FCA Announces Wholesale Market Study Into Investment and Corporate Banking

Following on from its review of competition in the wholesale financial sector announced in July 2014, on 19 February 2015, the Financial Conduct Authority (FCA) published a Feedback Statement announcing plans to conduct an in-depth market study into investment and corporate banking (the Market Study). The Market Study will assess whether competition in relation to certain aspects of investment banking and corporate banking is working properly, with detailed terms of reference to be published in Spring 2015.

Key Points

• The FCA's wholesale financial sector review encompassed four fields: markets and market infrastructure; investment banking; asset management; and corporate banking.
• The FCA has now decided to focus on investment banking and corporate banking for its first in-depth market study following that wholesale review.
• Concerns have been raised in relation to a perceived lack of transparency in the industry, in particular in relation to pricing and bundling. For example, the FCA is concerned that large universal banks may be able to offer low-cost corporate services in an attempt to win lucrative investment banking work, creating an unlevel playing field to others in the corporate banking market.
• A theme likely to develop in this regard will be the extent to which the FCA's Market Study will, or will not, seek to interfere with, or otherwise modify, the universal banking model.
• The FCA may wait until after 1 April 2015 to formally launch this Market Study, given that it will acquire broader concurrent competition powers on this date. These new powers will enable the FCA to conduct market studies under the Enterprise Act 2002 (EA02) or to exercise its existing powers under the Financial Services and Markets Act 2000 (FSMA).
• While the remedies which may be imposed are similar whichever powers are used, there are different procedural requirements and timetables for FSMA and EA02 market studies, which may influence the decision of the FCA.
• The next step following the formal launch of the Market Study will be for the FCA to gather information from a broad set of stakeholders. This process is likely to be onerous for firms, drawing resources away from other "run-the-bank" issues and projects.
• If the FCA concludes that competition is not working well in the identified markets, it may impose market-wide remedies, firm-specific remedies, or make a market investigation reference to the Competition and Markets Authority (CMA), which would entail a further 18-month in-depth investigation (extendable to two years).
• The fields of asset management and markets & market infrastructure are not included in the scope of the Market Study, in light of the wider ongoing regulatory reforms and other policy work that are currently affecting these areas. However, further investigation in these areas may follow at a later date.

Background

The FCA has a statutory objective to promote effective competition in the interests of consumers. In July 2014, it launched a wide-ranging review of competition in the wholesale financial sector, aimed at gathering views on areas that might benefit from further investigation through an in-depth market study. In its "Call For Inputs", issued to stakeholders as part of the review, the FCA outlined four main areas where it considered that there may be competition issues meriting further examination:

• markets and market infrastructure services;
• investment banking;
• asset management; and
• corporate banking.

Following a consultation process (which ended in October 2014), the FCA has now decided to focus on the areas of investment banking and corporate banking for its first in-depth market study following the wholesale review. The FCA says that it has reached this decision due to its concerns over a perceived lack of transparency in the industry, particularly in relation to pricing and bundling. The FCA also considers that the benefits of effective competition in these sectors could be significant. The FCA notes the UK's status as a global hub for investment banking, and refers expressly to the crucial role investment banking plays in the UK economy.

The FCA's Market Study will now form part of the FCA's wider work in the wholesale sector, which includes its input into the Fair and Effective Markets Review. This is the tripartite forward-looking assessment of the way wholesale financial markets operate, designed to reinforce confidence in the fairness and effectiveness of the fixed income, currency and commodities markets, which is due to publish its final recommendations in June 2015. These two work streams, however, will be run separately within the FCA and will have different objectives, despite their both covering wholesale markets.

The scope of the Market Study

The FCA has confirmed that the Market Study will focus on the following issues in relation to investment banking and corporate banking:

• transparency of investment banking and corporate banking services and the ability of clients to assess effectively whether they are getting value for money (including the ability to monitor whether they are getting best execution and the ability of clients to monitor the allocations made and ensure that the allocations are consistent with their wishes); and
• the cross-selling, bundling and tying of investment banking and corporate banking services.

This obviously gives the FCA a wide scope to examine in-depth the operation of the investment banking and corporate banking industries; given the review last year, it seems unlikely that this scope will be narrowed when the terms of reference are published later in the Spring. The concerns expressed by the FCA highlight that the Market Study will go to the heart of the industry, in particular, looking at how core services are provided and how fees are charged. For many operators, any adverse findings produced may well impact on their business model.

It is also notable that this Market Study will not only focus on activities that are within the FCA's regulatory perimeter, but may also include activities that are otherwise outside of the FCA's scope, such as corporate lending, if such activities might affect the functioning of the market. Non-regulated firms and/or non-regulated activities may therefore also be affected by any remedies ultimately imposed, depending on which legal basis the FCA uses to conduct the Market Study (see further below), and the precise scope of the terms of reference to be published in Spring 2015.

