Chair: Adam Bennett (St Antony’s College)
One of the key questions in the aftermath of the global financial crisis is how to restore trust, especially in wholesale financial markets? A string of large-scale market manipulation scandals have made this discussion even more topical. Given its prominence, PEFM was delighted to host Mark Yallop, chair of the FICC Markets Standards Board, to share his analysis of the issue. In his talk Mr. Yallop identified some perennial problems with financial markets and advocated for a standards-led approach to rebuilding trustworthiness.
Mr. Yallop began his talk with two examples of market manipulation. In the later stages of the Napoleonic Wars, de Beringer and his associates sought to spread news of Napoleon’s demise in order to inflate gilt prices and sell their holdings at a profit. They were eventually discovered, and tried by the English courts in the first case of market manipulation in their history. Much more recently, Tom Hayes, an interest rate derivatives trader in Tokyo, was accused of using more modern means to the same goal. Through instant messaging, he was supposed to have communicated with the traders setting the daily Yen LIBOR rate, convincing them to slightly change their estimates in the direction that suited his portfolio. In 2015, Hayes was sentenced to prison in the most recent market manipulation case in front of British courts.
These two stories illustrate some of Mr. Yallop’s central points. Technology – from the early 19th century use of the telegraph to 21st century instant messaging and financial innovation have increased the capacity for misconduct and made regulators’ task harder. However, these incidents also demonstrate that human temptation remains a powerful driver. On a more systematic level, they also indicate that markets operate through some basic mechanisms, which can be manipulated, and that two centuries of legal and regulatory attempts to deal with such conduct problems have not managed to achieve the desired result.
This leads Mr. Yallop to then question why do conduct failures keep recurring. He identifies three key problems. First, markets have increasingly moved away from reputation and standards and towards law and contracts as the nature of relationships becomes more commodified. Thus, the inherent conflict of interests that investment banks face is now resolved only through a narrow legal prism and formal rules: “if something is not illegal, we can do it”. Second, the nature of manipulation focusing on large short-term rewards and punitive discount over the longer term meant actors faced collective action problems, undermining collaboration to address problems in the system. Finally, regulatory approaches have largely failed to address the everyday live challenges of market participants. The absence of guidance and the ‘conduct void’ in terms of rules causes anxiety that actions might be reinterpreted in the future with hindsight, potentially leading to reductions in liquidity and trading activity.
Given these problems, Mr. Yallop identifies the key challenge as restoring trust in the markets following the global financial crisis. More precisely, he argues that to make it easier to judge trustworthiness, market participants need to be able to take responsibility for fixing problems and be provided with granular and public rules for how to prevent such issues from reoccurring. To achieve this, Mr. Yallop proposes a greater reliance on standards, which have three key advantages. First, they eliminate the (unintended) incentives for ‘legal arbitrage’ created by formal rules. Second, they reinforce the concept of professionalism, or the obligations that actors with greater knowledge acquire to act responsibly vis-à-vis those that have less information. Third, standards should improve efficiency given both their reach beyond individual jurisdiction and the interest of market participants to reduce unnecessary obstacles to trading.
This reasoning underpins the FICC Markets Standards Board (FMSB), established in 2016 and chaired by Mr. Yallop. The FMSB aims to give market participants the responsibility to fix conduct problems and improve trustworthiness through the publication of agreed-upon standards to address ‘conduct anxiety’. Therefore, the Board is practitioner-led and operated by participants in wholesale markets. Its membership boasts 40 institutions from all sides of wholesale markets that account for 80% of all sell-side activity and over $10 trillion in assets under management. They also have the support of key UK regulators. Based on their research, they have identified 70 issues on which they intend to publish standards, and will publish each year public reports on the rate of adoption of such standards by their members.
Overall, therefore, Mr. Yallop finds the FMSB fundamentally different from previous initiatives as it is a “private sector body empowered by the authorities to take charge of improving user outcomes”, featuring participants from all sides of the industry and a clear reporting mechanism. However, if the FMSB does not develop effective standards, he warns that regulators will step in with more formal rules, leading to less activity. The stakes, as he acknowledges, are certainly very high.
Ivaylo Iaydjiev (St Antony’s College, Oxford)