ATP - UK Regulation and Professional Integrity Ed15 PDF

Investment Advice Diploma UK Regulation and Professional Integrity Edition 15, December 2022 This learning manual relates to syllabus version 15.0 and will cover the exam on 12 March 2023 to...

Investment Advice Diploma UK Regulation and Professional Integrity Edition 15, December 2022 This learning manual relates to syllabus version 15.0 and will cover the exam on 12 March 2023 to 11 March 2024 Welcome to the Chartered Institute for Securities & Investment’s UK Regulation and Professional Integrity study material. This manual has been written to prepare you for the Chartered Institute for Securities & Investment’s UK Regulation and Professional Integrity examination. Published by: Chartered Institute for Securities & Investment © Chartered Institute for Securities & Investment 2022 20 Fenchurch Street, London EC3M 3BY, United Kingdom Tel: +44 20 7645 0600 Fax: +44 20 7645 0601 Email: [email protected] www.cisi.org/qualifications Author: Philip Read, Chartered FCSI Amrita Bhogal, Professional Standards Manager, CISI, (Chapter 4) Reviewers: Daniel Wynne Giuseppe Lucignano This is an educational manual only and the Chartered Institute for Securities & Investment accepts no responsibility for persons undertaking trading or investments in whatever form. While every effort has been made to ensure its accuracy, no responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication can be accepted by the publisher or authors. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise without the prior permission of the copyright owner. Warning: any unauthorised act in relation to all or any part of the material in this publication may result in both a civil claim for damages and criminal prosecution. Candidates should be aware that the laws mentioned in this workbook may not always apply to Scotland. A learning map, which contains the full syllabus, appears at the end of this manual. The syllabus can also be viewed on cisi.org and is also available by contacting the Customer Support Centre on +44 20 7645 0777. Please note that the examination is based upon the syllabus. Candidates are reminded to check the Candidate Update area details (cisi.org/candidateupdate) on a regular basis for updates as a result of industry change(s) that could affect their examination. The questions contained in this manual are designed as an aid to revision of different areas of the syllabus and to help you consolidate your learning chapter by chapter. Please note that, as part of exam security, hand-held calculators are not allowed in CISI exam venues. Candidates must use the onscreen calculator for all CISI CBT exams in all languages in the UK and internationally. Learning manual version: 15.4 (November 2023) ii Important – Keep Informed on Changes to this Workbook and Examination Dates Changes in industry practice, economic conditions, legislation/regulations, technology and various other factors mean that practitioners must ensure that their knowledge is up to date. At the time of publication, the content of this workbook is approved as suitable for examinations taken during the period specified. However, changes affecting the industry may either prompt or postpone the publication of an updated version. It should be noted that the current version of a workbook will always supersede the content of those issued previously. Therefore, candidates should not attempt to study for the exam using out-dated workbooks. Keep informed on the public ation of new workbooks and any changes to examination dates by regularly checking the CISI’s website: cisi.org/candidateupdate Learning and Professional Development with the CISI The Chartered Institute for Securities & Investment is the leading professional body for those who work in, or aspire to work in, the investment sector, and we are passionately committed to enhancing knowledge, skills and integrity – the three pillars of professionalism at the heart of our Chartered body. CISI examinations are used extensively by firms to meet the requirements of government regulators. Besides the regulators in the UK, where the CISI head office is based, CISI examinations are recognised by a wide range of governments and their regulators, from Singapore to Dubai and the US. Around 50,000 examinations are taken each year, and it is compulsory for candidates to use CISI learning manuals to prepare for CISI examinations so that they have the best chance of success. Our learning manuals are normally revised every year by experts who themselves work in the industry and also by our Accredited Training Partners, who offer training and elearning to help prepare candidates for the examinations. Information for candidates is also posted on a special area of our website: cisi.org/candidateupdate. This learning manual not only provides a thorough preparation for the examination it refers to, it is also a valuable desktop reference for practitioners, and studying from it counts towards your Continuing Professional Development (CPD). Mock examination papers, for most of our titles, will be made available on our website, as an additional revision tool. CISI examination candidates are automatically registered, without additional charge, as student members for one year (should they not be members of the CISI already), and this enables you to use a vast range of online resources, including CISI TV, free of any additional charge. The CISI has more than 40,000 members, and nearly half of them have already completed relevant qualifications and transferred to a core membership grade. Completing a higher level examination enables you to progress even more quickly towards personal Chartered status, the pinnacle of professionalism in the CISI. You will find more information about the next steps for this at the end of this manual. iii iv The UK Financial Services Sector........................................................................................1 1 UK Financial Services and Consumer Relationships................................................... 31 2 UK Contract and Trust Legislation.................................................................................. 55 3 Integrity and Ethics in Professional Practice............................................................... 77 4 The Regulatory Infrastructure of the UK Financial Services...................................117 5 FCA and PRA Supervisory Objectives, Principles and Processes..........................155 6 FCA and PRA Authorisation of Firms and Individuals..............................................209 7 The Regulatory Framework Relating to Financial Crime.......................................277 8 Complaints and Redress.................................................................................................347 9 FCA Conduct of Business and Client Money Protection.........................................365 10 Glossary and Abbreviations................................................................................................................... 463 Multiple Choice Questions...................................................................................................................... 475 Syllabus Learning Map............................................................................................................................... 509 It is estimated that this manual will require approximately 140 hours of study time. What next? See the back of this book for details of CISI membership. Need more support to pass your exam? See our section on Accredited Training Partners. Want to leave feedback? Please email your comments to [email protected] v  Before you open Chapter 1 We love a book!...but don’t forget you have been sent a link to an ebook, which gives you a range of tools to help you study for this qualification Depending on the individual subject being studied and your device, your ebook may include features such as: Watch video clips Read aloud A A Adjustable text size allows Pop-up definitions related to your function* you to read comfortably syllabus on any device* Highlight, bookmark Images, tables and Links to relevant End of chapter questions and make animated graphs websites and interactive multiple annotations digitally* choice questions * These features are device dependent. Please consult your manufacturers guidelines for compatibility The use of online videos and voice functions allowed me to study at home and on the go, which helped me make more use of my time. I would recommend this as a study aid as it accommodates a variety of learning styles. Find out more at cisi.org/ebooks Billy Snowdon, Team Leader, Brewin Dolphin ebook bw 18.indd 1 02/10/2018 12:01:33 vi  1 Chapter One The UK Financial Services Sector 5 1. The Role of the Government 3 2. Financial Investment in the Economy 7 3. Global Financial Services 10 4. Government and Central Banks’ Roles in Financial Markets 16 5. Economic, Financial and Stock Market Cycles 20 6. Global Trends and Their Impacts 24 This syllabus area will provide approximately 2 of the 80 examination questions 2  The UK Financial Services Sector In this chapter you will gain an 1 understanding of the following: The role that the UK government plays in the economy, in particular its input into regulation, taxation and social welfare. The factors that influence the UK financial services sector and the role of financial investment in the economy. The role and structure of financial services and its key participants in the UK, Europe, North America and Asia. The role of governments and central banks in financial markets. The impact of global trends. 1. The Role of the Government Learning Objective 1.1 Understand the factors that influence the UK financial services sector: 1.1.1 The role of the government in the economy: policy, regulation, taxation and social welfare 1.1 General Economic Policy Aims As well as providing a legal and regulatory framework for economic activity, the government plays a role directing and managing the economy. The key aims of a government’s economic policy are to: Achieve sustainable growth in national income per head of population. Sustainable growth would imply an increase in national income in real terms. 