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UK chancellor George Osborne established the fair and effective markets review (FEMR) in June, followed by a consultation in October, which asks the question: “How fair and effective are the fixed-income, foreign-exchange and commodities markets?”
The Financial Conduct Authority is engaging in supervisory work with firms on FX and how that fits in with the FEMR, according to a spokesman.
Meanwhile, the banking trade body Association for Financial Markets in Europe is consulting with the banks and will put out a response in January, according to a spokeswoman.
The FEMR consultation identifies that in FICC over-the-counter markets “there will always be at least a potential conflict of interest where market participants are trading on their own behalf as well as trading for or with clients”.
FX dealers might need to trade at times when they have private knowledge of a forthcoming trade, to respond to other trade enquiries, hedge pre-existing inventory and even pre-hedge the trade in question.
However, where such trading activity can move the market, it could be construed as front-running, meaning the trader is taking advantage of private information to benefit themselves, possibly to the detriment of the client.
The difficulty facing banks is distinguishing between legitimately pre-hedging and front-running, say industry participants. Pre-hedging is necessary for traders to protect themselves from market movements, says Pierre Pourquery, partner in financial services at audit firm Ernst & Young (EY).
“Banks have traditionally done this – sometimes you win, sometimes you lose” he says. "But it is a problem if it is not in the interest of clients. How can a trader demonstrate that pre-hedging is always in the best interests of a client?”
Front-running is straightforward to identify where the dealer is acting in an agency role, such as in equities. This is not the case in FX. The fact is that FX traders can take a position before or after receiving an enquiry from a client, as well as facilitate trades for a client, says Fred Ponzo, managing partner at consultancy firm GreySpark Partners.
“Unless foreign exchange becomes a wholesale agency model where traders charge a fixed commission instead of a spread, there is no argument to say that traders are front-running clients,” he says.
Far from riskless
FX is far from being a riskless activity for the banks, as they commit liquidity and use their balance sheet to extend liquidity to clients. A commission-based model in FX, similar to the equity world, would require a liquid market that exists independently of the banks pumping liquidity, which is simply not the case today.
Spot foreign exchange is a multi-trillion dollar market, but margins are exceptionally tight in leading, liquid currency pairs, thus squeezing the banks.
Seb Walker, managing partner at financial markets consultancy Tricumen, says a bank with substantial market share sees a sizeable percentage of client flows, and therefore has a better idea of how the market will move.
“Margins are so tight that the only way banks are able to make money in these markets is to take advantage of flow information and position [themselves] accordingly," he says. "If margins are so tight, the only way banks can support business and client demand is by taking positions that make revenues.
"I suspect that what it really comes down to is whether a client is disadvantaged by their actions.”
| One solution is to put a limit on [hedging], but I am not sure this is the answer and there is no best-practice guidance Pierre Pourquery |
The FEMR is also investigating the widespread practice of ‘last look’, whereby banks can pull a price off a platform to protect themselves against market moves or automated trading strategies that might exploit a dealer’s inability to refresh quotes quickly.
“But some market participants have argued that such practices may also incentivize market makers to delay a decision for longer periods in order to observe market moves and reject unprofitable trades or even engage in front-running of orders,” says the consultation document.
The banks are now being asked by regulators to come up with new frameworks and controls, says Pourquery at EY. The audit firm is working with traders, and compliance and legal staff at banks.
“We are discussing this with many banks, which are wondering now what to do, and how to implement new controls," he says. "It will require more data to be stored, to provide more transparency on trader activities.
“One solution is to put a limit on [hedging], but I am not sure this is the answer and there is no best-practice guidance.”
Meanwhile, the FEMR consultation document says some firms have started to segregate fix orders from other types of trading, to eliminate potential conflicts of interest, in light of the FX benchmark scandal.