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Chapter 1 2 5 11 The UK financial services industry – a European and global context The ﬁnancial services industry and the role of government The impact of EU directives on the investment industry European Market Infrastructure Regulation .
Figure 1. on this sector. most forms of capital-raising and saving involve financial intermediaries. and by minimising the costs for borrowers in relation to the number of savers that would otherwise have to be approached and to the variety of terms that they would demand. we provide an overview of the financial services sector and examine the impact of the international environment. ensuring the adequate provision of information. This is followed by a discussion of European moves to harmonise financial services. including economic and industrial policy. particularly Europe. The method of implementation of EU directives is then outlined. Evaluate the role and impact of the main ﬁnancial institutions. you should be able to: Explain the functions of the ﬁnancial services industry. Financial intermediaries significantly reduce information and transaction costs in the economy – by providing suitable services and products for savers to become investors.cfauk. before two of the main directives affecting the investment sector are considered in some detail – namely the Markets in Financial Instruments Directive (MiFID) and the directive on Undertakings for Collective Investment in Transferable Securities (UCITS). Financial intermediation. The financial services sector provides four core functions in an economy: 1. regulation. A financial system provides the mechanisms for channelling funds from savers to those who need to borrow funds. Savers can supply funds directly by holding the debt and equity securities issued by borrowers (the dotted lines) or they can supply funds via an intermediary such as bank or investment institution (the unbroken lines). 2 www.org .Chapter 1 The UK financial services industry – a European and global context In this chapter. Explain the role of government. taxation and social welfare. While there can be circumstances in which direct financing through capital markets is appropriate.1 overleaf illustrates some of the main flows that take place in a financial system. We introduce the role of the financial services sector and briefly outline the role of government in the economy. Chapter 1 Section 1 The ﬁnancial services industry and the role of government Section aims By the end of this section.
transmitted and received.org . Insurance allows individuals and companies with a risk exposure to transfer this to the insurance company in return for payment of a fee. Insurance companies. and a vehicle through which individuals can save. This transfer of responsibility for selecting borrowers to an institution allows pooling and more efficient management to take place.cfauk. Pooling and managing risk. The financial services sector provides mechanisms that allow the efficient management of risk. Increasingly. Pooled investment products such as unit trusts. 4. Investment companies. Similarly. They perform an intermediation function themselves. the banking sector interacts with the securities markets to raise capital (rather than relying on retail deposits) or to invest in those markets. Portfolio management.1: Capital ﬂows Borrowers Banks Debt markets Equity markets Other investment institutions Insurance companies Pension funds Savers Banks – and other credit institutions. Derivatives. unit trusts and investment trusts) also perform an intermediation function by collecting funds from savers and investing those funds in securities issued by borrowers – equities and bonds. also allow investors and borrowers to manage their risk exposures. pension funds and other investment institutions or vehicles (such as OEICs. The financial system provides the mechanisms for money and other financial assets to be managed. insurance or derivative products. companies and other borrowers. Payments and settlement services. also purchase the securitised assets of banks. such as insurance companies. 3. The financial system allows investors to manage their wealth through access to financial markets. This could be through pooled investment funds. 3 www. 2. specialist advice and investment management services.Section 1 The financial services industry and the role of government Figure 1. corporate pension funds pool the contributions of participants. open ended investment companies (OEICs) and investment trusts allow savers to pool their funds with other savers and so invest in a wider variety of investments. Securities have grown much faster than bank deposits as a share of total financial assets in recent years. such as options and futures. therefore reducing an individual’s overall risk exposure. such as building societies – have traditionally been a key source of finance for individuals.
