inflation expectations, but the very design of the policy framework meant that responding to an explosion in balance sheets, asset prices and macro imbalances was impossible.”

The FSA, formed in December 2001 as the UK’s first unified financial regulator, will be broken into two parts. Some of the staff will go into a new Prudential Regulatory Authority, to be formed as part of the Bank of England. This will be responsible for ‘microprudential’ regulation of financial firms including banks, investment banks, building societies and insurance companies.

Led by Sir Hector Sants, now the FSA chief executive, it will report to another new organ of the Bank, an independent Financial Policy Committee, charged with ‘macroprudential’ regulation – ensuring that systemic risks such as credit and asset price bubbles do not build up in the economy.

Most of the other FSA staff are likely to move into a separate Consumer Protection and Markets Authority, which will “regulate the conduct of every authorised financial firm providing services to consumers,” as well as being responsible for “ensuring the good conduct of business in the UK’s retail and wholesale financial services”.

A third new agency will bring together all the groups that at present fight white collar crime across many departments.

The reforms are expected to take place in a phased and measured way, over the next two years. However, they could involve significant disruption for derivatives firms, and could potentially cause confusion. The multiplication of regulators could mean firms having to cope with more reports and more inspections.

Belchambers said: “Our concern is about making sure we don’t have change for its own sake. After all, the FSA is a very different institution from what it was before the crisis. It makes sense to build on the FSA’s strengths and achievements of recent years and maintain that momentum.”

Some market participants believe parts of the agency have become much more adept in supervising financial markets recently.

In his speech, Osborne paid tribute to the FSA’s staff, but was scathing about its overall effectiveness, saying: “The FSA became a narrow regulator, almost entirely focussed on rules based regulation.”

This was a somewhat surprising criticism, considering that the FSA was most associated in the years before the crisis with the phrase “light touch regulation” – even though senior staff rejected that term. They preferred the concept of “principles-based regulation”, something that the UK was held to have pioneered. It was common at that time for financial firms to praise the FSA’s principles-based approach, contrasting it with the more heavily legalistic approach of US regulators, especially since the Enron scandal of 2001.

Belchambers believes the FSA has improved markedly in the past two years. “The FSA’s whole supervisory approach is much more focused on risk, particularly people risk, which is the root cause of nearly every crisis – as opposed to product risk – and on wholesale markets, governance and prudential regulation. Change is now inevitable, but we can at least argue for as much continuity as possible during this period of transition.”

Over the coming weeks and months, market participants will have to get to grips with how the new structure is actually going to change their working lives. It is not yet clear precisely where the financial markets division of the FSA will sit and who will run it, though it seems likely to fall under the CPMA.

“The name of the new Consumer Protection and Markets Authority does give us some concern,” Belchambers said, “insofar as a more consumerist approach may impact on wholesale markets and services. It could generate tensions between wholesale and retail and higher costs for all market participants. As with insurance, every form of protection comes at a price. If the regulation of wholesale markets becomes driven by consumer protectionism, higher cost – and it will be yet another ‘pass on’ cost – could be the inevitable consequence.”

Jon Hay +44 207 779 8372 jhay@fow.com

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