Insights on regulatory and market developments in Australia
A speech by Commissioner Cathie Armour at the Australian Regulatory Summit 2019, Sydney, 4 June 2019
Good morning to you all. Thank you for inviting me to speak.
Let me begin by acknowledging the Traditional Owners’ ongoing connection to and custodianship of the lands on which we meet today, and pay my respects to elders past, present and future.
Today’s conference will discuss how markets are changing – in particular, to adapt to new regulation, technology and innovation.
As a market and conduct regulator, ASIC has a role to play in this changing environment. We care about how these changes impact on financial markets, investors and consumers and more broadly on our community.
In this context it is pleasing to see there are sessions today which focus on just that: what are the outcomes required for investors of the future?
We are just four months on from the release of the Final Report of the Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry. That report highlighted the harms that unlawful and unethical conduct can inflict on consumers and investors.
Now I know that that many of the case studies highlighted at the Royal Commission – say, funeral insurance or car loans – may seem a long way from the work you do or the business of your firms, especially those of you who work in corporate businesses or in wholesale financial markets.
But no matter where your business operates, it is critical that all firms who operate in our financial system conduct themselves in a professional way to produce fair outcomes for their customers. This is key to our joint endeavour – successful businesses which contribute to a robust financial system that serves our community.
Reflecting the lessons from the work of the Royal Commission, at ASIC we have been regularly emphasising the need for professionalism and fairness in our markets. Professionalism as your standard, and fairness embraced and embedded in everything you do.
These imperatives need to be prioritised for there to be meaningful cultural change in the industry. And remember – as Commissioner Hayne emphasised – meaningful change is the ultimate responsibility of financial institutions.
What are the hallmarks of professionalism? Broadly, these are competence – that is, having the right skills – and conscientiousness – that is, caring about other people and acting ethically.
And what about fairness? Fairness is a well-established focus for ASIC – our vision statement is ‘a fair, strong and efficient financial system for all Australians’.
Fairness is also clearly embedded in the law. Section 912A imposes the obligation to act ‘efficiently, honestly and fairly’ on financial services licensees. Fairness also implies even-handedness in dealing with consumers, and sound ethical values and judgment. There are also clear echoes of professionalism here.
The Royal Commission’s examination of misconduct and its causes was framed by four key observations:
- First, the connection between conduct and reward. In most cases poor conduct was driven by the pursuit of profits and gains by firms and individuals. It is apparent that it matters how people get paid and what they are paid to do;
- Second, the asymmetry of power and information between financial services firms and their customers. Customers had a lack of knowledge and understanding and very little ability to negotiate terms;
- Third, the presence of intermediaries who may have appeared to be independent at first glance but were often conflicted in their ability to act in the interests of their customers; and
- Fourth, too often, financial services entities that broke the law were not properly held to account.
So we have taken these observations and incorporated them into the way ASIC approaches its task as market conduct regulator.
As you know, regulators like ASIC use many different tools to do their work. One of these tools is formal enforcement action. ASIC has adopted a ‘Why not litigate?’ stance. This does not mean ‘litigate first’ or ‘litigate everything’. It does mean that where ASIC is satisfied breaches of the law are more likely than not; and the facts of the matter show pursuing it would be in the public interest then we will actively ask ourselves: ‘Why not litigate this matter?’
Now, with the lens of fairness and professionalism, let’s consider some specific topics at the forefront of our minds in market regulation.
First, let me tell you about our enhanced methods of supervision.
ASIC is changing the way we supervise the firms we regulate – adopting an enhanced and more strategic supervisory approach.
Our aim is to promote permanent cultural and behavioural changes in firms individually and across the financial services industry more broadly.
We believe this approach helps detect cultural, organisational and management failings that could lead to conduct problems, breaches of the law and unfair outcomes. Supervision adds a focus beyond current known non-compliance by looking at factors that create significant risk of future breaches.
There are two elements to our new supervision program. The first is called Close and Continuous Monitoring and commenced last October. The hallmark of this program is in-depth supervision of five significant financial firms, being each of the four largest banks and AMP.
- To date, ASIC has conducted over 250 onsite interviews with banking staff at all levels.