Industrial policy may involve grants and subsidies to promote certain sectors considered worthy of support. and investment banks. Life insurance deals with death. mutual funds and pension funds. underwriters and mergers’ advisors. etc. savings institutions accept deposits and make loans. house. or unit trusts and investment trusts. 4 www. or for which the market does not punish externalities such as pollution (and hence carbon taxes. Mutual funds. Investment institutions are also intermediaries. 2 The role of government Broadly speaking. which act as brokers. First is the production of services which private firms are either unwilling to produce or for some reason are not allowed to produce (or at least not exclusively). which then lend on these funds as direct loans or investments. which offer financial services as well as traditional deposit and lending facilities. the banking sector contains a wide range of different types of banks. Insurance companies act to offer protection against the occurrence of unfortunate events in exchange for a premium.org . Deposit institutions accept deposits from economic agents. and investment institutions. are also important collective savings vehicles. government regulations may also include banning dangerous chemicals. Financial intermediation involves the transfer of funds between surplus and deficit agents: we distinguish here between deposit-accepting institutions. such as banks and savings institutions. General insurance companies will tend to hold shorter term assets reflecting their more immediate need for cash. ensuring drug safety standards.g. including universal banks. whereas general insurance involves loss or damage to property. Like banks. The different nature of life and general insurance is reflected in their different investment strategies. Pension funds are now significant institutional investors in many countries. governments essentially perform four functions. Life insurance policies tend to cover longer periods and so insurers tend to hold longer term assets reflecting the longer term nature of their liabilities. promoting food and hygiene standards. tobacco taxes). This is often referred to as ‘market failure’. ‘green’ activities). However. such as bonds and equities. such as insurance companies. etc. Of course.Chapter 1 The UK financial services industry – a European and global context 1 Institutions There are a wide range of financial intermediaries linking savers and borrowers. although they usually operate under different rules to banks. maintaining road and air safety. This public provision includes defence. and for which the market may not provide a satisfactory solution (e. These institutions include commercial banks and building societies. law and order and investment in roads. The central bank is a key financial institution that is involved in setting the monetary framework within which both the economy and financial institutions operate (see chapter 24). car. but unlike banks they invest the funds they raise in tradable securities.cfauk. Here we briefly review the main institutions in an advanced financial system. especially with falling state pension and an aging population. illness and retirement policies. The deposits become liabilities of these institutions.
Redistribution of income and wealth is also a policy of most governments. In many economies today. Chapter 1 Section 2 The impact of EU directives on the investment industry Section aims By the end of this section. A major development 5 www. principally to protect the consumer. emphasis is placed on controlling inflation by using interest rates. This includes regulation to promote competition. the role of this institution is covered in more detail in chapter 24. The fourth function is the stabilisation of the economy by attempting to reduce fluctuations in income and employment and to control movements in the general price level. In the UK. you should be able to: Explain the legal status of EU directives within the UK Explain the purpose and scope of the Markets in Financial Instruments Directive (MiFID) with respect to: Passporting Roles of the home and host state Core and non-core investment services Financial instruments covered by the legislation Explain the purpose and scope of the UCITS Directive 1 Harmonisation of financial services i n Europe There have been a number of measures taken by the European Union aimed at the harmonisation of company and financial services laws of the member states. In 2008/09. and this will often be achieved through transfer payments to households – for example. This is part of the ‘project’ of promoting a single market in the European Union. for example.Section 2 The impact of EU directives on the investment industry The second function is the regulation of firms. to prevent fraud. a minimum wage guarantee.org . state pension payments and other welfare payments. we also saw many governments intervene to stabilise the financial system through capital support for distressed financial institutions. The third function is to intervene in the distribution of income generated by private market transactions in order to conform to some criterion of equity. In the UK. This is covered in more detail in chapter 5.cfauk. this is carried out by the Bank of England. etc. Governments also attempt to regulate markets through restrictions on entry into the market and rules governing behaviour in markets. the Financial Conduct Authority (FCA) plays the main role in regulating financial markets. Taxation is also used to achieve a better distribution of income among the population.