Key Areas of Concern Identified by The FCA

(a) Bundling and Cross-selling
The FCA acknowledges that investment and corporate banks bundle products and services "for efficiency reasons". However, it has raised concerns that there may be a detrimental effect on consumers where the power of a provider in relation to one aspect of the bundle excludes competitors. Key here is the concern that large universal banks can offer low-cost corporate services in an attempt to win lucrative investment banking work, creating an unlevel playing field to others in the corporate banking market. A theme likely to develop in this regard will be the extent to which the FCA's Market Study will, or will not, seek to interfere with, or otherwise modify, the universal banking model.

Respondents to the FCA's Call For Inputs also complained about:

• transparency of pricing in bundled services;
• the assessment of the quality provided in bundled services; and
• the barriers of entry to market for independent providers who cannot provide bundled services.

The FCA considers that providing services in a bundled package may distort the market by enabling some of the services to be provided at below cost prices. The FCA is concerned that such bundled packages are offered by an investment bank in anticipation of receiving future mandates for other services, such as the provision of corporate broking services "free of charge" or at a lower cost in the hope of obtaining future equity capital markets work. This example is cited by the FCA as justification for the Market Study, noting that "once the customer is locked-in (if switching costs are perceived to be high), excess profits can be made on further services sold to the customer". One of the FCA's key concerns is that institutional clients are overpaying for investment banking or corporate banking services, which may ultimately impact investment decisions and be passed on to retail clients.

Bundling has obviously been a key theme in a number of regulatory areas recently. MiFID II is addressing some of the issues that have arisen from investment firms' bundling of products and services, and is implementing new requirements in this area. For example, MiFID II requires firms to inform clients whether it is possible to buy bundled services separately, to provide separate evidence of costs and charges of each component, and to separate payment for research from payment for execution services. However, the FCA makes clear in its Feedback Statement that these regulatory changes do not undermine its case for conducting the Market Study.

(b) Equity and Debt Issuance
Feedback received by the FCA on competition issues arising in connection with debt and equity issuance services was apparently largely split. Many respondents felt that this area had already been sufficiently investigated by the Office of Fair Trading's market study on equity underwriting conducted in 2011, but others appear to have raised concerns about fees, conflicts, and the benefits and pitfalls of syndication.

The FCA indicates in the Feedback Statement that it remains concerned about the effect of bundled services, fees and the limited control that issuing companies have over who invests when new securities are issued or placed. Syndication is also identified as a potential issue. While the FCA accepts that it is not clear whether syndication actually leads to better or worse outcomes for competition or clients, it considers it to be an area that could benefit from further investigation.

The FCA also raises concerns regarding situations where inadequate advice is given, which leads to a client paying too much for a target company or an IPO's pricing being set at the wrong level. Similarly, the FCA notes that conflicts of interest may arise during share allocations leading to an investment bank favouring its prime brokerage or hedge fund clients when allocating shares. The FCA has chosen to highlight this perceived issue in the press release accompanying the Feedback Statement.

(c) Best Execution
Perhaps surprisingly, the FCA's summary of the feedback it received in relation to best execution is relatively brief, despite this being the topic arguably most affected by other recent regulatory developments. Respondents apparently made it clear that the FCA should allow time for the industry to take into account the FCA's thematic review on Best Execution and Payment for Order Flow that was published in late 2014, particularly since regulatory obligations arise in this respect. In addition, MiFID II introduces further obligations on investment firms when executing client orders. Despite these recent changes, the FCA has included best execution in the first limb of its Market Study and will examine, in particular, whether firms are able to monitor effectively whether they are achieving best execution. The FCA has noted that, despite best execution rules being in place, brokers may still execute orders to maximise their gains, rather than act in the best interests of clients. The FCA considers that this issue may arise as a function of:

• the high cost of accessing multiple trading platforms to achieve best execution;
• the value to brokers of orders that are not executed at the best price; and/or
• the difficulties that clients face in monitoring best execution.

Asset Management and Market Infrastructure Excluded From the Market Study

The FCA makes clear in its Feedback Statement that while it has chosen to prioritise the corporate and investment banking sectors for its first market study following its wholesale financial sector review, it considers certain aspects of asset management and market infrastructure to be potential candidates for formal market studies at a later date, once the impact of ongoing regulatory reforms and policy work becomes clearer.

Asset managers should therefore bear in mind that the following issues are "on the FCA's radar" for potential further investigation in the future:

• the difficulty which some institutional investors have in negotiating fees and monitoring asset managers;
• the role of investment consultants and potential conflicts of interest arising from the provision of advice and asset management services;
• the incentives and ability of asset managers to control costs incurred on behalf of investors along the asset management value chain; and
• the bundling of some ancillary services and the quality of some services provided.