3  To find out how real income (ie, the physical flow of goods and services) has changed, it is necessary to correct for changes in prices. As the economy grows then so does national income, and as a consequence, the demand for goods and services increases. Sustainable growth gives the impression that major fluctuations in the business cycle (boom and bust cycles) are avoided, and that economic activity/output grows in an upward trend. This is seen as the key aim and outcome of the government’s economic policy. Control inflation in prices – a key objective of the economic policy of many governments. The UK government’s aim is for a moderate inflation level of approximately 2%. Inflation is not all bad. This is one of the objectives of the Bank of England (BoE). At the time of the workbook update (December 2022), the inflation rate was 11.1%. Full employment – the achievement of full employment does not mean that everyone who wants a job will be employed. Instead, it means setting a target level of employment where there are low levels of unemployment and involuntary unemployment is a short-term issue, not a long-term trend. Manage the balance of payments – between exports and imports. The wealth of a country relative to others (ie, their ability to borrow) depends on the achievement of an external balance over time. Deficits in external trade, with imports exceeding exports, may also damage the prospects for economic growth and have an impact on the perceived creditworthiness of a country. 1.2 Fiscal Policy This is a government policy on taxation, public borrowing and public spending. Direct taxation is the taxation of incomes of individuals and on the profits of companies (corporation tax), as well as on wealth transfers in the form of inheritance tax. Indirect taxation is the taxation of products and services that consumers/companies purchase and use, ie, value added tax (VAT). 4  The UK Financial Services Sector The Public Sector Net Cash Requirement (PSNCR) is the official term for the UK Government’s budget 1 deficit. That is the rate at which the government must borrow in order to maintain its financial commitments. It used to be known as the public sector borrowing requirement (PSBR). A government can intervene in the economy by: spending more money and financing this expenditure by borrowing (issuing gilts to investors) collecting more in taxes without increasing spending (ie, increase tax levels/lower threshold levels), and collecting more in taxes in order to increase spending, thus diverting income from one part of the economy to another. As the government increases its spending, national income tends to rise in real terms. Increasing the taxes raised without increasing spending indicates a contractionary fiscal stance. Governments may raise taxation to ease inflationary pressures in the economy. Collecting more in taxes in order to increase spending, thus diverting income from one part of the economy to another, indicates a broadly neutral fiscal stance. If the government raises taxes and spending by the same amount, there will be an increase in aggregate monetary demand. Taxpayers would have saved some of the money they pay in increased tax, but the government will spend all of the increased tax within the real economy. Therefore, the net effect is that more real money is spent. This effect is called the balanced budget multiplier. As government spending or tax reductions may be inflationary, and the impact of higher domestic prices makes imports relatively cheaper and exports less competitive in international markets, the government fiscal policy has important implications for the balance of payments (discussed later in section 2.3). Government fiscal policy is also used to reduce unemployment and stimulate employment. For example: increased government spending on capital projects, on which people are employed to work government-funded training schemes, and taxation of companies on the basis of the numbers and pay levels of employees. Government spending, however, can create and increase inflationary pressures on the economy which can lead to the creation of more unemployment. Fiscal policy, therefore, must be used with great care, even if the aim is to create new jobs. The impact of changes to a government’s fiscal policy is not always certain. The policy to pursue one aim (eg, lower inflation) can have a knock-on effect on the pursuit of other aims (eg, employment). The effects of fiscal changes can take a very long time to feed through to the economy – by which time other factors may have changed, complicating the overall outcome. The government balances how its fiscal policy will affect savers, investors and companies alike. Companies are affected by tax rules on dividends and profits, and by tax breaks for certain activities. A feature of a government’s fiscal policy is that it needs to budget what it plans to spend, leading to how much it will, therefore, need to raise – through taxation or by borrowing. 5 The planning of a government’s fiscal policy usually follows an annual cycle. In the UK, the most important statement of changes to policy is the Budget, which takes place in the autumn of each year. The Chancellor of the Exchequer will also deliver a pre-budget report in the spring. Because of the annual planning cycle of government finances, fiscal policy is not very responsive to shorter-term developments in the economy. Therefore, the government will use monetary policy for shorter-term adjustments of the economy. 1.3 Monetary Policy Monetary policy is concerned with changes in the amount of money in circulation (the money supply) and with changes in the price of money – interest rates. These variables are linked with inflation in prices generally, and also with exchange rates – the price of the domestic currency in terms of other currencies. Since 1997, the most important aspect of monetary policy in the UK has been the influence over interest rates exerted by the Bank of England (BoE). The Monetary Policy Committee (MPC) of the BoE has the responsibility of setting interest rates, with the aim of meeting the government’s inflation target of 2% based on the consumer prices index (CPI), and staying within 1% of this target. The CPI is the name used in the UK for the harmonised index of consumer prices (HICP), a standard European- wide measure of inflation. Where the BoE do not meet this target, they have to explain why to the Government. The MPC influences interest rates by deciding the short-term benchmark repo rate – the rate at which the BoE deals in the money markets. This is known as the BoE’s base lending rate, or base rate for short. The base rate affects the commercial rates, which financial institutions then set for the different financial instruments they offer or deal in (eg, mortgage and personal loan rates). Therefore, if the MPC changes the base rate, commercial banks will normally be expected to react quickly by changing their own deposit and lending rates accordingly. 1.3.1 Monetary Policy Committee (MPC) Meetings The MPC meets eight times a year to set the interest rate. Ahead of the meeting, it receives extensive briefings on the economy from BoE staff. This includes a half-day meeting – known as the pre-MPC meeting – which usually takes place a week before the MPC’s interest-rate-setting meeting. The nine members of the committee are made aware of all the latest data on the economy and hear explanations of recent trends and analysis of relevant issues. The committee is also told about business conditions around the UK from the Bank’s agents. The agents’ role is to talk directly to businesses to gain intelligence and insight into current and future economic developments and prospects. 1.4 Regulation Chapter 5 provides a detailed overview of the regulatory infrastructure of UK financial services. At the heart of financial services regulation in the UK is His Majesty’s Treasury (or HM Treasury or Treasury). The UK government sets the tone for the high-level directions and HM Treasury is responsible for implementing this and having oversight of the framework. 6  The UK Financial Services Sector 1.5 Social welfare 1 Chapter 2 section 2.5 (benefits) and chapter 2 section 2.7 (Retirement and Pensions) provide some details on the social welfare support that is provided by the Government. This does not include detailed information as this is a specialist subject and entitlement to benefits is complex and is based on selective criteria. 2. Financial Investment in the Economy Learning Objective 1.1 Understand the factors that influence the UK financial services sector: 1.1.2 The role of financial investment in the economy: primary markets; secondary markets; balance of payments; exchange rates 2.1 Primary Markets The term primary market refers to the market for new issues of shares or other securities (for example, debt instruments). Governments and companies need capital in order to carry out their activities (for example, spending on infrastructure projects by the government and the purchase of premises, and machinery by companies). In order to raise this capital, they may issue securities, such as shares or loan stock. Shares represent a share in the ownership of a company (shareholders are the owners of a company). Investors buy shares in a company, in the hope of either capital appreciation of that value of the company, and therefore of the price of the share, or of income, if the company earns profits and pays them to its investors in the form of dividends. Loan instruments represent borrowings by the issuer, which would normally expect to be repaid at some time. They, therefore, have a capital repayment value to the investor and (usually) a coupon, which represents the interest that will be paid periodically to the investor. An example of a loan instrument issued by a company is a debenture; an example of a loan instrument issued by the UK government is a gilt. In order to raise the money, it needs, whether by way of share capital or loan capital, the issuer will offer the new securities on the primary market. Primary markets are important both for new ventures – for example, a company that is just being established – and for existing ventures that are raising new capital, or which have been in existence for a while but are just introducing their existing shares to the public market for the first time. For a new company, listing its shares for the first time, the London Stock Exchange (LSE) acts as the primary market in the UK; the market through which it reaches its initial investors and raises a new tranche of capital. The process of introducing shares or loan stock on to the market for the first time is known as listing them. So, for example, shares in the UK public limited companies are likely to be listed on the LSE. 7 2.2 Secondary Markets Once an investor has bought a holding in shares or loan instruments, they may not wish to hold them indefinitely. They may stop satisfying their needs because: their circumstances change (they may need the money back, or their investment objectives change), or the investment itself changes (it rises in value, so that the investor wants to sell it to capitalise on the gain. Alternatively, if the securities are shares, the company may have become less profitable and stopped paying worthwhile dividends; the investor may want to switch to an investment giving a better return). The secondary markets offer a mechanism for the investor to sell or switch investments; they are the market in which investors sell shares or bonds that have already been introduced to the market. Thus, they offer an exit route for investors who want to sell their investments. They also offer a route for investors to buy securities which are already in existence from other investors. As a place on which investors can, through their stockbrokers, trade in shares, loan stocks and other securities, the LSE is one such secondary market. In the case of shares and loan instruments being dealt on the secondary market, the company raises no new money; cash travels via the market from the buying investor to the seller. It is only when securities are issued on the market for the first time (via the primary market) that the issuer (company) raises new money. 