thereby making markets more efficient and reducing the cost of raising capital to industry generally. markets and insurances and pensions respectively – were established. chaired by Baron Alexandre Lamfalussy. Since 1999. The controls they must apply to counter the risk of money laundering and terrorist financing. It consists of 42 measures. It comprises a four-level procedure that speeds up the legislative process. including 24 EU directives to be transposed into the law of each member state.org . the European Union has adopted or updated requirements concerning. among other things: • • • • • • The amount of capital which firms should hold. The Alternative Investment Fund Managers Directive is also currently under discussion – this affects regulation of hedge funds and private equity. Since its formation. These objectives are designed to promote Europe’s wider economy by removing barriers and increasing competition among financial services firms. To achieve open and secure retail markets. The tests to apply when assessing the suitability of new controllers or large shareholders. The rules they must comply with when carrying on business with their customers. a number of FSAP measures have been adopted using this new process – the first directives to be adopted in line with this approach were the Market Abuse Directive and the Prospectus Directive. the Lamfalussy approach. the fundamental review of the capital adequacy regime for the European insurance industry. To create state of the art prudential rules and structures of supervision. The disclosures which companies must make when seeking new capital. is currently being developed through the Lamfalussy framework.cfauk. On 1 January 2011. The Committee of European Securities Regulators (CESR) was also established at this time. and regulations. three new European authorities for the supervision of financial activities – for banks. The arrangements also make provision for legislation to be modified as required to keep pace with market and supervisory developments.Chapter 1 The UK financial services industry – a European and global context in relation to financial services harmonisation within the EU occurred in 1999 when the Financial Services Action Plan (FSAP) was launched. Their establishment followed a review of financial market regulation after the financial 6 www. which apply directly in all member states. The FSAP has three specific objectives: • • • To create a single EU wholesale market. The requirements they must impose to counter the risk of market abuse. Completion of the FSAP within a tight deadline was accompanied by a new legislative approach to developing and adopting EU financial services legislation. and Solvency 2. The approach is based on the recommendations of the Committee of ‘Wise Men’. The Markets in Financial Instruments Directive (MiFID) (covered below) and the Transparency Directive also followed this approach. It divides the legislation into high level framework provisions and implementing measures.
ESMA may be asked for technical advice by the Commission as it develops its legislative proposal. A new supervisory role (in particular for credit rating agencies). The ability to launch a fast track procedure to ensure consistent application of EU law. It will work in close cooperation with the new European supervisory authorities. Monitoring systemic risk of cross border financial institutions. if need be. This is described below. Level 1 directives and regulations continue to set out the high level political objectives on the area concerned. Its main powers are: • • • • The ability to draft technical standards that are legally binding in EU Member States. surveillance and supervision were not effective in time.cfauk. The European Securities and Markets Authority (ESMA). 2. 3. transparency. The ability to enter into administrative arrangements with supervisory authorities. The European Securities and Markets Authority (ESMA) aims to ensure the integrity. These will not replace national supervisory authorities. However. arbitration between national authorities. The aim is to create a network of authorities where the national authorities are responsible for daily surveillance. The European Insurance and Occupational Pensions Authority (EIOPA). Additional responsibilities for consumer protection (including the ability to prohibit financial products that threaten financial stability or the orderly functioning of financial markets for a period of three months). while the European authorities are responsible for coordination. while day-to-day supervision will continue to be carried out by national supervisory authorities. Emergency powers. operates. contributing to the harmonisation of technical rules applicable to financial institutions. ESMA will work at a high level setting standards. efficiency and orderly functioning of securities markets in Europe.org . The European Systemic Risk Board (ESRB) will monitor the entire financial sector to identify potential problems which could contribute to a crisis in the future. the coordination between national authorities was far from optimal.Section 2 The impact of EU directives on the investment industry crisis of 2007/08. Occasionally. and when transnational financial institutions faced problems. ESMA has been given a greater role in Level 2 in drafting what can be considered 7 www. international organisations and the administrations of third countries. introduced under the Lamfalussy approach. as well as enhancing investor protection. Participating in Colleges of Supervisors and on-site inspections. The crisis highlighted the failings of the supervision system in Europe: the accumulation of excessive risk was not detected. • • • • • In general. monitoring and. New powers in resolving disagreements between national authorities. at this early stage. The European Banking Authority (EBA). The new EU supervisory system has resulted in some changes regarding how the fourlevel legislative procedure. The three new European supervisory authorities are: 1.