Similarly, in respect of markets and market infrastructure providers, the FCA has identified the following areas which may benefit from further investigation through a future market study:

• the extent to which data and licences are provided on a fair, reasonable and transparent basis;
• the effect of the vertical silo model on competition and whether stand-alone providers can compete effectively;
• whether all market participants who require clearing services are able to obtain them on a fair, reasonable and transparent basis; and
• whether co-location services are being provided on a fair, reasonable and transparent basis.

However, these issues are heavily impacted by European Directives, such as the AIFMD, MiFID II, and EMIR. We consider that, until these initiatives are fully embedded, it will be difficult for any regulator to distinguish any ongoing and unresolved competition issues in the industry that will remain unaddressed by the incremental and continuing impact of these regulations.

Next steps: timetable and procedure

The Feedback Statement states that the terms of reference for the in-depth Market Study will be published in "Spring 2015". No further details are given, but it may well be that the FCA will wait until after 1 April 2015 to formally launch this Market Study, given that it will acquire broader concurrent competition powers on this date. These new powers will enable the FCA to conduct market studies under the EA02 or to exercise its existing powers under FSMA. There are different procedural requirements and timetables for FSMA and EA02 market studies, which may influence the decision of the FCA as to whether to pursue a FSMA or EA02 market study in this case.

In particular, if the FCA chooses to pursue the Market Study under its EA02 powers, then it will be subject to statutory deadlines, which would require it to complete the Market Study within 12 months of it formally being launched. The FCA would also be required to reach a preliminary view and make a proposal as to whether or not to make a market investigation reference (for a further 18-month in-depth market investigation by the CMA) within six months, and consult interested persons on its proposed decision. Alternatively, if the Market Study is carried out under the FCA's FSMA powers, its current guidance states that it will aim to publish its final report within six to 12 months from the formal launch of the Market Study, but this is not a legally binding deadline.

The powers of the FCA to gather information will also vary depending on whether the Market Study is conducted under its FSMA or EA02 powers. Under the EA02, the FCA has broader powers to request information from firms it does not regulate under FSMA. However, this advantage must be weighed against the possibility that the binding statutory deadlines applicable to an EA02 market study may limit the amount of information the FCA can gather in the time available, as well as the extent of the analysis it can carry out before deciding whether or not the market should be referred to the CMA for further investigation (as expressly recognised in the FCA's consultation on its draft competition concurrency guidance, published in January 2015).

At this stage, it is unclear whether the FCA intends to carry out the Market Study using its FSMA or EA02 powers. Its draft guidance on its concurrent competition powers states that it will make such decisions "on a case-by-case basis", and no clear indication is given in the Feedback Statement or related press releases. However, the position should be clarified when the terms of reference are published in due course.

In either case, the next step following the formal launch of the Market Study will be for the FCA to gather information from a broad set of stakeholders. The FCA will expect firms to provide it with information on a voluntary basis, but it also has formal powers with which it can gather information under both FSMA and EA02. This process is likely to be onerous for firms, drawing resources away from other "run-the-bank" issues and projects.

Potential outcomes

It is, of course, difficult to predict at this early stage what the outcome of the FCA's Market Study will be, particularly as the precise scope of the Market Study is yet to be defined. However, the FCA will have a range of options available to it if it concludes that competition is not working well in the identified markets and that remedies are required to address the problems. These will be similar whether the Market Study is carried out under the FCA's FSMA powers or its new EA02 powers.

The FCA may decide to impose market-wide remedies, including changing or potentially withdrawing existing rules, publishing general guidance, or proposing enhanced industry self-regulation. It may also pursue firm-specific remedies if appropriate, including using own initiative variation powers or own initiative requirement powers, cancelling permissions, public censure, and/or even imposing financial penalties. The FCA has already shown itself to be willing to tackle competition concerns arising from market studies using its own powers (as seen, for example, in its provisional remedy proposals in the Retirement Income Market Study, published in December 2014).

Alternatively, the FCA may decide to refer the investment banking and/or corporate banking markets to the CMA for an in-depth market investigation. The FCA may also accept remedial undertakings in lieu of such a reference, although it has stated that it expects to accept such undertakings rarely in practice. It is important to note that the FCA has the power to make a market investigation reference to the CMA whether or not it has carried out the Market Study using its EA02 powers, provided that the legal criteria for making a reference are met (namely, that the FCA has reasonable grounds to suspect that any feature, or combination of features, of a market or markets in the UK for the supply or acquisition of financial services prevents, restricts or distorts competition).

In the event that a market investigation reference is made to the CMA, the further in-depth investigation would be required to be completed within 18 months (extendable to two years if the CMA considers there are special reasons for doing so).