8  The UK Financial Services Sector 2.3 The Balance of Payments 1 The balance of payments in an economy measures the payments between that country and others. It is, therefore, made up of the country’s exports and imports of goods and services, and of transfers of financial capital. It thus measures all the payments received, and money owed, from overseas parties – less all the payments made, and debts owed, to people overseas. 2.3.1 Current and Capital Accounts The accounts used to measure the UK’s balance of payments are: the current account, and the capital and financial account. An exchange rate is the conversion of one currency for the purpose of conversion to another currency. Therefore, the balance of payments between the UK and other countries is important for a number of reasons, not least the impact that it may have on UK exchange rates (and, therefore, on the competitiveness of UK exports and of imports into the UK economy). A deficit on the current account means that the country is not matching its overseas expenditure with its current overseas income. How much this matters depends on the size of the deficit and on how persistent it is; a small negative balance, or one which only lasts for a short time, may not be regarded as too serious; it can be financed by the country running down its reserves somewhat, or by capital inflows. One method of correcting a current account deficit is to allow sterling to fall in value against other currencies. This tends to make foreign goods and services more expensive for UK buyers and so encourages them to reduce imports and buy British instead. In addition, it makes UK goods and services cheaper for overseas customers, helping UK exports. Both these factors will help to restore a positive current account balance. However, if the current account is also being financed by rising overseas debt, this can create concerns about the stability of the economy, which may lead to government action to raise interest rates (so as to prevent an outflow of investment funds). Higher interest rates can encourage foreign investors to invest in sterling assets pushing up the exchange rate as they buy sterling to do so. Rising interest rates may well lead to a strengthening of the currency – which is clearly at odds with the strategy, discussed in the previous paragraph, of trying to manage the current account through a low exchange rate. Thus, persistent surpluses and deficits on the balance of payments can create a considerable headache for a government, and can impact on exchange rates, interest rates and, consequently, other activities in the economy. Although the UK government is not responsible for setting interest rates, this has been the responsibility of the Bank of England for several years. This is explained further in section 4.1 of this chapter. 9 3. Global Financial Services Learning Objective 1.1 Understand the factors that influence the UK financial services sector: 1.1.3 The role and structure of the global financial services sector and its key participants: UK; Europe; North America; Asia 3.1 Financial Services in the UK The structure of financial regulation is covered in detail in chapter 5, where the relationship between His Majesty’s Treasury (HMT), the BoE, the Financial Policy Committee (FPC), the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA) is explained. The Treasury is the UK’s economics and finance ministry. It is responsible for formulating and implementing the government’s financial and economic policy. Its aim is to raise the rate of sustainable growth and achieve rising prosperity and a better quality of life with economic and employment opportunities for all. 3.1.1 The UK Regulators’ (FCA and PRA) Priorities for work in the International Arena The following are the FCA’s and PRA’s key priorities in relation to international regulation: Better regulation, ie, extensive consultation with stakeholders, consideration of the use of non- legislative tools, rigorous impact assessments of policy options, and subsequent review of measures to assess their actual impact. Enhanced supervisory cooperation to improve oversight of firms operating on a cross-border basis. Promotion of principles-based and risk-based approaches in global forums, such as the sectoral committees and the Financial Stability Board (FSB). 3.2 Financial Services in the US The regulatory structure is quite complicated, daunting and confusing, with its own costs and complications. However, one great advantage of this complicated and duplicative system is that it gives someone with an innovative idea more than one place to turn to; there is no monopoly regulator. 10  The UK Financial Services Sector 1 3.2.1 The Regulatory Agencies There are five federal regulators of depository institutions, as well as one or more regulators in each of the states. The states also regulate lenders and mortgage originators that are not depositories. There are overlapping responsibilities and jurisdictional disputes throughout this framework. For example, federal bank regulators and the 50 state bank regulators are constantly struggling for jurisdiction with respect to consumer protection issues. As another example of regulatory complexity, a commercial bank’s holding company is usually regulated by the Federal Reserve, while the primary safety-and-soundness regulator for the bank itself is the Federal Office of the Comptroller of the Currency (OCC), or one of the state bank regulators. 3.2.2 The Securities and Exchange Commission (SEC) The mission of the US SEC is to protect investors, maintain fair, orderly and efficient markets, and facilitate capital formation. The laws and rules that govern the securities industry in the US derive from a simple and straightforward concept: all investors, whether large institutions or private individuals, should have access to certain basic facts about an investment. The SEC oversees the key participants in the securities world, including securities exchanges, securities brokers and dealers, investment advisers and mutual funds. The SEC is concerned primarily with promoting the disclosure of important market-related information, maintaining fair dealing, and protecting against fraud. 11 It is the responsibility of the SEC to: interpret federal securities laws issue new, and amend existing, rules oversee the inspection of securities firms, brokers, investment advisers, and ratings agencies, and oversee private regulatory organisations in the securities, accounting, and auditing fields, and coordinate US securities regulation with federal, state and foreign authorities. Key Legislation Investment Company Act of 1940 This Act regulates the organisation of companies, including mutual funds, that engage primarily in investing, reinvesting and trading in securities, and whose own securities are offered to the investing public. The regulation is designed to minimise conflicts of interest that arise in these complex operations. Investment Advisers Act of 1940 This law regulates investment advisers. With certain exceptions, this Act requires that firms or sole practitioners compensated for advising others about securities investments, must register with the SEC and conform to regulations designed to protect investors. Sarbanes-Oxley Act of 2002 This Act mandated a number of reforms to enhance corporate responsibility, enhance financial disclosures and combat corporate and accounting fraud, and created the Public Company Accounting Oversight Board (PCAOB) to oversee the activities of the auditing profession. Dodd-Frank Wall Street Reform and Consumer Protection Act A compendium of federal regulations, primarily affecting financial institutions and their customers, that the Obama administration passed in 2010 in an attempt to prevent the recurrence of events which caused the 2008 financial crisis. The Dodd-Frank Wall Street Reform and Consumer Protection Act, commonly referred to as simply ‘Dodd-Frank’, is supposed to lower risk in various parts of the US financial system. 3.2.3 The Federal Reserve The Federal Reserve banks hold the cash reserves of depository institutions and make loans to them. They move currency and coin into and out of circulation, and collect and process millions of cheques each day. They provide cheque accounts for the Treasury, issue and redeem government securities, and act in other ways as fiscal agents for the US government. They supervise and examine member banks for safety and soundness. The Reserve banks also participate in the activity that is the primary responsibility of the Federal Reserve system: the setting of monetary policy. 3.2.4 The Office of the Comptroller of the Currency (OCC) The OCC charters, regulates and supervises all national banks. It also supervises the federal branches and agencies of foreign banks. Headquartered in Washington DC, the OCC has four district offices, plus an office in London to supervise the international activities of national banks. 12  The UK Financial Services Sector The OCC’s nationwide staff of examiners conducts on-site reviews of national banks and provides 1 sustained supervision of bank operations. The agency issues rules, legal interpretations and corporate decisions concerning banking, bank investments, bank community development activities and other aspects of bank operations. 