or the implementing legislation does not properly comply with the terms of the directive. for example setting out what authorisation information firms must provide to competent authorities. Financial market participants can also be required to report publicly whether they comply. The Commission will also be able to follow its usual procedures for referring a case against the Member State to the Court of Justice. efficient and effective supervisory practices within the European System of Financial Supervision. ESMA will also take other steps under Level 3 to ensure supervisory convergence.Chapter 1 The UK financial services industry – a European and global context subordinate acts (known as delegated acts and implementing acts). templates and procedures for communicating information or processes between competent authorities. to comply with them. while implementing acts are similar to executive measures. giving effect to the substantive requirements. ESMA can be requested to launch an enquiry and can issue a recommendation addressed to the national authority within two months of launching its investigation.cfauk. While not legally binding. Council. They are different from directives. ESMA will develop guidelines and recommendations with a view to establishing consistent. Regulations are the most direct form of EU law . the court should interpret the law in such a way as to achieve the result required by the directive. Commission or the Stakeholder Group. This latter method may only alter a statute in so far as it is necessary to implement the directive. On this basis. At the request of a national competent authority.as soon as they are passed. This means that between a member state and a company or individual. this does not apply. Between two companies and/or two individuals (known as the horizontal direct effect). the European Parliament. the programme of harmonisation consists mainly of a series of directives issued under article 58 of the European Treaty. At Level 4. which are addressed to national authorities. Problems can arise when a directive has not been implemented by the due date. ESMA will also be able to launch investigations on its own initiative. the provisions of the directive must be given precedence over national law. 8 www. if necessary. involving particular authorities or individuals. Delegated acts are concerned more with the substantive content of the legislative requirement. on a par with national laws. and to ensure the common. standard forms. and by the Commission alone. These directives require member states to amend their law. and decisions. which apply in specific cases only. in applying national law in this situation. uniform and consistent application of Union Law. This might include.org . 2 The legal status of EU directives within the UK In general. the European Court has held that the directives have a vertical direct effect. In such cases. At Level 3. However. a fast track procedure has been introduced by the regulation establishing ESMA. or by the more recent tendency of delegated legislation under section 2(2) of the European Community Act (1972). they have binding legal force throughout every Member State. who must then take action to make them part of national law. for example. The guidelines and recommendations are addressed to competent authorities or financial market participants. ESMA now has a new role. Regulations are passed either jointly by the EU Council and European Parliament. these have been strengthened under ESMA and competent authorities must now make every effort to comply and must explain if they do not intend to comply. Directives can be implemented by primary legislation.
a company. may follow the rules of the ‘home state’ in which it is based.Section 2 The impact of EU directives on the investment industry 3 The Markets in Financial Instruments Directive (MiFID) One important objective of such a harmonisation of trade has been to give firms the right to trade financial services throughout the EU on the basis of a single authorisation ‘passport’ from their home regulator. if a firm only performs ancillary services. This reverses the 1993 ‘host state’ rule requiring compliance with rules of the member state in which business is done. MiFID: • • • Upgrades advice that involves a personal recommendation to a core investment service that can be passported on a stand-alone basis. which was implemented in the UK in November 2007. but it makes significant changes to the regulatory framework to reflect developments in financial services and markets since the ISD was implemented. Clarifies that operating a multilateral trading facility (MTF) is covered by the passport. it is subject to MiFID in respect to both these and also ancillary services (and it can use the MiFID passport to provide them to member states other than its home state). If a firm performs investment services and activities. MiFID widens the range of ‘core’ investment services and activities that can be passported. However. ‘host states’). Under MiFID. 9 www. The Investment Services Directive (ISD) created a ‘single passport’. Execution of orders on behalf of clients. Underwriting in respect of issues of any financial instruments and/or the placing of such issues on a firm commitment basis. Investment services and activities are: • • • • • • • • Reception and transmission of orders in relation to one or more ‘financial instruments’. whether offering services in another member state through a branch or cross-border.e. In addition to the services covered by the ISD. the ‘home state’) may engage in investment services throughout the European Economic Area (EEA) without separate authorisation by other member states (i. The placing of financial instruments without a firm commitment basis. The passport only allows a firm to provide in a host member state those investment services that have been authorised by that firm’s home member state authority. Dealing in any financial instrument for an investment firm’s ‘own account’. a parallel development has focused on harmonising key prudential standards. The operation of multilateral trading facilities.cfauk. Extends the scope of the passport to cover commodity derivatives. including market making and principal dealing. it is not subject to MiFID (but nor can it benefit from the MiFID passport).e. The making of personal recommendations. Managing portfolios of investments in financial instruments. To ease doubts about the rigour of home country regulation. The ISD has been superseded by the Markets in Financial Instruments Directive (MiFID). MiFID distinguishes between ‘investment services and activities’ and ‘ancillary services’. credit derivatives and financial contracts for differences for the first time. under which an authorised firm incorporated in one member state (i. Firstly.org . MiFID has the same basic purpose.
