Restoring Trust in Foreign Exchange
The global foreign exchange (FX) market is a paradox. With daily trading volume of around US$5 trillion, it’s the world’s deepest and most liquid financial market. And yet recent FX trading scandals have thrown light on the inherent difficulties of ensuring fairness in a market with no central trading venue, no standardised data, little transparency and no code of conduct.
In June this year, three UK government agencies, the Bank of England, the UK Treasury and the Financial Conduct Authority (FCA) issued new recommendations for the FX market as part of their Fair and Effective Markets Review (FEMR). Can these help restore investors’ trust in FX?
Across the wholesale, non-exchange-based markets for fixed income products, commodities and currency (FICC), say the regulators, notions of fairness have recently been sorely tested.
The misdeeds for which bank dealers have collectively received multi-billion dollar fines include the attempted manipulation of benchmarks and market prices, the misuse of confidential information, misleading clients and attempted collusion. However, the authors of FEMR remind us, transparency in the wholesale “over-the-counter” (OTC) markets for bonds and currencies has its limits.
By contrast with equity markets, where most trading occurs on stock exchanges’ central limit order books, offering high levels of transparency both pre- and post-trade, in the FICC markets transparency is limited by design.
Being able to avoid the publication of orders and quotes in advance of trading and of prices and volumes after trades have occurred is a desirable characteristic of FICC markets, most investors told UK regulators during a consultation process conducted ahead of the publication of the FEMR. This is because limited transparency helps firms undertake large transactions without their trading strategies being revealed to the wider market.
Complicating efforts to achieve a level playing field for FX market participants and to benchmark best execution levels, it’s conventional and legal for dealers to charge a non-disclosed “mark-up” to clients, as part of the headline quote. This practice, say the FEMR authors, can exacerbate conflicts of interest in situations where a firm executes client orders against its own capital, as is often the case in deals with large banks, or when orders are conducted on an agency basis.
In a statement issued in May after being fined nearly US$900 million by US authorities, US bank JP Morgan reminded its FX clients that, going forward, it was not obliged to disclose if a mark-up was included in its own quotes, nor how much it was earning on any particular transaction.
And many FX trading platforms allow dealers a “last look” at prices shown to clients: in other words, the market maker has a final opportunity to reject an order after a client commits to trade at a quoted price.
“A lot of the buy-side doesn’t know ‘last look’ exists,” David Mercer, chief executive of FX electronic platform LMAX, told Thomas Murray IDS. LMAX requires dealers to post firm, executable prices on its own platform.
“At its worst this practice grants the market maker a free option and the chance to optimise profit. It doesn’t exist in any other asset class, so why does it need to exist in FX?” queries Mercer.
Global regulators have attempted to reduce the scope for the manipulation of the widely used WM/Reuters FX benchmark by widening the daily “window”, during which dealers’ quotes and trade prices are recorded to calculate the benchmark, from one minute to five.
However, it has been suggested that this reform, which took effect for major currency rates in February 2015, has led to an increase in fix-related trading costs: one consultant, NewChange FX, estimated in April that bid-offer spreads have jumped by 37% on average in response to the wider calculation window.
In the FEMR, UK regulators have recommended other FX market reforms: the time-stamping of FX orders and executions, a review of the last look practice and the implementation of a global FX code. Such a code would provide a comprehensive set of principles to govern trading practices, information handling, the treatment of counterparties and standards for trading venues.
According to LMAX’s Mercer, the time stamping of orders should now be automatic market practice, “both when an order is received and when it’s executed, to the millisecond. You can then benchmark those prices against third-party reference data.” However, whether investors are able to avail themselves of this level of transparency is still to be proven. Thomas Murray IDS’s experience when seeking to obtain time stamping for its benchmarking isn’t as successful. “The key appears to be in the definition”, says Brian Ward, a director at Thomas Murray. “The quality and completeness of reporting varies in the banking community. Some will say that they are able to provide time stamping on the freely convertible currencies, but not for restricted currencies; others will state that “indicative” pricing is available. The increasing regulatory environment is pushing the participants to be transparent and it’s slowly getting there, but it’s not perfect just yet. It’s even worth pressing on the definition of time stamping, to my mind it’s the time of execution, but I suspect some are treating it as the time the trade is recorded for audit purposes on the accounting or reporting systems. Working within reasonable tolerances that may be fine, but in a period of high volatility, effective monitoring can be harder.”
However, the implementation of broader reforms in FX is likely to take time, particularly given the global nature of currency trading. In the meantime, investors and asset managers need to move away from a reliance on the daily fix, accept that FX trading carries an explicit cost, and make better use of data.
“Part of the problem surrounding the fix was that asset managers were apparently trading for free, but those executing the client order were taking risk.” says LMAX’s Mercer. “A bank may have swallowed the risk in return for making money on other trades with the client, but it had to be compensated somehow. Investors need to consider how they will pay for execution in future.”
“And investors need to move with the technological times,” he says. “There are smarter ways to execute FX trades than via the fix or over the phone. Service providers, whether bank, broker, or exchange, need to give investors the necessary tools.”
While there is far greater scrutiny in the execution and reporting of foreign exchange, FEMR may just be the start. There has to be a duty on all of the participants, including the investor, to take greater responsibility in truly establishing a level of trust that is experienced elsewhere in the financial industry.