3.2.5 The US Treasury The Treasury department is the executive agency responsible for promoting economic prosperity and ensuring the financial security of the US. It is responsible for a wide range of activities, such as advising the President on economic and financial issues, encouraging sustainable economic growth, and fostering improved governance in financial institutions. It operates and maintains systems that are critical to the nation’s financial infrastructure, such as the production of coin and currency, the disbursement of payments to the American public, revenue collection, and the borrowing of funds necessary to run the federal government. The department works with other federal agencies, foreign governments and international financial institutions to encourage global economic growth, raise standards of living, and, as far as possible, predict and prevent economic and financial crises. The Treasury also performs a critical and far-reaching role in enhancing national security by implementing economic sanctions against foreign threats to the US, identifying and targeting the financial support networks of national security threats, and improving the safeguards of the financial systems of the US. 3.2.6 The Financial Industry Regulatory Authority (FINRA) The Financial Industry Regulatory Authority (FINRA) is the largest independent regulator for all securities firms doing business in the US. As at December 2019, FINRA oversaw nearly 3,500 brokerage firms, around 153,900 branch offices and approximately 624,000 registered securities representatives. FINRA touches virtually every aspect of the securities business – from registering and educating industry participants to examining securities firms; writing rules; enforcing those rules and the federal securities laws; informing and educating the investing public; providing trade reporting and other industry utilities; and administering the largest dispute-resolution forum for investors and registered firms. 3.2.7 Commodity Futures Trading Commission (CFTC) The US Commodity Futures Trading Commission (CFTC) is an independent agency of the US government that regulates the derivatives markets. The mission of the CFTC is to protect market participants and the public from fraud, manipulation, abusive practices and systemic risk related to derivatives – both futures and swaps – and to foster transparent, open, competitive and financially sound markets. In carrying out this mission, and in promoting market integrity, the CFTC polices the derivatives markets for various abuses and works to ensure the protection of customer funds. Further, the agency seeks to lower the risk of the futures and swaps markets to the economy and the public. To fulfil these roles, the CFTC oversees designated contract markets, swap execution facilities, derivatives clearing organisations, swap data repositories, swap dealers, futures commission merchants, commodity pool operators and other intermediaries. 13 3.3 Financial Services in Europe The European Union works towards a single European market in various trade sectors, finance being one of the most important. The aim is to remove barriers to inter-state trade by, among other things, ensuring that similar regulatory rules are in place. From a financial services perspective, this should mean that, in terms of investor protection, it makes no difference to a customer whether they buy a financial product from a provider in their home state, or from another member state. A single market in financial services has long been an objective of the EU. In a single market, financial institutions authorised to provide financial services in one member state are able to provide the same services throughout the EU, competing on a level playing field within a consistent regulatory environment (also known as ‘passporting’). Such a single market in financial services will: ‘act as a catalyst for economic growth across all sectors of the economy, boost productivity and provide lower-cost and better-quality financial products for consumers, and enterprises’. 3.3.1 Financial Services in the EU In the wake of the 2007/09 financial crisis, the European Union adopted a series of structures changes to secure financial stability within the EU. The European system of financial supervision was introduced in 2010 and consists of the following: European Systemic Risk Board. Three supervisory authorities: The European Insurance and Occupational Pensions Authority (EIOPA) The European Banking Authority (EBA) The European Securities and Markets Authority (ESMA). 3.3.2 Structure of EU legislation Level 1 – Framework Acts (Regulation and Directives) – the Council of the European Union and the European Parliament adopt the framework acts (developed by the European Commission). Level 2 – Delegated Acts and Implementing Acts – detailed provisions to specify the content and the procedures set forth in the framework acts are drafted by the European Commission. In addition, the European Supervisory Authorities (ESAs) are responsible for drafting additional Level 2 text in the form of ‘Regulatory Technical Standards’ and ‘Implementing Technical Standards’, these would be endorsed by the European Commission. Level 3 – Guidelines and Recommendations by the ESA’s – for example, ESMA guidelines and recommendations to national competent authorities and market participants ensure uniform application of the level 1 and level 2 acts. More recently, ESMA has been producing question and answer (Q&A) guidance documents. Level 3 measures are not permitted to go beyond the intention and requirements of the Level 1 text. Level 4 – Supervision of the Member States – Supervision of European Acts by the ESA’s. 14  The UK Financial Services Sector 3.3.3 Brexit and the Impact of EU Legislation in the UK 1 Following the end of the transition period on 31 December 2020, the UK is no longer a member of the European Union. At this point, the UK ‘onshored’ all EU financial regulations into UK law via the ‘European Union (Withdrawal) Act 2018’. What this meant in practical terms is that a number of EU regulations, such as the Market Abuse Regulation (EU MAR) were taken into UK law and named as UK MAR. An exact copy of the EU Regulation (which the UK would have helped to develop/shape) was placed in UK law – a small number of amendments were made due to having significant impact or consequences in the UK market. HM Treasury has now started a formal review of financial services in the UK. It has published consultations on a ‘Wholesale Markets Review’ (review of MiFID II) and the Future Regulatory Framework (the UK regulatory landscape). In July 2022 the UK Government published the ‘Financial Services and Markets Bill 2022’, which among other things will provide the Act and powers for HM Treasury, the PRA and the FCA to implement the proposals. The UK government has stated that it will not make changes just for the sake of change, rather all changes will be to make UK financial services fit for purpose and nimble. Therefore, throughout the workbook all references to legislation (such as MiFID, SFTR, EMIR, and MAR) refer to the UK regime as this is what applies to UK regulated firms. 3.4 Financial Services in Asia 3.4.1 China The main bodies responsible for regulating financial services in China are as follows: The China Securities Regulatory Commission (CSRC) The China Banking and Insurance Regulatory Commission (CBIRC) The People’s Bank of China (PBOC). 3.4.2 Hong Kong The main bodies responsible for regulating financial services in Hong Kong are as follows: Securities and Futures Commission (SFC) Stock Exchange of Hong Kong (SEHK) Hong Kong Futures Exchange (HKFE) Hong Kong Monetary Authority (HKMA) Insurance Authority (IA). 3.4.3 Japan The main bodies responsible for regulating financial services in Japan are as follows: Financial Services Agency (FSA), which includes planning, supervisory and inspection functions. Self-regulatory organisations (SROs), such as the various Japanese securities exchanges and the Japan Securities Dealers’ Association (JSDA). 15 3.4.4 Singapore The main bodies responsible for regulating financial services in Singapore are as follows: Monetary Authority of Singapore (MAS) Singapore Exchange (SGX) Securities Industry Council (SIC). 4. Government and Central Banks’ Roles in Financial Markets Learning Objective 1.1 Understand the factors that influence the UK financial services sector: 1.1.4 The role of government and central banks in financial markets: interest rate setting process; money market operations and quantitative easing; fiscal policy; other interventions 4.1 The Interest Rate Setting Process Setting UK interest rates was once the Chancellor’s responsibility; however, the system was subject to abuse. Chancellors periodically overruled the advice of Treasury experts, especially when an election approached. For this reason, following the 1997 election, one of first actions of the new Chancellor’s was to depoliticise the rate-setting process. Responsibilities for setting interest rates were assigned to the BoE’s MPC (see section 1.3). The MPC has operated in an extremely able and transparent manner during recent years. It announces each decision to change rates or keep them unchanged precisely at noon on the day each meeting ends. Gone are the days when sudden and unexpected rate announcements would spook investors. As already explained in section 1.3, the organisation attempts to fully explain its views to the public. MPC members frequently give speeches outlining their views. Meeting minutes, including the voting record of each voting member, are made available soon after each meeting. Post-meeting press conferences are the norm, not the exception. The MPC is made up of nine members – the governor, the two deputy governors, the bank’s chief economist, the executive director for markets and four external members appointed directly by the Chancellor. The appointment of external members is designed to ensure that the MPC benefits from thinking and expertise, in addition to that gained inside the BoE. Members serve fixed terms, after which they may be replaced or reappointed. Compared to other government rate-setting agencies in Washington and Brussels, the MPC is a model of openness. Each MPC member has expertise in the field of economics and monetary policy. Members do not represent individual groups or areas. They are independent. Each MPC member has a vote to set interest rates at the level they believe is consistent with meeting the inflation target. The MPC’s decision is made 16  The UK Financial Services Sector on the basis of one person, one vote. It is not based on a consensus of opinion. It reflects the votes of 1 each individual MPC member. A representative from the Treasury also sits with the committee at its meetings. The Treasury representative can discuss policy issues but is not allowed to vote. The purpose is to ensure that the MPC is fully briefed on fiscal policy developments and other aspects of the government’s economic policies, and that the Chancellor is kept fully informed about monetary policy. 