Regulatory Framework of UK Financial Market Finance Essay

The Financial Services Authority (FSA) is an independent non-governmental body (quasi-judicial body) and a company limited by guarantee that regulates the financial services industry in the United Kingdom. It aims to promote efficient, orderly and fair financial markets, to help retail consumers achieve a fair deal and to improve its business capability and effectiveness. The Financial Services and Markets Act 2000 (FSMA) gives the FSA following statutory objectives:

Statutory objectives

The Financial Services and Markets Act imposed five statutory objectives upon the FSA: market confidence: maintaining confidence in the financial system; public awareness: promoting public understanding of the financial system; financial stability: contributing to the UK's financial stability; consumer protection: securing the appropriate degree of protection for consumers; and reduction of financial crime: reducing the extent to which it is possible for a business carried on by a regulated person to be used for a purpose connected with financial crime

Actions relating to the 2007-2009 sub prime crisis

The FSA has been held by some observers to be weak and inactive in allowing irresponsible banking to precipitate the credit crunch which commenced in 2007, and which has involved the shrinking of the UK housing market, increasing unemployment (especially in the financial and building sectors), the public acquisition of Northern Rock in mid-February 2008, and the takeover of HBOS by Lloyds TSB. On the 18th of September 2008, the FSA announced a ban onA short sellingA to reduce volatility in difficult markets lasting until January 16, 2009 In the UK, there is a choice of two principal institutions that provide public markets for equity securities. These are: The London Stock Exchange; and PLUS Markets Group London is a highly attractive international centre that offers applicants access to a vast base of investor capital. This, together with the UK's more principles based approach to regulation and corporate governance (which stands in marked contrast to many prescriptive regulatory overseas regimes), results in the London market providing a more cost-effective offering with a lower cost to access capital than its counterparts in the US,

The London Stock Exchange plc

Founded in 1801 it is one of the largest Stock Exchanges in the world with over 1,600 companies listed on the Main Market, coming from over 60 countries and spread across 42 sectors. In 2006 £8.4 billion of funds were raised in new issues on the market with 66 new companies being listed. A further feature is the liquidity it offers for shares traded on the secondary market (i.e. after IPO). It also offers the widest investor base of all the UK markets and its secondary market is also the most liquid. A significant portion of this liquidity is generated by the inclusion of shares in the FTSE Index Series, which covers all primary listed shares on the Main Market (but not secondary listed shares or Depository Receipts

Structure

The London Stock Exchange has four core areas: Equity markets - enables companies from around the world to raise capital. There are four primary markets; Main Market, Alternative Investment Market (AIM), Professional Securities Market (PSM) and Specialist Fund Market (SFM). Trading services - highly active market for trading in a range of securities, including UK and international equities, debt, covered warrants, exchange traded funds (ETFs), Exchange Traded Commodities (ETCs) Reits, fixed interest, contracts for difference (CFDs) and depositary receipts. Market data information - The London Stock Exchange provides real-time prices, news and other financial information to the global financial community. Derivatives - A major contributor to derivatives business is EDX London, created in 2003 to bring the cash equity and derivatives markets closer together.

Financial instruments traded in secondary market in UK

Preferred stock

Preferred stock differs from common stock in that it typically does not carry voting rights but is legally entitled to receive a certain level of dividend payments before any dividends can be issued to other shareholders.

Convertible Preference Shares

Convertible preferred stock is preferred stock that includes an option for the holder to convert the preferred shares into a fixed number of common shares, usually anytime after a predetermined date. Shares of such stock are called "convertible preferred shares" (or "convertible preference shares" in the UK)

Derivatives

The derivatives market is the financial market for derivatives, financial instruments like futures contracts or options, which are derived from other forms of assets. It has no independent existence without an underline asset and these are basically designed for investors to manage the risk efficiently and at the same time allowing them to hedge or speculate the market.

Forwards

A forward is a non-standardized contract between two parties to buy or sell an asset at a specified future time at a price agreed today. This is in contrast to a spot contract, which is an agreement to buy or sell an asset today. It costs nothing to enter a forward contract. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position. The price agreed upon is called the delivery price, which is equal to the forward price at the time the contract is entered into.

Futures

Futures is a standardized contract between two parties to buy or sell a specified asset of standardized quantity and quality at a specified future date at a price agreed today (the futures price). The contracts are traded on a futures exchange. Futures contracts are not "direct" securities like stocks, bonds, rights or warrants. They are still securities, however, though they are a type of derivative contract. The party agreeing to buy the underlying asset in the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position.

Options

An option is a derivative financial instrument that establishes a contract between two parties concerning the buying or selling of an asset at a reference price during a specified time frame. During this time frame, the buyer of the option gains the right, but not the obligation, to engage in some specific transaction on the asset, while the seller incurs the obligation to fulfil the transaction if so requested by the buyer. The price of an option derives from the value of an underlying asset (commonly a stock, a bond, a currency or a futures contract) plus a premium based on the time remaining until the expiration of the option.