- ASIC staff have been onsite in these institutions for more than a total of 95 days since the program was launched.
Already we are providing important feedback to CEOs and other business leaders on concerns we are finding in their management reporting and control systems.
We have also introduced a more tailored enhanced supervisory approach for high risk or complex market intermediaries. These reviews are more intensive and on-site reviews than previous reviews. One of our first thematic reviews was to consider the practices in the foreign exchange businesses of some firms. Once again, we will provide firms with detailed feedback from our reviews.
The second element to our supervision program is our review of corporate governance practices. We are examining the CCM institutions, as well as other financial services firms and selected ASX 100 entities. Key areas of focus are the governance processes and practices on the oversight of non-financial risks and around variable remuneration to key management.
We will report publicly on the corporate governance program – our aim is to highlight better practices and areas of weaknesses to assist listed firms build rigorous governance models.
The Australian crypto-asset market has been relatively quiet this year but this may well change. The first week of April 2019 saw the largest recorded trading volumes in crypto-assets globally in 10 months and many consider it may be the start of a new bull market for crypto-assets.
While the technology surrounding crypto-assets is exciting, we have seen concerning examples of offers for these assets that appear to involve misleading or deceptive conduct, or that are promoted in a way that does not comply with the regulatory framework.
As is common when there is a novel technology or idea that captures people’s imagination, we also continue to encounter many scams involving imaginary crypto-assets.
Last week we updated our Information Sheet 225 on initial coin offerings and crypto-assets to clearly prompt businesses seeking to issue or promote these products to better understand their obligations and obtain the assistance they need to ensure they comply with all relevant Australian laws.
We are also working and sharing information with other domestic and international regulators as they clarify how crypto-assets are regulated across taxation, anti-money laundering, payment systems and financial services.
So my message, if you are issuing a crypto-asset or your business is involved with a crypto-asset, is read and apply INFO 225 so you are clearly distinguished from any scams trying to capitalise on speculative hype around crypto-assets. Scams clearly do not reflect the level of fairness we expect for investors.
High frequency trading
Another technology impact on our markets is high frequency trading (HFT).
High frequency trading is not new but is a continuing example of financial intermediation developed to exploit modern electronic markets. High frequency traders do not invest and have no ongoing interest in the businesses or products of their transactions. They exploit technological advantages in pricing and execution.
On this slide [Slide 2] you can see key statistics about the prevalence of HFT in the Australian equity and Australian–US dollar cross-rate foreign currency markets. These results come from our most recent review published late last year.
You can see that while representing a small portion of market users – less than 0.5% in equities and 2% in the AUD/USD FX – high frequency traders are responsible for a disproportionately large amount of activity: in both markets, a quarter of the turnover. In the equity market, high frequency traders submit 45% of all orders and account for 27% of trades, and in the AUD/USD cross rate across electronic inter-dealer platforms submit 38% of all orders and account for 31% of trades.
Nevertheless, our studies show that high-frequency traders contribute positively to price formation, which benefits all investors in the market. They also provide important liquidity during market stress or peak demand.
The technology arms race appears to be losing its potency. Traders continue to invest in faster and better technologies but now seem to be achieving minimal gains – they are competing for the same signals. They are undertaking less arbitrage and more position taking, with less intraday trading and longer holding times.
We also concluded that the costs imposed on natural users of the market from HFT intermediation continue to decline.
High frequency trading remains an area of interest to ASIC, but we do not consider there is reason to be concerned by the HFT we have observed in these markets. Our reviews of high frequency trading reinforce the strength of the Australian market structure and the importance of having a varied mix of traders and investors in our markets. At this stage, we think the balance of fairness for investors is appropriate.
This month we will publish our most recent review of market cleanliness in the Australian listed equity market.
What is market cleanliness? It is a measure of possible information leakage and likely insider trading before material price sensitive announcements. We measure and monitor market cleanliness because market integrity is fundamental to a fair and efficient financial market. In markets where investors perceive they are at an unfair informational disadvantage they tend to protect themselves by reducing their exposure to the market or demanding a higher return.
The analysis we’ve done is really sophisticated and insightful. We incorporate these insights into our surveillance of the equity markets.