4.2 Money Market Operations The BoE’s framework for its operations in the sterling money markets is designed to implement the MPC’s interest-rate decisions while meeting the liquidity needs, and thus contributing to the stability of the banking system as a whole. The BoE is the sole issuer of sterling. This enables the Bank to implement monetary policy and makes the framework for the Bank’s monetary operations central to liquidity management in the banking system as a whole and by individual banks and building societies. The Bank’s market operations have two objectives, stemming from its monetary policy and financial stability responsibilities as the UK’s central bank. The objectives are to: implement monetary policy by maintaining overnight market interest rates in line with the bank rate, so that there is a flat risk-free money market yield curve to the next MPC decision date, and very little day-to-day or intra-day volatility in market interest rates at maturities up to that horizon, and reduce the cost of disruption to the liquidity and payment services supplied by commercial banks – the Bank does this by balancing the provision of liquidity insurance against the costs of creating incentives for banks to take greater risks, and subject to the need to avoid taking risk onto its balance sheet. 4.3 Fiscal Easing and Other Interventions Quantitative easing (QE) is sometimes described as ‘printing money’, but this is a misleading statement. It risks giving the impression that the central bank simply hands out cash, getting nothing in return. What actually happens is that a central bank buys government bonds, from banks and non-banks, on the open market. The seller of the government bonds lodges the proceeds of the sale with its own counterparty bank, increasing the size of its deposit holdings; that counterparty bank, in turn increases its deposits at the central bank (so-called ‘reserves’). So, there is no direct effect on counterparties net financial position. The seller of the government bonds ends up with more money in its bank account but no change in its total assets. The two banks, counterparty and central, end up with larger balance sheets, but the rises in assets and liabilities are of equal size. 17 Taking this into consideration, then perhaps a better and more accurate description of the process of QE is that it replaces one liability of the consolidated public sector (longer-term government bonds) with another (deposits at the central bank). The US was the first country following the financial crisis of 2007–09 to turn to quantitative easing. With interest rates slashed to between 0% and 0.25%, the Federal Reserve bought billions of dollars’ worth of assets, including mortgage-backed assets, to try to unblock markets. But there is a longer-term threat: by plunging into the debt markets, the government risks inflating a bubble in bonds, which will burst in a few years’ time, once the economy begins to bounce back, driving up interest rates and making the government’s massive debt burden extremely costly to service. Following the start of the programme announced in 2009, the BoE has been purchasing bonds over various periods. As of November 2022, the total amount of quantitative easing stood at £841 billion. Of this figure, the majority has been used to purchase UK government bonds, with just over £16 billion used to buy UK corporate bonds. In February 2022 the MPC voted to unwind the ‘portfolio’ by ceasing to reinvest maturing bonds, conduct a programme of corporate bond sales (to be completed no later than the end of 2023). In May 2022, the MPC asked the Bank of England to develop a strategy for UK Govt bond sales, with the process of increasing gilt sales taking effect from September 2022. In November 2022, the BoE undertook its planned Gilt sales, continuing to perform this until the 08 December 2022. The BoE announced that Gilt sales will focus on the short- and medium-term maturities and were set at £750 million for each auction. Details of Gilt sales schedules for 2023 will be available on the BoE website. 4.4 Money Supply and its Effects Money supply is used to describe the total amount of money circulating in an economy and, as with many concepts in economics, there are different ways of measuring it. For example, economists often talk about the following: Narrow money – a term used to describe the total sum of all financial assets (including cash) which meet a pretty narrow definition of money; for example, they must be very liquid and available to finance current spending needs. A deposit which is fixed for a long period does not, therefore, meet this definition. Broad money – in contrast, this term is used to describe the total sum of a wider range of assets – including some which are not as liquid as those falling within the definition of narrow money. It may include, for example, money held in savings accounts which are not instant access accounts. 18  The UK Financial Services Sector When governments attempt to affect the economy, one of their tools is the money supply. This is 1 measured by reference to the monetary aggregates – of which there are four, all published by the BoE. The most important of the four are known as M0 and M4: M0 is the measure of notes and coin in circulation outside the BoE, plus operational deposits at the BoE. (This is, therefore, quite a narrow definition of money.) M4 is the measure of notes and coin in circulation with the public, plus sterling deposits held with UK banks and building societies by the rest of the private sector. (This is thus a broader definition.) 4.4.1 How Money Supply Affects Inflation, Deflation and Disinflation Inflation is the term used to measure the general rise in prices in an economy. The BoE is charged with taking steps to keep inflation within a certain range. Interest rates are the main, and most promptly effective, tool it has at its disposal for doing this; but the money supply is also a factor. In this section we will look at why this is so. If money is regarded as being held mainly for transactional (spending) purposes, an excess of money will mean that more money is chasing the same amount of assets, and, therefore, pushing their prices up. Conversely, if there is less money in supply, there is less to be spent – so asset prices will fall correspondingly. Deflation is the term used to describe a general fall in the level of prices, and disinflation is the term for a reduction in the rate of inflation (ie, a slowing of price growth – as opposed to a fall in prices). Using the quantity theory of money, price growth can, in theory, be slowed (disinflation) or even reversed (deflation) through changes to the money supply. 19 5. Economic, Financial and Stock Market Cycles Learning Objective 1.1 Understand the factors that influence the UK financial services sector 1.1.5 The main stages of economic, financial and stock market cycles, including: national income; global influences and long-term growth trends 5.1 National Income (NI) In order to make the goods and services they create, firms use labour provided by households. They have to pay those households for the labour (work) they provide – thereby providing households with income. Households pay firms for the goods and services they need and consume – therefore, the income of firms form the sales revenue received from goods and services purchased and consumed by households. This creates a circular flow of income and expenditure: income and output are different sides of the same coin. Three key measures of economic activity are: national income (NI) gross national product (GNP), and gross domestic product (GDP). 20  The UK Financial Services Sector UK national income is defined as: 1 ‘the sum of all incomes of residents in the UK which arise as a result of economic activity, from the production of goods and services. Such incomes, which include rent, employment income and profit, are known as factor incomes because they are earned by the so-called factors of production: land, labour and capital.’ Source: Office for National Statistics Measuring NI is useful for the following purposes: Measuring the standard of living in a country (national income per head). Comparing the wealth of different countries. Measuring the change in national wealth and the standard of living. Ascertaining long-term trends. Assisting central government in its economic planning. 5.1.1 Gross Domestic Product (GDP) National income is largely derived from economic activity within the country itself. Domestic economic activity is referred to as total domestic income or domestic product. It is measured gross. The term gross domestic product (GDP) refers to the total value of income/production from economic activity within the UK. 5.1.2 Gross National Product (GNP) As we noted at the start of section 5.1, NI assumes that the circular flow of income in the economy is closed. However, in reality, of course some of the UK’s NI arises from overseas investments and some is generated within the UK by people who are non-residents. The difference between these items is net property income from abroad. The sum of gross domestic product, plus net property income from abroad, is the gross national product (GNP). We can, therefore, show the relationship between GDP, GNP and national income like this: GDP Plus Net property income from abroad Minus Net payment outflow to foreign assets Equals GNP Minus Capital consumption Equals NI (net) 21 5.1.3 Summary The gross domestic product is made up of: C + I + G + (X – M) This measure gives us one way of looking at the level of national economic activity. It also shows us that if a government wants to influence levels of activity, it may be able to do so by influencing one or more of the components of the formula above. Where: C – Consumer expenditure – (spending by households) I – Private investment in firms G – Government spending Net exports – total exports (X) minus imports (M) 5.2 Global Influences Just as events in other countries affect the UK economy, they also affect the UK stock market. Rates of growth in the rest of the world are especially important for economies (like the UK’s) that have a large foreign trade sector. If trading partners have slow growth, the amount of exports a country can sell to them will grow only slowly. This limits the country’s own opportunities for investment and growth. Different national economies may be at different stages of the business cycle at any one time. However, with increasing globalisation of trade and investment, there is a tendency for their economic cycles to become increasingly correlated (tied in with one another). In particular, the large size and economic wealth of the economy of the US exerts a significant influence on the economies of other countries, particularly its major trading partners, such as the UK. The importance of the US in the world economy means that investment markets, such as equity and bond markets, often react most closely to what is happening in the economy and markets of the US. If there is an economic recovery in the US, it is anticipated that this recovery will soon affect other economies, as US consumers and companies will demand more goods and services available on world markets. The stimulus to other countries will have knock-on effects in those countries as companies’ earnings are boosted and employment rises. As well as monitoring the growth of individual economies, we can measure growth and output for larger regions – and, indeed, for the world as a whole. The International Monetary Fund (IMF) publishes a report called the World Economic Outlook twice a year. 22  The UK Financial Services Sector 5.3 Long-Term Growth Trends 1 Governments and international organisations try to look forward and not only influence the short-term economic outlook, but also to learn from analysing longer-term trends, and influence these as well. Even quite small changes in growth, year-on-year, can have a considerable cumulative effect over a longer period. The UK government, for example, has a stated aim of increasing long-term growth (known as the trend growth rate) through strategies aimed at increasing employment opportunities and productivity, by promoting economic stability and by way of its wider economic policies. 