Swaps

A swap is a derivative in which counterparties exchange certain benefits of one party's financial instrument for those of the other party's financial instrument. The benefits in question depend on the type of financial instruments involved. For example, in the case of a swap involving two bonds, the benefits in question can be the periodic interest (or coupon) payments associated with the bonds. Specifically, the two counterparties agree to exchange one stream of cash flows against another stream. Usually at the time when the contract is initiated at least one of these series of cash flows is determined by a random or uncertain variable such as an interest rate, foreign exchange rate, equity price or commodity price.

Global Depositary Receipts

(GDR) is a certificate issued by a depository bank, which purchases shares of foreign companies and deposits it on the account. GDRs represent ownership of an underlying number of shares. It facilitates trade of shares, and are commonly used to invest in companies from developing or emerging markets. Prices of GDR are often close to values of related shares, but they are traded and settled independently of the underlying share. For example, UK investors wanting to buy shares listed in emerging market countries like Russia can face a tough time when there are government restrictions on who can own and trade them. GDRs offer a solution. Instead of trying to buy the share in its local market, the investor buys a depositary receipt, which represents the shares, instead. These are issued by investment banks, listed in the investor's home market and traded separately from the underlying share. Apart from easier access, the key advantages of global depositary receipts include the fact they are priced in the investor's home currency (typically US dollars), carry lower dealing costs and pay more timely dividends, again in dollars, than the shares they represent. Whilst similar in most respects to American Depositary Receipts, GDRs tend to be listed in European markets like the London Stock Exchange.

Related innovative instruments

Swaption:

A swaption is an option granting its owner the right but not the obligation to enter into an underlying swap. Although options can be traded on a variety of swaps, the term "swaption" typically refers to options on interest rate swaps. There are two types of swaption contracts: A payer swaption gives the owner of the swaption the right to enter into a swap where they pay the fixed leg and receive the floating leg. A receiver swaption gives the owner of the swaption the right to enter into a swap in which they will receive the fixed leg, and pay the floating leg.

Swaption = option, on an interest rate swap

A pay-fixed swaption protects its purchaser from interest rates rising above a chosen rate, the strike rate. Likewise, a receive-fixed swaption protects its purchaser from falling interest rates. The cost (premium) of the swaption depends on several factors; but for otherwise equivalent pay-fixed swaptions the lower the fixed rate, the higher the swaption premium. The opposite dynamic holds for receive-fixed swaptions. The interest rate at which the cost of a pay-fixed swaption equals the cost of an otherwise equivalent receive-fixed swaption is referred to as the at the money swap rate for that period.

Credit Default Swap

A credit default swap (CDS) is a swap contract in which the protection buyer of the CDS makes a series of payments (often referred to as the CDS "fee" or "spread") to the protection seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) experiences a credit event. 1Securitization is a structured finance process that distributes risk by aggregating assets in a pool (often by selling assets to a special purpose entity), and then issuing new securities backed by the assets and their cash flows. The securities are sold to investors who share the risk and reward from those assets.

Collateralized Debt Obligations

Collateralized debt obligations (CDOs) are a type of structured asset-backed security (ABS) whose value and payments are derived from a portfolio of fixed-income underlying assets. CDOs securities are split into different risk classes, or tranches2, whereby "senior" tranches are considered the safest securities. Interest and principal payments are made in order of seniority, so that junior tranches offer higher coupon payments (and interest rates) or lower prices to compensate for additional default risk. A equity hybrid is a financial instrument that contains both debt and equity characteristics. Hybrid instruments can be designed so that they exhibit changing proportions of debt and equity over time. In addition, hybrid instruments may incorporate derivative characteristics. Some of the better known hybrid instruments include certain classes of preference shares, convertible notes, capital protected equity loans, profit participating loans, perpetual debt, endowment warrants and equity swaps.

This diagram above shows that corporations finance their activities by raising debt (such as issuing bonds payable) or by issuing common shares (equity) or do a little bit of both. Corporations (and the capital markets) are very inventive in designing not only new types of derivative instruments, but also new types of primary securities that have characteristics of both debt and equity. These new types of securities are called 'hybrid securities or investment vehicles'. 2Tranche is one of a number of related securities offered as part of the same transaction. In the financial sense of the word, each bond is a different slice of the deal's risk. Transaction documentation usually defines the tranches as different "classes" of notes, each identified by letter with different bond credit ratings.

