Legal spotlight

In our new series bringing legal issues under the spotlight, Simon Gleeson, partner in Allen & Overy's regulatory group in London, outlines the key regulatory changes now shaping the bond markets

The invisible elephant

In the European Union the recent Market Abuse and Markets in Financial Instruments Directives have caused particular consternation in the debt markets. Regulators regulate for the markets they can see, and from the perspective of any national regulator the largest thing in his field of vision is invariably the local stock exchange. Regulatory initiatives therefore focus on regulating that stock exchange and the equity trading that takes place on it. This leads to a number of interesting assumptions. These vary from simple misconceptions (for example, that price transparency is a function of exchange trading) through to absolute fallacies (that the value of a security can only be reliably determined by comparison with other trades in that particular security). It may be some time before the primary regulatory influence on the credit markets is not the law of unintended consequences.

Various trade associations are currently engaged in promulgating research intended to make clear to regulators the size, scope and importance of the credit markets, and perhaps more importantly to make clear the fact that measures which have a substantial investor protection function in the equity markets do not necessarily translate easily or at all to credit. At the same time, however, increasing formalisation of trading mechanisms in the credit markets is producing exchange trading, or at least exchange-like trading, in unexpected places: for example, Eurex plans to list the first exchange-traded credit derivatives-based futures contract by the end of the year. Other exchanges are not far behind.

The areas that appear to occupy regulators most at the moment are:

- Conflict management. Over and above the recent regulatory initiatives in this area, the new Markets in Financial Instruments Directive (MiFID) will impose obligations in relation to organisational requirements, conflicts of interest and conduct of business which although not new to UK-based institutions are likely to be less flexible than the ones that currently apply. Separately, the Market Abuse Directive imposes inside information controls on debt issuers, which owe nothing to the realities of the debt market but much to the idea that what is good for equities must also be good for debt.

- The thrust of MiFID is to impose a duty of suitability on some institutional as well as retail relationships, excluding only pure inter-professional arrangements. Regulators are torn between maintaining the efficiency of the market and imposing 'investor protection' measures in favour of non-experts. Since for the regulators almost everyone other than an authorised bank will be regarded as a non-expert, there is a danger that regulators will seek to prescribe market participants' obligations to their clients, particularly in the design and use of complex financial products notwithstanding the sophistication of the clients concerned.

- Risk management. The regulatory emphasis reflected in the new Basel Accord is on the systems a bank has in place to monitor its credit exposures and manage those credit exposures at an institutional level. But the construction of such a system poses interesting legal challenges. These arise from the fact that the bank is seeking to manage credit exposures which exist in different markets with different standards of conduct. The sharp division between non-transferable loans and transferable securities has gone but the merging of loan and bond exposures into a single 'credit' to be managed as a whole creates fundamental challenges in terms of the control of information flows. Clearly there is potential for tension between a holistic approach to conflict management and risk management.

The road to self-awareness

It should be acknowledged that regulators are not alone in finding it hard to keep up with growth in the credit markets. A recent report by the Counterparty Risk Management Policy Group II, an industry body, called for urgent action to strengthen the market infrastructure for trading in advanced financial products such as credit derivatives. This follows the warning given by UK regulator the Financial Services Authority (FSA) earlier this year that chief executives of major participants in the over-the-counter credit derivatives market had a responsibility to ensure that their firms' back-office systems and controls were capable of keeping pace with growth in their business in that market. Perhaps more worryingly, a recent investigation by the FSA revealed that firms were not always able to identify all of their exposures to a particular counterparty on an institution-wide basis. This appeared to be a particular problem with prime broker and trading relationships. The current view amongst regulators appears to be that market participants have allowed their trading activities to expand faster than their ability to document, monitor or control them.

By an unfortunate coincidence of timing, this issue arises in the run-up to the implementation of Basel II. Basel II implementation effectively involves a trade-off for banks in the form of a reduction in capital requirements in exchange for greater regulatory scrutiny of risk assessment and control systems within the bank. For an individual institution, this translates into a massive exercise in documenting, testing and reporting on systems and controls across the institution as a whole with (for European banks at least) a hard deadline of January 1, 2008. This is not the ideal situation in which to begin making major changes to risk exposure monitoring.

Regulators are fully aware of this. Market participants should therefore expect increased scrutiny on back-office and risk control systems over the next 12 months or so.

Setting the price of tulips?

There is no shortage of predictions of unforeseen market shocks in the credit markets for reasons ranging from the break-up of the euro to the 'bursting of the hedge fund bubble'. Regulators generally recognise that it is not their function to support market prices. However, recent focus between regulators has been on financial market stability, and regulators have recently debated whether they should be prepared to act in some cases in response to market movements which are so great that they pose a threat to the stability of the financial system generally. It is fair to say that repeated attempts at this in the equity markets have in general led to the conclusion that market shocks are like oil slicks: governmental intervention after the event at best does no good, and often does positive harm. However, it is often argued that the credit markets are different in that they are indissolubly linked to the payment system which, in turn, is a necessary adjunct of the real economy. The issue of whether the Long-Term Capital Management bail-out is a precedent to be followed or a mistake to be avoided is likely to continue amongst regulators for some time - or at least until the next market shock.