5.3.1 Market Behaviour The economy as a whole has a great influence on the financial markets. In a recession and at the start of a recovery, inflation and interest rates are typically low or falling. Low interest rates mean that the coupons on yields on fixed-interest securities will look relatively attractive, so investors will be prepared to pay higher prices for such securities. Conversely, the higher interest rates generally seen in a boom period will result in lower prices for fixed-income securities. That is, investors will not be willing to pay a high price to secure the fixed coupon attached to the security. The prices of equities (company shares) also tend to reflect market sentiment about prospects for the economy and so are influenced by the stages of the economic cycle. The main share price indices, such as the FTSE 100 Index in the UK and the S&P 500 Index in the US, serve as barometers for the market. Share prices can be sharply influenced by changes in sentiment, and these can happen quickly – for example, because of news that a particular economic indicator has been announced as being significantly different from what was expected. If there is a new expectation of an economic recovery, for example, share prices may rise in anticipation. People will expect that the recovery will mean better prospects for companies, higher profits, and, therefore, increasing share prices and dividends. They will therefore be prepared to pay more for those shares – and the expected rise in prices becomes self- fulfilling. A situation of persistently rising share prices is often called a bull market. If expectations about economic recovery are dented – for example, because there are reports of rising unemployment or bankruptcies – then share prices may drop back again. If an economy is booming, higher interest rates or concerns that it might be coming to an end can reverse the general direction of share prices. A persistent downward trend in equities prices is often called a bear market. In the long run, share prices benefit from a steadily growing economy, with rising output, in which corporate earnings can grow. 23 6. Global Trends and Their Impacts Learning Objective 1.1 Understand the factors that influence the UK financial services sector 1.1.6 The impact of global trends: globalisation of business, finance and markets; advances in technology; regulatory challenges 6.1 International Markets The financial markets in the UK are regarded by many as one of the main world markets for dealing in a variety of assets – from shares to bonds, to currencies, to derivatives and commodities. But these UK-based markets face stiff competition from other financial centres, which try to compete for international business by introducing innovative financial instruments, ensuring speedier or more secure settlement, or making dealing cheaper and quicker. In addition to these longer-term considerations, financial markets in the UK are affected on a daily basis by what is going on overseas. For example, including the following: The price of assets dealt in on UK markets is affected by events on foreign markets. If events in the US mean that its stock market falls sharply, then other world markets invariably suffer as a result. (As the old adage has it, if the US stock market sneezes, the whole world catches a cold!) Many multinational companies have their shares traded on more than one stock market. Events affecting the shares in one place will affect the prices at which they are quoted in others, through arbitrage. Arbitrage is activity which aims to take advantage of the different prices at which an asset might be traded on different markets; it has the effect of bringing those prices back into balance. Many companies quoted on the LSE have operations around the world – so economic events in other countries affect their value and profitability. Events affecting other countries’ currencies can have a significant effect on UK markets, through the economy and interest rates. Because of these and similar factors, the wealth of UK people and businesses, which is tied up in shares or other investments, can be affected by what is happening in the international markets. 6.2 Globalisation of Business and Finance In terms of business and finance, the term globalisation tends to be used in several ways: It is often used to describe the increasingly interrelated and interconnected nature of business and financial systems. Businesses which were once essentially local now increasingly cross borders: banks offer services to people and businesses in many different countries, and businesses find their raw materials, and sell to customers, much further afield than used to be the case. It is also used to describe the way in which various things (products, processes and, in some cases, lifestyles) are becoming more similar around the world – as people and businesses become more mobile, taking their ways of doing things with them, and as international standards are established to make it easier for international trade and activity to take place. 24  The UK Financial Services Sector You can probably think of some examples pretty easily: McDonald’s is a good example of a retail 1 business that provides a pretty similar consumer experience wherever you are in the world. In the arena of finance, HSBC (which provides banking, investment and a host of other services) has offices in approximately 64 countries and used to describe itself as ‘the World’s local bank’ – perhaps in an attempt to show that, while it may be truly global, it also makes an effort to reflect local business practices wherever it operates. A customer of HSBC, or any other global banking organisation, could probably move from one country to another without having to change the banking group with which they deal. However, they have now moved away from using this title as result of a change of direction and withdrawal from a small number of countries – at one point they had offices in around 79 countries. The pace at which trade and finance becomes globalised, and the rate of flow of goods, services and money around the world increases as a consequence, has also been helped by the efforts of governments and many multinational organisations such as the World Trade Organisation (WTO) and the Organisation for Economic Co-operation and Development (OECD). The WTO deals with the rules of trade between different nations and among its aims are the liberalisation of trade laws between countries. It provides a forum in which governments can negotiate the basis on which their countries will trade with one another. The OECD describes itself as: ‘an international organisation helping governments tackle the economic, social and governance challenges of a globalised economy’. Among other things, it aims to help contribute to world trade, and to support sustainable economic world growth. Globalisation is seen as good by some (for example, if it enables poorer countries to participate in international trade) and as bad by others (for example, if it results in the loss of national identities and an increasingly homogeneous world – or if it results in the rise of huge multinationals, which are so big that they are seen as being beyond the control of governments and regulators). Whatever your view, it is an increasing fact of life. 6.3 Impacts of Technology Technology has had a huge impact on the way businesses interact, and on how profitable they are. A number of issues arise from this, in the context of global dynamics. Some businesses – including financial services firms – have found that they can outsource or offshore certain activities (typically call centres and computer programming) to countries where appropriately skilled labour is cheaper, such as India. For some types of businesses – including in financial services – the internet has been a key factor in this development: it is easy for buyers and sellers to find one another, and electronic communications – coupled with increasing clarity on the law regarding electronically concluded agreements – has speeded up the pace at which they can do business across borders. If one country has access to new technologies which have not yet been adopted, or cannot be afforded, in another, the first country can benefit from a significant economic advantage. 25 6.4 Regulatory Challenges The financial crisis of 2007–08, led to an unparalleled period of regulatory innovation and change impacting the financial services sector. Change on the scale of the US Dodd-Frank legislation and the EU programme of regulatory reform brought a unique opportunity to build a regulatory framework that achieves significant gains in levels of protection for customers and levels of financial stability for the local, as well as global, economy. However, undertaking reform on such a significant scale also risks making changes that are broader in scope than may be necessary or which are focused purely on domestic concerns or issues while ignoring the impacts on wider, international financial markets. This can lead to regulation that is inappropriately extra-territorial in effect, and to elements of regulation that diverge significantly between major financial centres. This danger is particularly pronounced in an industry that is as global and interconnected in nature as financial services. This is still an ongoing issue and relevant even today. 6.4.1 Duplicative Requirements Regulators in the US and EU have been calling for consistency in implementing G20 and other reforms to avoid regulatory arbitrage. Introducing identical or similar requirements in different jurisdictions could lead to some entities becoming subject to multiple overlapping regulatory regimes. This could have the effect of: introducing unnecessarily duplicative requirements, and distorting competition between market participants by the uneven application of duplicative regimes encouraging participants to make venue choices based on avoidance of administrative complexity, potentially reducing the focus upon execution quality and fragmenting international markets, and increasing the compliance burden or costs of compliance for regulated entities without achieving any additional benefits by way of customer protection or market stability (eg, where such entities are required to comply with requirements in several different jurisdictions, firms will need to build systems to ensure compliance with the various requirements). There can also be cases when additional obligations can be imposed on non-regulated entities. The G20 (or G-20 or Group of Twenty) is an international forum for the governments and central bank governors from Argentina, Australia, Brazil, Canada, China, France, Germany, India, Indonesia, Italy, Japan, Mexico, Russian Federation, Saudi Arabia, South Africa, South Korea, Turkey, the UK, the US, and the European Union (EU). 