Inside the FSA

Hector Sants, head of wholesale markets at the Financial Services Authority, talks to Nicholas Dunbar about his plans for increased regulatory focus on fixed-income structured products and hedge funds


The Financial Services Authority, the UK’s financial super-regulator, has been criticised in some quarters for heavy-handedness in dealing with certain retail markets. But in the wholesale markets the situation is different. Here the Financial Services Authority (FSA) has so far demonstrated a lighter touch than regulators in other jurisdictions such as Germany or Japan.

It isn’t hard to think of reasons why. In derivatives, London is now the world’s undisputed trading capital, trading $643 billion notional a day in over-the-counter currency and interest rate derivatives, leaving the US a distant second at $355 billion, according to Bank for International Settlements figures. The world’s financial powerhouses have flocked to the City, buoying the UK economy as a whole. The FSA, whose powers are set by an act of parliament, may be discouraged from rocking the boat.

However, the phenomenal rewards enjoyed by derivatives structurers and marketers have arguably proved too tempting for some. Since late 2002, a series of Risk stories have shown that institutional buyers of derivatives products can easily become lost within the ever-growing complexity of structures coming out of London. Some customers, such as Spain’s BZ Gestion and Italy’s Gruppo Editoriale Espresso, have dismissed senior people. Others, such as Poste Italiane and Germany’s HSH Nordbank, have begun legal proceedings against major banks, accusing them of mis-selling.

Despite their unhappiness, none of these customers has complained to the FSA. It may be that non-UK based customers of London banks prefer to handle things bilaterally. But the FSA also sees such disputes as contractual, and has apparently reserved its enforcement firepower for its battles on behalf of UK retail investors. No doubt bankers at the major London firms would like to see this continue.

In May 2004, the FSA hired one of these bankers to head its wholesale and institutional markets division. Hector Sants, formerly European chief executive officer at Credit Suisse First Boston, is one of the weightiest industry figures to join a regulator in recent times. We asked him a few questions.

A number of recent issues have concerned one-sided relations between big banks and a number of their customers. There’s a view that the FSA considers such issues as being purely contractual disputes that it would rather not get involved in.

HS: I think in general the wholesale community is extremely keen to see the caveat emptor concept preserved. If you were to talk to the industry, it would make a powerful argument that this concept is critical to the effective functioning of a wholesale market. So we need to make it clear that we are not seeking to be disruptive, or in any way trying to undermine that general conceptual description of a successful wholesale market. But it’s clear that we must aim to ensure a fair marketplace within that backdrop of caveat emptor.

On the subject of conflicts, last year I wrote to Risk magazine [September 17, 2004] about the approach wholesale firms should take to structured derivatives products, and the reputational risks and judgement processes they should have in place when they are conducting transactions in that area. Existing FSA principles state that we expect an appropriate degree of transparency in how the risks of those products are communicated from seller to buyer. So we expect the seller of the product to make sure the buyer has a full understanding of the risks inherent in that product.

But we have not said that they then have a legal responsibility for the on-selling of that product from the buyer to a further third party. This is an area where we will continue to give further consideration over whether we have exactly the right balance and we will continue our dialogue with the industry on this point.

I think you have to be very careful about imposing obligations on people on one end of a chain with respect to actions by unconnected third parties at the other end. Unworkable obligations could be detrimental to the efficient workings of the marketplace.

Is there a danger of the caveat emptor principle being abused when you have small banks that are persuaded to use derivatives documentation? If the structured credit market goes downhill, you may get a lot of complaints. Aren’t you concerned about that?

HS: First, any complaints we receive about regulated firms will be investigated. Second, to be absolutely clear, we believe that efficient markets are transparent markets, and fair markets are transparent markets. Therefore, we would not condone any lack of transparency that leads to the unfair treatment of counterparties.

We absolutely believe that any firm selling complex products should ensure that all the relevant risks are visible to the purchaser. The risks don’t just include the risks they are taking on by purchasing the product, but also the price they are paying for the product. If people are not operating in a transparent way, that would be against our regulatory principles.

I said when I took on this job eight months ago that I think the regulatory system has been more focused on the listed equity market than on the fixed-income market. This is for a number of justifiable reasons, partly because historically UK pension funds have been listed equity investors rather than fixed-income investors. Therefore, the UK regulatory focus has been more equity-based.