Dot-com bubble burst, - 2001

The dot-com bubble was a speculative bubble covering roughly 1995-2000 during which stock markets in industrialized nations saw their equity value rise rapidly from growth in the more recent Internet sector and related fields. While the latter part was a boom and bust cycle, the Internet boom sometimes is meant to refer to the steady commercial growth of the Internet with the advent of the world wide web as exemplified by the first release of the Mosaic web browser in 1993 and continuing through the 1990s. The period was marked by the founding (and, in many cases, spectacular failure) of a group of new Internet-based companies commonly referred to as dot-coms. A combination of rapidly increasing stock prices, market confidence that the companies would turn future profits, individual speculation in stocks, and widely available venture capital created an environment in which many investors were willing to overlook traditional metrics such as ratio in favour of confidence in technological advancements.

The Sub prime crisis, 2007-2009

In the UK, where the financial market is most developed, H1 2008 turnover for several market derivatives reached a respectable 38% of the deal volume transacted in the base market. However, the outstanding notional value of these derivatives still accounts for only roughly 1% of the size of the UK commercial investment market. At this stage, market derivatives failed to effectively mitigate property risk. There was still a long way until their market potential was reached. Equivalent to today's proportions for equity derivatives, the potential is estimated to be about 40% of the base market size. However, although the derivatives market is still small, its effect on the subprime crisis was already valuable. First, property derivatives might have accelerated the market clearance. Forward prices reflect, in equilibrium, the expectations of the market. In doing that, they are much more timely and realistic than forecast surveys and thus catalyse more realistic valuations. Liquidity: As market derivatives are standardized, trading volume is concentrated in a small number of fungible contracts. For example, in the heterogeneous market for physical properties and for MBS, liquidity typically evaporates in a sharp downturn. In Q2 2008 for example, transaction volume for UK commercial properties tumbled to GBP 6.1 billion, a 60% drop from the previous year. According to a survey, investors are waiting to see how far values fall. Further, the Royal Institute of Chartered Surveyors (RICS) reported a collapse in housing transactions, mainly due to the inability of many to secure mortgage finance. Time-on-market for housing more than doubled compared to the previous year. Finally, liquidity in the MBS market globally collapsed in 2008. At the same time, the nascent property derivatives market did not dry up but reached record trading volumes.

Global nature of the financial market

The OTC segment operates with almost complete disregard of national borders. Derivatives exchanges themselves provide equal access to customers worldwide. As long as local market regulation does not impose access barriers, participants can connect and trade remotely and seamlessly from around the world. The fully integrated, single derivatives market is clearly a reality within the European Union. Taken as a whole, the derivatives market is truly global. For example, today almost 80 percent of the turnover at Eurex, one of Europe's major derivatives exchanges, is generated outside its home markets of Germany and Switzerland, up from only 18 percent ten years ago.

Europe's leading role within the derivatives market

Today, Europe is the most important region in the global derivatives market, with 44 percent of the global outstanding volume - significantly higher than its share in equities and bonds. The global OTC derivatives segment is mainly based in London. Primarily due to principle-based regulation, which provides legal certainty as well as flexibility, the OTC segment has developed especially favourably in the UK's capital. The unrestricted pan-European provision of investment services, in place since the introduction of the European Union's Investment Services Directive (ISD) in January 1996, has strengthened the competitive position of Europe in the global market environment. Many European banks are currently global leaders in derivatives. Historically, large derivatives exchanges were almost exclusively located in the US. Strong European derivatives exchanges appeared only after deregulation and demutualization in the 1980s and 1990s. These European exchanges were more independent of their users, who had been less supportive of significant changes at US exchanges. They revolutionized trading by introducing fully electronic trading and by setting industry standards. Over the years European players have strengthened their position, increasing their global market share from 24 percent in 1995 to almost 40 percent in 2007. They are now among the largest exchanges worldwide in a sector where the biggest players are international exchange groups that offer trading globally.

Drivers of innovation

Competition is the major driving force behind these product and technology innovations. Every product innovation is an opportunity for exchanges and broker-dealers to compete for new trading volumes. Consequently, even product segments that have been introduced recently are heavily contested. Meanwhile, technological innovations can often be a good way to enter a market. Electronic trading helped Eurex win the market for derivatives on long term German government bonds (Bund Future) the benchmark in European fixed-income markets, which had been served mainly by UK derivatives exchange LIFFE (London International Financial Futures and Options Exchange) before 1996. Facts and figures mentioned above, when summed up, gives a brief idea about secondary markets in UK. To summarise what has happened to the UK in the past ten years it would be as follows. Investment and growth have remained relatively subdued, compared with previous periods and with more dynamic growth areas, while at the same time being fairly stable. The UK has benefited from high levels of foreign direct investment. The finance sector became more important to the UK in both an absolute and a relative sense, and both domestically and in relation to the world economy, while manufacturing continued its long term decline. Household wealth grew mainly as a result of the housing bubble and the rise in the stock market, which along with easy credit and cheap imports led to a boom in retail consumption.

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