6.4.2 Incompatible or Conflicting Requirements In the past, regulators have commented that duplicative regulation is not a particular concern, as firms subject to multiple regimes should comply on a highest common factor basis. However, it may not always be possible for a regulated entity (or another entity subject to the relevant regulation) to comply with the requirements it may be subject to in every jurisdiction. 26  The UK Financial Services Sector 6.4.3 Regulatory Uncertainty and Disproportionate Compliance Burden 1 As we saw with the emergency short-selling bans/reporting regimes imposed in 2008–09, this kind of power can lead to uncertainty for firms required to comply. They are required to monitor the situation in all countries where they trade, and may be required to set up systems on short notice to comply (or to report/monitor their systems manually if the ban/reporting requirement is only temporary). This can make firms reluctant to trade in particular markets, to the detriment of their clients. If local regimes have different territorial scope, it can make monitoring and compliance far harder (eg, a firm will not just have to monitor the markets in which it is trading, but may also have to monitor local regulation in other jurisdictions where a particular security is listed, or where a particular entity is established). If the extra-territorial scope of emergency powers is unclear (eg, EU short-selling regulation emergency powers), it may be almost impossible for firms to predict which jurisdictions they should be monitoring. The Financial Stability Board (FSB) is an international body that monitors and makes recommendations about the global financial system. The FSB’s objective is to promote international financial stability by coordinating national financial authorities and international standard-setting bodies to work towards developing strong regulatory, supervisory and other financial sector policies. It fosters a level playing field by encouraging coherent implementation of these policies across sectors and jurisdictions. The FSB, working through its members, seeks to strengthen financial systems and increase the stability of international financial markets. The policies developed in the pursuit of this agenda are implemented by jurisdictions and national authorities. 27 Summary of this Chapter You should have an understanding and knowledge of the following after reading this chapter: The role of government and its policy on taxation, public borrowing and public spending. The role of financial investment in the economy – primary and secondary markets (their purpose, who uses them and why). The balance of payments – what they are and why they are so important. The role and structure of financial services in the UK, Europe, US and Asia – processes and purpose. The role of government and central banks: Interest rate setting Supply of money, and its effects Fiscal easing. The factors that influence the financial services sector in the UK: National income GDP Global trends – globalisation. 28  The UK Financial Services Sector End of Chapter Questions 1 Think of an answer for each question and refer to the appropriate section for confirmation. 1. What is the role of government in the economy? Answer reference: Section 1.1 2. Who sets monetary policy in the UK? Answer reference: Section 1.3 3. What is the role of financial investment in the economy? Answer reference: Sections 2.1 & 2.2 4. What is the main difference between primary and secondary markets? Answer reference: Sections 2.1 & 2.2 5. What is the role of the Bank of England? Answer reference: Sections 4.1 & 4.2 6. What is quantitative easing (QE)? Answer reference: Section 4.3 7. What are GDP and GNP? Why are they so important? Answer reference: Sections 5.1.1 & 5.1.2 8. What is the impact of globalisation on financial services firms? Answer reference: Sections 6.1 & 6.2 29 30  1 2 Chapter Two UK Financial Services and 5 Consumer Relationships 1. Financial Risks and the Needs of Consumers 33 2. How the Financial Risks and Needs of UK Consumers are Met 39 3. Professional Conduct and Ethical Practice 48 This syllabus area will provide approximately 4 of the 80 examination questions 31 32 UK Financial Services and Consumer Relationships In this chapter you will gain an understanding of: The main financial needs, priorities and 2 risks of UK consumers. Budgeting and managing finances, lifestyle changes and their impact on finances and provisions for dependants before and after death. Financial planning and financial advice. How professional conduct and ethical practice affect the perception of consumers. 1. Financial Risks and the Needs of Consumers Learning Objective 2.1 Understand the main financial risks, needs and priorities of UK consumers: 2.1.1 Balancing, budgeting and managing finances; debt acquisition and accumulation 2.1.2 Lifestyle changes and their impact on finances; funding and safeguarding major investments, including: housing; incapacity; unemployment and unplanned difficulty in earning income; income provision during retirement and old age; taxation 2.1.3 Provision for dependants before and after death 1.1 Balancing, Budgeting and Managing Finances One of the key elements of a financial plan is to help the client understand how their financial position is advancing (or deteriorating) over time, and how their income and outgoings balance against one another. 33 The adviser should be able to help them understand their budget by preparing a schedule of income and outgoings. This should include the following elements. 1.1.1 Current Income and Outgoings Income may include such things as: earned income from employed and self-employed jobs income received from investments and deposits rental income from investment property financial support from others, eg, a former spouse or partner, or a trust state benefits. Outgoings may include: Rent or mortgage payments. Spending on basic items (food). Council tax. Utilities (gas, water, electricity). Taxes – including National Insurance contributions (NICs) and income tax (for self-employed individuals). TV license, phone and internet charges. Maintenance being paid to a former spouse or in respect of a child. Credit card and loan payments. Regular insurance premiums. Contributions to pensions and regular savings plans. Sums budgeted for holidays and major life events. 34  UK Financial Services and Consumer Relationships If outgoings are greater than income, or if there is little difference between the two, then changes must be made to redress the balance. There is no point in consumers undertaking specific financial commitments if they cannot afford or do not need them. 2 1.1.2 Debt Acquisition and Accumulation At some stage in our lives, we will need to borrow money from a financial institution, normally a bank. Even wealthy clients may require access to borrowings from time to time. In order to fund a sizeable purchase, such as a home or a second property, the loan may be secured on the asset being bought by way of a mortgage. In some cases, if the loan is to be repaid from income and the borrower has little track record, additional security – perhaps by way of a guarantee from a family member – may also be required. Smaller loans for the purchase of specific things, such as a holiday or a car, are not normally required to be secured by the bank. In addition, consumers who are also business people may seek funding to buy into or establish their business – for example, to fund the initial purchase of share or partnership capital and, at a later stage, to fund expansion, take over another business or move into new markets. This may be by way of a loan provided by the client, who may therefore need to borrow this money, perhaps secured on the family home or some other asset. They also may need an advance if the business finds itself in difficulty and needs emergency funding. 1.2 Lifestyle Changes and their Impact on Finances The financial life cycle is a concept that is used for the purpose of considering what people’s financial needs typically are at various stages in their lives. Although not everyone’s life follows this pattern, many people’s do – so it can be a useful tool for predicting what products and services will be in most demand as the population’s demographic (in terms of age) changes. Particular products and services can be target-marketed at people who occupy specific stages in the cycle. For example, the following stages can be identified: Childhood – characterised by dependence for most needs on adult carers. Financial needs are usually few, though a child may have a need for a savings account, and perhaps a cashpoint card. Single young adulthood – usually at this stage the person is either in further education or in their first job. Income may still be relatively low, but the individual may also have few financial commitments as yet and a reasonable amount of disposable income. The thought of saving for the future may not be a high priority. Young couple, no children – at this stage there may be two incomes coming into the household and, with no children, no major financial commitments. However, if the couple are attempting to get on the property ladder, saving for a deposit may be a priority. If they have already bought, then the right mortgage may be important. Parents with dependent children – usually a couple, but lone parents are becoming increasingly common. At this stage, disposable income is likely to fall: in addition the parent(s) may have less time for leisure activities. Saving for a larger property or for school fees may be a priority. 