One of our key strategic objectives in the wholesale business is to increase our focus on the fixed-income area. We have launched a number of initiatives. One is that we currently have a series of workshops on the subject of transparency in the secondary bond markets. Later in the year we will be publishing a discussion paper on the subject. We’ve also made it clear that we will continue to have a dialogue with the industry about how to improve transparency and ensure effective management of conflicts in the structured products market. That will be one of our supervisory themes in the coming year.

So relative to the historical balance between fixed income and equity, you can expect increased focus on structured fixed-income products over the coming years. I think that is justified not just by the structural shift in investment profile among UK investors, but also by the fact that the structured market is very fast-growing and we expect it to continue to increase. So you can see we certainly expect to put more supervisory resources into it.

I put it to you that you may be susceptible to being gamed by clever bankers. An analogy is with the rating agencies that in the past have been used for spread-ratings arbitrage. Rating agencies cannot pay people as much as banks do, and structured credit products are given very high ratings that may not reflect the risks, but customers nonetheless use these ratings as a guide to buying the products. I wonder if a similar situation might not arise with you.

HS: First, we are not responsible for regulating rating agencies. Second, clearly the FSA is a human capital organisation, and a key component of its effectiveness is the knowledge and experience of the people it employs. It is always going to be a challenge to retain and promote talent where we are in competition with the commercial sector. When you include bonuses, the commercial sector tends to be able to offer more attractive financial packages. That is a key issue for the FSA’s management.

Critical to being a successful regulator in the wholesale space is to build a partnership with senior managers of the firms we regulate, who should seek to hold the same values and objectives as us of creating a better marketplace. To think that the regulator on its own can effectively regulate is too simplistic a model.

I believe the vast majority of people in the City are decent people seeking to do the right thing, and that’s particularly true of senior managers. Clearly, we have tools to ensure they are focused on those challenges, and that includes enforcement, but we are not an enforcement-led regulator. Enforcement is primarily there to reinforce our messages and act as a deterrent. In extremis, people understand that we will act in support of our regulatory philosophy, but generally speaking we’re seeking to build a partnership.

Have you had any specific complaints regarding structured products?

HS: While we wouldn’t comment on individual complaints, a general comment would be that our statement that we will show increased supervisory focus on these matters in the future is not a function of the level of complaints. It is a function of thoughtful analysis by us of potential risk in the future. It is an anticipatory move, to respond to our analysis of risks in the future, not complaints to the FSA. Of course, on a global basis a number of issues have occurred – such as Parmalat – that have led to an increased focus on structured products. But our initiative is absolutely not a response to any specific complaints.

Moving on to hedge funds, we understand that you ask London-based funds to register with the FSA. Given that the capital that hedge funds globally can deploy is significant and growing, is your approach changing?

HS: Part of our job is to anticipate areas of increasing risk. Hedge funds are an increasingly important component of the financial system. Therefore, it is absolutely appropriate that we should ensure we have a full understanding of the consequences of that expansion with respect to our statutory objectives, and make sure we have appropriate responses to the risks they may pose. They could pose some kind of systemic, liquidity-based risk in the event of a lot of redemptions or a failure in the sector.

Then there is the question of conduct: whether they are more prone to market abuse than other market participants because of their fee-based performance structure. There’s the issue of to what degree retail investors should be able to purchase hedge fund products.

Finally, since these are globally based institutions, there’s the more complicated issue of to what extent a national regulator can engage with these risks. Potentially, if all the intervention did was move the hedge funds to a more lightly regulated jurisdiction, I’m not sure we would have achieved any reduction of the risks to the financial system. We already have a number of initiatives in place. We’ve already obtained balances from UK-based prime brokers to see whether that tool should be put in place on a more embedded basis. We will publish a general discussion paper on our analysis of these factors during the coming year.

But hedge funds are becoming more confident in their behaviour. For example, what do you think about the way hedge funds have used contracts for differences to affect corporate takeovers?

HS: The issue of publication of contracts-for-difference holdings during a takeover is a matter for the takeover panel and we support their initiative in this area. In the area of our responsibility, we already monitor contracts for difference with regard to market abuse and insider dealing.

Finally, do you have a message for institutional customers of regulated firms that are concerned about structured derivatives products?

HS: We are determined to ensure that our current principles and rules are rigorously applied to the fixed-income derivatives market, and we are increasing our supervisory focus in that area. We’re looking to see that the sellers of structured products ensure there is appropriate transparency around the risks and issues inherent in those products, which thus allows the purchasers of those products to understand the risks. If market participants feel there are transactions occurring where there is not that level of full risk transparency, we would like to hear about it.

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