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FMIs will have to do more self-regulation under Bank of England plans

FOCUS: Companies involved in financial market infrastructures (FMIs) will have to engage in more self-assessment and will have to more carefully consider how their businesses are structured under new regulatory plans published by the Bank of England.09 Jan 2013

The Bank has published its plans for the regulation of FMIs, which are sets of rules, contracts or processes designed to manage, reduce and allocate the risk arising from transactions undertaken by financial institutions.

FMIs are operated by commercial organisations but the Bank said that the top priority of those running FMIs must be market stability. Many FMIs are effectively monopolies so regulation is needed to protect the whole market, it said.

The Bank has published (18-page / 3.6MB PDF) a consultation document on how it plans to regulate FMIs from 1 April when responsibility for that regulation passes to it from the Financial Services Authority. That transfer will happen on the enactment of the Financial Services Bill.

The Bank said that the regulatory regime is based on international standards drawn up by central banks and securities market regulators working through the Committtee on Payment and Settlement Systems (CPSS) and the International Organization of Securities Commissions (IOSCO) in their joint document Principles for Financial Market Infrastructures (188-page / 1MB PDF).

Under these plans companies running FMIs will have an increased responsibility to participate in their own regulation. The Bank emphasised in the document that this is not self-regulation, but that companies will have increased responsibility for policing themselves.

"Supervised institutions themselves will have full and primary responsibility for satisfying the minimum standards in the CPSS-IOSCO Principles, and the various regulatory requirements in EMIR, the prospective CSDR, associated binding technical standards and UK recognition requirements," said the Bank's proposal. "Consistent with that, the Bank will expect FMIs to complete their own self-assessments against the Principles, and provide these to the Bank."

"FMIs will be expected to review their self-assessment at least annually, and alert the Bank to any material changes that occur between such reviews. This self-assessment will be an important test of FMIs’ ability and willingness to demonstrate their understanding of, and commitment to, risk objectives. For example, a self-assessment which paints an overly optimistic picture of an FMI against risk standards, or takes too narrow a view, may indicate that inadequate priority is being given to those standards, weaknesses in risk management, or the management and board’s misunderstanding of the standards," it said.

"Self-assessment does not, however, mean self-regulation. The FMI’s self-assessment will not replace the Bank’s own judgement, but will be used as one input to the Bank’s assessment. It will be viewed as indicative of the FMI’s own risk tolerance and risk management capability," the Bank's proposal said.

This means that FMIs will need to thoroughly review their existing arrangements to ascertain any potential risk areas. The annual requirement to self-assess compliance with the CPSS-IOSCO Principles will provide additional challenges to internal compliance arrangements.

FMIs should also be concerned about the fact that the Bank will make judgments on what it thinks will happen and regulate accordingly.

"The focus of Bank supervision will go beyond assessing compliance with rules and requirements. The Bank will seek to reach forward-looking judgements on whether an FMI’s governance, operational design, policies or actions pose unacceptable risks to financial stability objectives," the Bank said. "Where the Bank judges such risks unacceptably high, it will expect the FMI to take action to reduce them."

Despite the fact that the 'test of materiality' will be high, meaning that the Bank will only take action where a situation is very serious, organisations need to be aware that regulatory intervention could be based on the Bank's view of future risks.

Under these proposals the Bank's aim will be to ensure that organisations balance their commercial needs with the needs of the market for fair and transparent mechanisms for administering systems such as central counterparty (CCP) systems and securities settlement systems.

"If FMIs are operated only in the private interests of their managers, owners, or even their members, they may under-invest in the mitigation of risks to the wider system. The Bank’s role as supervisor is to ensure that the infrastructures are managed in a manner that is consistent with the public interest including reducing systemic risk," it said.

"It is important that the Bank’s and other authorities’ encouragement for the development and use of financial market infrastructure to [increase the use of CCP systems] does not create a new class of too-important-to-fail institutions. In assessing FMIs’ risk management, recovery and resolution plans, the Bank will therefore seek to ensure that FMI management planning takes proper account of protecting the system as a whole, and, to that end, that sufficient priority is given to continuity of key services, without systemic disruption and without recourse to public funds," it said.

"Responsibility for each FMI’s design and operation sits firstly with the board and the management of the firm that manages the FMI," said the proposal. "Section 4 explains how the Bank’s supervisory approach, and the practical application of its supervision, will therefore be centred on an expectation that the board and managers of FMIs take full responsibility for managing the infrastructure in a manner that protects the stability of the FMI and with regard to the financial system as a whole. The Bank’s aim is to establish a framework that creates incentives for the operators of FMIs to manage and mitigate systemic risk."

This approach makes sense, but it will require some difficult calculations from FMIs. They are going to be asked to produce "convincing evidence" that non-core services don’t materially distract the FMI’s board or management from its core services or risk management objectives.

This seems very subjective and will be particularly intrusive to the business models of a number of FMI’s. In some cases, it may be difficult to separate core and non-core services from existing services provided to participants.

Though the Bank has asked for feedback on its plans there is little time and major change is not likely ahead of the implementation date of 1 April. FMIs must do what they can to put systems in place that meet the Bank's demands but should closely monitor points at which regulation has an impact on commercial priorities.

Tony Anderson, Michael Lewis and Angus McFadyen are members of the payments and financial products team at Pinsent Masons, the law firm behind Out-Law.com

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