35  Empty-nesters – this is the term used for parents whose children have left home and are independent. Such people may suddenly find that they have more disposable income than they have had for a long time – in addition, their careers may be well advanced, so their incomes are reasonably high, and, if they are fortunate, they may also have paid off a large proportion of their mortgages and be living in a property which has increased in value. However, for many, this stage has not been so easy – their property may have fallen in value, and, because of the difficulty of getting on the property ladder, their adult children may still be living at home. Retired – an increasing proportion of the population. Retirees who have been in employment or otherwise managed to save for much of their lives may have accumulated a reasonable amount of capital; in addition, if they are homeowners, they may have capital locked up in the value of their homes. Their financial needs may centre on ensuring that this capital generates enough income for them to live on; on provision of long-term care when their health is not so good; and perhaps on how they may best leave any surplus assets to their intended beneficiaries on death. This traditional pattern is, however, changing – for a variety of reasons: Empty-nesters may find that instead of caring for their children, they are now caring for their elderly parents – which places an additional financial and time burden on them. This pattern is likely to continue, and indeed increase, as the population ages. The increasing longevity of people means that the issue of paying for care into old age is gaining in importance – especially if the adult children of the elderly population are unwilling or unable to shoulder this burden. Affordability issues – brought about by the fact that wage inflation has not kept pace with house price inflation. This means that many people who would, in earlier decades, have been on the housing ladder, are now renting or, increasingly, remaining in the family home until well into adulthood. This means that would-be empty-nesters may, in some cases, have both their own parents and their adult children living with them. 1.2.1 Planning for Retirement Planning for retirement is an important element of the process – even for the youngest clients. As people live longer, and (even with rising retirement ages) face the prospect of a longer non-working old age, it is important that they consider the ways in which they can fund their needs as they get older. Pensions and associated products are the main retirement planning products. Occupational Pension Schemes Occupational pensions are pensions provided by an employer to its employees. They are either salary-related (also known as defined benefit (DB)), or money purchase (defined contribution (DC)). Personal Pensions Personal pensions are offered by commercial financial services providers, such as life companies. All personal pensions are money purchase schemes; they may be set up by a client who is arranging their pension privately – a popular option for the self-employed, or those who move between jobs regularly. Some employers also offer access to them and in this case they are not classified as occupational schemes. Personal pensions, self-invested personal pensions (SIPPs), group personal pensions (GPPs) and retirement annuity contracts are all forms of personal pension; see section 2.7 for more on SIPPs and GPPs. 36  UK Financial Services and Consumer Relationships Stakeholder schemes are a form of personal pension which meet certain requirements, eg, in terms of low charges and accessible minimum contributions; they are designed to make pensions more affordable for those on lower incomes, but have also been popular with other sectors of the population on account of their apparent value for money. Like ordinary personal pensions, they are offered by 2 commercial organisations, such as life companies. Those in occupational money purchase schemes can shop around on the open market for the best annuity option for them to convert to. This may let them get considerably better value than was previously the case. In addition to the existing alternative of income drawdown (also known as unsecured pension, an option which allows pensioners to defer converting their pension pot into an annuity for a period prior to age 75, perhaps until conditions are more favourable, by drawing on the capital of their pension fund), they can now also opt for a short-term annuity. This option lets them use part of their pension fund to buy a fixed-term annuity, which may be for up to five years. In the meantime, the remainder of the fund stays invested in the markets. When the short-term annuity comes to an end, and depending on their view of conditions in the market at the time, the pensioner has the option to: buy another short-term annuity buy a lifetime annuity, or move to drawdown prior to age 75. Pension Changes (Pension Freedoms) Since 2014, it is no longer compulsory to take out an annuity on retirement. Rather, pension holders are able to draw down their pension in cash. This is currently available to individuals in money purchase schemes. Members of final salary schemes can avail the option by converting their fund to a defined contribution (money purchase) scheme – however, there is some debate as to whether this is sensible and would need agreement from the schemes’ trustees. The approach taken by the government is that individuals should be able to control their pension rather than be forced to take out an annuity, which they see as poor value and pay low interest rates. The pension freedoms allow individuals in defined contribution schemes (money purchase) to: take all of the money out as a lump sum (although tax will be paid on any amount over the 25% tax- free lump sum amount) increase the flexibility of income drawdown by removing the minimum guaranteed income requirement for a drawdown option with no upper limits remove restrictions on lifetime annuity payments to make them more flexible, and the ability to pass on the pension to dependants, tax-free if the pension holder dies before they reach the age of 75. The lifetime allowance permitted in your pension pot for the tax year 2022/23 is £1,073,100 – which has been frozen until 2025/26 tax year. 37 1.2.2 Taxation Individuals are liable to tax on their income, and this is accounted for to His Majesty’s Revenue & Customs (HMRC) annually. Income tax is accounted for by reference to income earned in each tax year. The tax year runs from 6 April in one year to 5 April in the following year. Income for individuals includes earnings from employment or self-employment and income from investments. It also includes some government benefits. For people who are employed, the figure that they show as earned income should include their salary or wages, and any bonuses, commission, fees, and benefits in kind. This covers items such as the use of a company car, subsidised loans and the cost of private medical insurance. Earnings for work carried out on an employed basis, in the UK, are subject to the pay as you earn (PAYE) system. Under this system, the employer deducts the employee’s personal income tax before paying the net amount to that employee and pays it over to HMRC. Based on the employee’s earnings, HMRC issues a tax code for each employee and the employer uses this to calculate how much tax it should deduct each month. Tax Rates Tax is not charged at a single flat rate. There are different rates for different levels of income. In addition, in some cases there are different rates of tax charged for different types of income, ie, earned income and investment income. Personal allowance, irrespective of an individual’s date of birth (these threshold £12,570 levels are frozen until April 2026) The Personal Allowance goes down by £1 for every £2 of income above the £100,000 limit. (Source: https://www.gov.uk/government/publications/rates-and-allowances-income-tax/income-tax- rates-and-allowances-current-and-past#tax-rates-and-bands) Basic rate tax 20% From £12,571 to £50,270 (ie, on the next £37,700) From £50,271 to £125,140 Higher rate tax 40% (the limit was reduced from £150,000 with effect from 6th April 2022) Over £125,140 (Individuals will not have a personal allowance) Additional rate tax 45% (this amendment took effect from 6th April 2023) Inheritance Tax (IHT) and Chargeable Transfers Inheritance tax (IHT) is often thought of as a tax which is levied when someone dies; but this is something of a misnomer, as IHT can, in fact, apply when assets are transferred in a variety of ways – for example, by gifts. If this were not the case, people would avoid it simply by giving away their assets to their children before they died. 38  UK Financial Services and Consumer Relationships IHT is, in fact, primarily a tax on wealth. Usually, this means wealth that is left to someone else on its owner’s death, but it also applies to gifts within seven years of death and to certain lifetime transfers of wealth. 2 To summarise, IHT is a tax on gifts or transfers of value. There are two main chargeable occasions: Gifts made during the lifetime of the donor (lifetime transfers). Gifts or transfers on death, for example, when property (meaning assets of the deceased, not physical property) is left to someone in a will (the death estate). 1.3 Provision for Dependants Before and After Death Estate planning is the job of planning what will happen to a client’s assets on their death. It may include significant elements of tax planning, so as to minimise the effects of tax on what is passed on to the client’s legatees (the people they leave money to). Refer to section 2.4 of this chapter for further details. 2. How the Financial Risks and Needs of UK Consumers are Met Learning Objective 2.2.1 Understand how the main financial risks, needs and priorities of UK consumers are typically met: financial planning and financial advice; state benefits; credit finance and management; mortgages; insurance and financial protection; retirement and pension funding; estate and tax planning; savings and investment 2.1 Financial Advice The relationship between consumer and financial adviser is very important to the success of the planning process. We could think about this relationship from three different perspectives – the legal, the personal, and the skills which an adviser needs to foster such a relationship. Legal – in some cases, a financial adviser will be an independent financial adviser (IFA), or part of an IFA firm. Here, their relationship with the customer is that of agent – the adviser acts as the agent of the customer in any transactions they arrange on their behalf, and is responsible for providing them with advice, based on a selection of suitable options. In other cases, however, the adviser may be an employee of a single product provider (or of a provider offering its own and a small range of other providers’ products) and is called ‘restricted’ as they act as the agent of the provider(s) and not of the client. These differing legal relationships must be disclosed to the customer and carry different legal responsibilities. Personal – in order to provide appropriate advice, at the outset, financial advisers need a good deal of personal detailed background information about their clients. This includes not only their current financial situation, but also their plans, hopes and aspirations