The role of risk management in capital markets

The role of risk management in capital markets

How can organisations strike the right balance between fairness and effectiveness to rebuild public trust in capital markets?

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Head of Banking Risk and Regulation

KPMG in the UK

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The financial crisis unquestionably damaged the reputation of capital markets. Trust has been restored to a degree but if confidence is to be sustained going forward the right balance must be struck between fairness and effectiveness.

In practice, that calls for more transparency for end users, tech-driven efficiencies and greater regulatory alignment globally. To be positive and workable regulation must be informed by industry insights. 

The Fair and Effective Markets Review (FEMR), carried out by HM Treasury, the Bank of England and the Financial Conduct Authority, was undertaken with the aim of raising standards of conduct in the wholesale financial markets. Among the key areas of action identified by FEMR was to strengthen regulation and improve quality and clarity in relation to fixed-income, currencies and commodities (FICC) trading practices. 

One specific outcome of the report was the establishment of the FICC Markets Standards Board. Intended as a collaborative way to “harness the technical knowledge and innovation of market participants, while using the powers available to the authorities to hold firms to their responsibilities”, it is a prime example of how the industry has taken steps to improve conduct and maintain the effectiveness of markets while increasing fairness to participants and end-users. 

Time for action

While regulation has achieved a great deal, the onus is on industry to rebuild trust by improving its operations. In terms of modernisation, the FICC markets lag behind other sectors. Products are often negotiated bilaterally and may contain extremely complex cash flows. There is a lack of standardisation over trade structure, technical clauses and information transparency.

Yet this need for change can be perceived as a positive. There is a great opportunity to establish a ‘new normal’.

Real effectiveness relies on liquidity and the ability to transfer risk. Both can be enhanced with the right technologies and market participants. Nevertheless, if transaction costs become excessive or the flexibility of risk management strategies is impaired, efficient transfer of risk becomes difficult.

Each change initiative must adhere to design principles outlined in the FEMR if market fairness is to prevail. As the LIBOR and FX rigging scandals show, any lack of fairness has widespread damaging consequences, undermining trust in the whole industry.

Thankfully, the FICC industry has already made progress on reform. Increased use of electronic marketplaces and post-trade processing tools have aided transparency. In addition, risk management frameworks have developed in certain areas that were previously overlooked: managing conflicts of interest; segregation of duties; and wholesale conduct risk.

Technological edge

Of course, more needs to be done. Blockchain technology could make a major difference. A platform for payments and settlements already exists. The ideal is to offer services that are fair and effective – and at the same time, profitable.

End-users are ultimately the arbiters of whether the market is fair and effective. It is important to capture their feedback and measure it against performance criteria. Steps might include greater transparency with respect to profit margins; clarity on agency and principal flows; and attestations over codes of conduct. If a new way of doing business is to take root, new standards must be implemented in spirit; not just in form.

As FICC markets are among the most interconnected in the world, global harmonisation is crucial for future success. The FX Global Code developed by the Bank for International Settlements is an excellent example of cross-border consistency. Work of this kind must continue. 

Despite the uncertainties of Brexit, London remains a global financial centre of excellence and its role cannot be allowed to diminish. London must seize the opportunity to cement its position by remaining at the forefront of innovation in the FICC industry.

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