This follows from the UK’s obligations under the EU directive on Undertakings for Collective Investment in Transferable Securities (UCITS). industrial strategy and related matters. The FCA is responsible for recognising a scheme under UCITS.e. safekeeping and fund administration. UCITS III is split into two parts: the Management Directive and the Product Directive. and puts in place a combined investment limit on all of a fund’s exposure to any one group of companies. while introducing additional features such as performance figures. Investment research and financial analysis or other forms of general recommendation relating to transactions in financial instruments (introduced by MiFID). and which is authorised in any member state of the EU. 10 www. can be marketed without further authorisation in any other member state subject only to the local marketing laws. Under this 1985 directive. and advice and services relating to mergers and the purchase of undertakings. Services relating to underwriting. and investment in other funds. including custodianship and related services such as cash/collateral management (extended definition from ISD 1). which is an entirely new document that is designed to provide investors with a shortened ‘core’ version of the current prospectus. are: • Safekeeping and administration of financial instruments for the accounts of clients.org . Investment services and ancillary services related to the underlying of derivative instruments covered by MiFID. 4 The UCITS directives The FCA gives ‘automatic’ recognition to certain collective investment schemes constituted in a member state of the EU other than the UK. ‘MiFID II’ is currently being prepared to extend the scope of MiFID. and the current prospectus will still be available for all investors. The directive also aims to protect investors by ensuring that management companies are suitably capitalised. The Management Directive increases the scope of management companies’ activities that can be passported to include discretionary management. Foreign exchange services where these are connected to the provision of investment services. Advice to undertakings on capital structure.Chapter 1 The UK financial services industry – a European and global context Ancillary services. services falling outside the scope of MiFID. and that they have appropriate measures in place for risk management and reporting. a collective investment scheme which complies with its conditions. • • • • • • A further directive. The original UCITS Directive (termed UCITS I) was amended in 2002 by a new directive which has come to be known as UCITS III. i. where the firm granting the credit or loan is involved in the transaction. Granting credits or loans to an investor to allow the investor to execute a transaction. The simplified prospectus does not replace the current prospectus. The Product Directive expands the range and type of financial instruments that are permitted within UCITS funds. The directive also introduces the simplified prospectus. in particular allowing investment in derivatives for investment as well as for existing risk reduction purposes (subject to certain risk controls). The directive also increases the investment limits for particular types of financial instruments.cfauk.