Our main observations from this review are:
- The overall cleanliness of the market in the 2016 – 2019 review period was stable. There was a decrease in the cleanliness of the market in 2016, but this was followed by two consecutive years – 2017 and 2018 – of increased cleanliness.
- On average over the review period, 0.6% of accounts that traded before a material announcement were deemed suspicious. These accounts profitably traded on average 5.1% of the volume before each announcement.
- While the percentage of suspicious accounts remained stable over the period, there volume traded appeared to have increased.
- There was more suspicious trading before announcements related to mergers and acquisitions than other types, however the suspicious trading was generally not accompanied by abnormal price action.
- There was more suspicious trading and abnormal price action before unscheduled announcements than scheduled announcements. Suspicious trading and/or abnormal price action before unscheduled announcements are less likely to be driven by normal speculation than scheduled announcements.
- Announcements by smaller companies are more likely to be unclean. Many of these smaller companies are in the materials sector.
A key takeaway from this study is that those involved in potential M&A activity should put in place robust information security measures as early as possible in the transaction cycle.
We will increase our monitoring of brokers with high concentration of anomalous order flow and clients with repeat patterns of anomalous trading. We are determined to ensure our equity market operates fairly.
Retail OTC derivatives
Let me turn next to the retail OTC derivatives market. We continue to see misconduct in this sector.
This slide [Slide 3] depicts the retail OTC derivatives sector in Australia. It is an active and growing market with an annual turnover of $11 trillion and over 450,000 investors. The products offered by retail OTC derivatives issuers in Australia include binary options, margin foreign exchange and contracts for difference.
Last year we published results of a review that found client losses in retail OTC derivatives trades were high, with the percentage of unprofitable traders being up to 80% for binary options, 72% for CFD traders and 63% for margin FX traders.
Regulators in many jurisdictions (such as Europe, Japan, North America and China) have restricted or prohibited the provision to retail investors of certain OTC derivatives. As there are not similar restrictions in Australia, there is a risk of regulatory arbitrage.
Recently we publicly warned Australian issuers that they may be dealing with overseas investors illegally and to cease any non-compliant activities immediately. There may be consequences overseas for potential breaches of overseas law, but in any event, ASIC will consider whether breaching overseas law is consistent with obligations under Australian law to provide services ‘efficiently, honestly and fairly’. ASIC is also concerned some AFS licensees may be making misleading or deceptive statements about the scope or application or effect of an AFS licence.
ASIC has conducted reviews, enhanced surveillance and taken enforcement action in this sector. We remain concerned about consumer harm with the way these products are offered and structured. We will continue to be active in this sector.
Before I conclude, I want to leave you with a call to action about LIBOR.
As you know, LIBOR, the key international interest rate benchmark, will not continue beyond 2021. LIBOR is deeply embedded in financial markets globally – and is no doubt used by many of you here today.
Australian entities have varying degrees of exposure to LIBOR through their derivatives, loans and investment holdings. You also need to make sure you are aware of any business practices or systems dependencies on LIBOR. The transition away from LIBOR could be complex and may have significant implications on your risk management, operational processes and IT infrastructure. Insufficient preparations for the transition could have a negative impact on your business, clients and the markets in which you operate.
We recently wrote to the CEOs of several major Australian financial institutions regarding their preparations for the end of LIBOR. We are seeking assurance that the senior management in these institutions fully appreciate the impact and risks, and are taking appropriate action ahead of the end of 2021. Professionalism requires nothing less.
I urge you all to assess the extent of your use of LIBOR and to take timely action to plan for a world in which LIBOR is no longer available.
- aware of the size and nature of your exposure to LIBOR;
- putting in place robust fall-back provisions in contracts referencing LIBOR; and
- taking action to transition to alternative rates?
In conclusion, ASIC’s focus is on making Australia’s financial system a fair, strong and efficient one for all Australians. We apply this lens to our work; we expect the firms we regulate to also do this.
Commissioner Hayne acknowledged that fairness ‘may lie at, or at least close to, the heart of community standards and expectations about dealings with customers’. Fairness and professionalism will enhance your business and its success. Most importantly, they will lead to a robust financial system that serves our community well.