By Rupert Walker, Managing Editor, GlobalTrading
The FX market should continue the dialogue that led to its Code of Conduct, identify ways to share data and examine initiatives that promote efficiency.
- FX Global Code is principles-based rather than rules-based, contrary to the trend across other financial services
- Prosecutors struggle to win cases against malpractice in the FX markets and often have to rely on inadequate legislation
- The regional centres of FX trading are shifting
- Electronic non-bank market makers are proliferating and trading is becoming more relationship-based
- Private initiatives enhancing transparency and fairness might establish normal practices that be formalised in regulation
- Regulation can be selective rather than wholesale
- It is important to maintain a constant dialogue within the industry and promote the issue of regulation as a discussion topic in the media
The world’s financial markets are continuing to adjust to a vast array of new regulations and tighter levels of scrutiny imposed in the wake of the global financial crisis almost a decade ago and amid its disclosures of abusive activities. Legislation, especially in the US and Europe, aims to improve transparency and risk control, reduce market distortions and extreme volatility, and eliminate malpractice and fraud.
Meanwhile, the global FX market has largely avoided rule-based regulatory oversight. However, following several scandals, in May 2017 the Bank for International Settlements (BIS) issued a new code of conduct for foreign-exchange trading.
The 78-page code, developed by a partnership of central banks and market participants from 16 jurisdictions around the world, complemented a version that was released a year earlier. It is not designed to replace local laws, but the 55 principles were compiled through consultation with all the major stakeholders. Central banks have made it clear they expect fairness, discretion and high ethical standards. (1)
In addition to a general exhortation to ethical behaviour and good governance, the standards incorporate principles and processes for trade execution, information sharing, risk management and compliance, and confirmation and settlement.
The Code is expected to apply to all FX market participants, including sell-side and buy-side entities, non-bank liquidity providers, operators of e-trading platforms as well as other entities providing brokerage, execution, and settlement services.
However, its principles are guidelines; they are not legal obligations and there are no explicit punitive consequences for breaching them. Instead, they are “intended to serve as a supplement to any and all local laws, rules, and regulation by identifying global good practices and processes.” (2)
Guy Debelle, deputy governor of the Reserve Bank of Australia, explained at the launch of the Code of the Code on 25 May, that it is principles-based rather than rules-based, because “the more prescriptive the Code is, the easier it is to get around. Rules are easier to arbitrage than principles…If it’s principles-based and less prescriptive then market participants will have to think about whether their actions are consistent with the principles of the Code.” (3)
Arguably however, this embrace of self-regulation and reliance on peer-pressure to encourage good practice is inconsistent with the trend for the strict, detailed regulation and legally accountable measures being imposed on other sectors of the financial industry.
For instance, the Markets in Financial Instruments Directive (MiFID) II, which will be introduced across the European investment services industry in January 2018, is unambiguously rule-based. Moreover, the MiFID II regulations will cover the trade execution of most FX instruments, with the notable exception of spot transactions.
In this context, and against a background of historical and topical malpractice among FX market practitioners, it is debatable whether or not a principles-based code is sufficient, desirable or even feasible.
There is no single regulator of the global FX market. Instead regulation is dispersed among national central banks, and activities at the institutional level are also closely monitored and supervised by government bodies.
Prosecutors have often found it difficult to pursue criminal cases against banks or individual employees for market malpractice.
But, there have been notable successes. An international investigation into currency misdeeds saw seven banks, including Citigroup, Barclays and JPMorgan Chase agree to pay about $10 billion in fines for sharing confidential information about clients. The UK Serious Fraud Office closed down its own investigation into currency rigging in 2016, so the US has been the sole authority to bring individual charges. Three former HSBC employees are awaiting federal trial in Manhattan and, separately, a former London-based currency trader at HSBC is on trial in New York for his alleged role a front-running scheme. (4)
However, it is uncertain if the Code and current regulation will be enough to deter and identify future malpractice.
Furthermore, the nature of the FX market is changing rapidly with the adoption of new technologies and a proliferation of bank and non-bank electronic trading platforms. In addition, reduced risk appetite is affecting trading behaviour, and there is also a shift towards booking FX trades in regional centres such as Hong Kong and Singapore.
In order to assess how the global FX markets could be more tightly and uniformly regulated, an understanding of its current structure and composition and trends in liquidity provision and trading patterns is essential.
The industry should continue the comprehensive dialogue that led to the creation of its May 2017 Code, identify ways to share data and information on both a formal and informal basis, and critically examine private sector initiatives that promote greater market transparency and efficiency.
The BIS Quarterly Review, December 2016, contains a detailed analysis of the composition of the global FX market, and the latest developments. (5)
FX Market Activity
For the first time in 15 years, FX trading volumes contracted between two consecutive BIS Triennial Surveys. Global FX turnover fell to $5.1 trillion per day in April 2016, from $5.4 trillion in April 2013. In particular, spot trading fell to $1.7 trillion per day in April 2016, from $2.0 trillion in 2013. In contrast, trading in most FX derivatives, particularly FX swaps, continued to grow.
The decline in global trade and gross capital flows in past few years partly explains why FX spot activity has fallen. Different monetary policies in major currency areas and the rise of long-term investors in FX markets have also played a significant role.
The volume of trading for hedging and liquidity management rather than for taking currency risk (by leveraged traders and “fast money”) has risen, so spot and FX swaps, have moved in opposite directions. The decline in prime brokerage has been associated with a fall in trading by hedge funds and principal trading firms, with spot market volumes contracting as a consequence.