EMIR imposes three new requirements on those who trade derivatives: (1) To clear OTC derivatives. The Regulations repeal provisions in UK domestic law which are either inconsistent with EMIR or are no longer required. by the end of 2012. central counterparties and trade repositories. Introduction of master feeder structures to permit asset pooling. Replacement of the simplified prospectus with a key investor information document (see chapter 7. that have been declared subject to the clearing obligation. the Regulations are intended to ensure that EMIR is fully effective and enforceable in the UK. UCITS V is currently being prepared. The regulation requires anyone who has entered into a derivatives contract to report and risk manage their derivative positions. In the UK. It implements the Group of Twenty’s (G20) commitment to have all standardised OTC derivatives cleared through a central counterparty in the European Union (EU). (3) To report derivatives to a trade repository. The G20 commitment was made following the 2008 financial crisis. A procedure for cross-border fund mergers. section 4 for more information).org .Section 3 European Market Infrastructure Regulation A new UCITS Directive (UCITS IV) was implemented in July 2011. A new notification procedure for cross-border marketing. The main changes in the UCITS IV directive include: • • • • • • A passport for management companies (which will be subject to prudential and conduct of business measures broadly similar to those in MiFID). Strengthening of supervisory co-operation. Reporting to Trade Repositories and Requirements for Trade Repositories and Central Counterparties came into force on 15 March 2013. Chapter 1 Section 3 European Market Infrastructure Regulation The European Market Infrastructure Regulation (EMIR) came into force on 16 August 2012 and covers over-the-counter (OTC) derivatives. The technical standards on OTC Derivatives. 11 www. By doing so. through a central counterparty (CCP). The regulations came into force on 1 April 2013. HM Treasury have implemented EMIR through The Financial Services and Markets Act 2000 (Over the Counter Derivatives. (2) To put in place certain risk management procedures for OTC derivatives transactions that are not cleared.cfauk. Central Counterparties and Trade Repositories) Regulations 2013.
insurance or reinsurance undertaking.org . The clearing and risk management obligations apply to certain non-financial counterparties while the reporting obligation applies to all of them. A financial counterparty is any investment firm. The details of the three requirements are set out in section 7 of chapter 2 of this manual. institution for occupational retirement provision or alternative investment fund managed by an alternative investment fund manager.Chapter 1 The UK financial services industry – a European and global context All three obligations apply to financial counterparties. credit institution. A non-financial undertaking is any other undertaking established in the EU.cfauk. UCITS or UCITS manager. 12 www. A non-financial counterparty (in relation to a particular class of derivative) is one whose position has exceeded the threshold set for that class of derivatives by the Commission.
including the public provision of certain goods (e. In many economies. MiFID enables an investment firm established in one member state to operate throughout the European Economic Area without separate authorisation by the member states in which it does business. regulation of markets to protect consumers. such as banks. 3. this role is often delegated to an independent central bank. (ii) By delegated legislation under section 2 of the European Communities Act (1972). pooling and managing risk.2 1. European Union directives are issued under Section 58 of the European Treaty and have to be complied with by all member states. Method (ii) is now more commonly used. and investment institutions. 13 www. 3. The aim of a directive is the harmonisation of laws across member states. defence). 5.Chapter 1 Key facts 1. such as insurance companies. The main types of financial institutions are deposit-taking institutions. 1.1 1. provision of payments mechanisms and portfolio management. 2. improving the distribution of incomes through taxation and social welfare payments and maintaining economic stability. It is left to member states to implement the directive into national law. and allows a member state to alter a statute in so far as it is necessary to implement the directive. 2.org . A directive prescribes a particular result to be achieved by a particular date.g. There are two methods of implementing a directive: (i) By primary legislation. The financial system provides four key functions: financial intermediation. primarily through control of inflation. collective investment funds and pension funds. Governments undertake a number of important economic functions. The UCITS Directives give automatic recognition in the UK to other collective investment schemes constituted in an EU member state other than the UK. 4.cfauk.
Which of the following is a deposit-accepting institution? (a) Mutual fund.org . Answers 1. Which one of the following describes a European Union directive? (a) A reprimand to a state that is breaking a European Union law. (b) Bank. (c) Link to CFA Level One The material in this chapter is not covered in CFA Level One. (c) A directive that all EU member states have to implement into national law. (c) Investment trust. (d) Pension fund.Chapter 1 Self-assessment questions 1.cfauk. 14 www. (b) A directive that an EU state can choose to implement into national law. (b) 2. (d) A note of guidance issued to EU states on an aspect of EU law. 2.
org .cfauk.Self-assessment questions 15 www.
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