A New Beginning for Fair & Transparent FX Markets

The release of the final Global Code of Conduct (“Code”) on 25 May 2017 is a watershed moment for the foreign exchange (FX) market.  The FX market, which is a global decentralized market for the trading of currencies, is the largest market in the world in terms of trading volume, with turnover of more than $5 trillion a day.  The Code was developed by the Foreign Exchange Working Group (“FXWG”) working under the auspices of the Markets Committee of the Bank for International Settlements (“BIS”).  The Code was also created in partnership with a diverse Market Participants Group (MPG) from the private sector.  A Global Foreign Exchange Committee, formed of public and private sector representatives, including central banks, will promote and maintain the principles.  

The Code establishes a common set of 55 principles for good practice in the FX market, including ethics, transparency, governance, information sharing, electronic trading, algorithmic trading and prime brokerage.  The Code took almost two years to complete, with the first half issued in May 2016.  Our article on the first phase of the code is available here.  Market participants will need time to conform their practices with the principles of the Code and it is anticipated that most will need approximately 6-12 months to do so, a time frame set to align with new requirements for transparency and best execution under MiFID II, which comes into force on 3 January 2018. 

The Code is organized around six primary principles:

  1. Ethics
  2. Governance
  3. Information sharing
  4. Execution
  5. Risk Management and compliance
  6. Confirmation and settlement processes

The Code comes on the heels of difficult times in the FX markets, with the stated goal of restoring public faith in the market in the aftermath of the FX scandal which resulted in $11 billion in fines being levied worldwide on some of the largest financial institutions, as well as another $2 billion in settlements in related class action litigation.  Moreover, custodian “excessive” FX profit cases have also resulted in around $1.2 billion in settlement costs and penalties, and multi-year supervised remediation.  

“All of us recognise the need to restore the public’s faith in the foreign exchange market.  We share the view that the global code plays an important role in assisting that process and also in helping improve market functioning,” said the Reserve Bank of Australia deputy governor Guy Debelle, who headed the FXWG.

The FX scandal was the subject of investigation by government authorities across the globe, including the Federal Reserve, the Department of Justice, and the Commodities and Futures Trading Commission (“CFTC”) in the US and the Financial Conduct Authority (“FCA”) in the UK.  The investigations alleged that for almost a decade, traders coordinated trading strategies in order to manipulate benchmark rates and price fix bid/ask spreads, as well as trigger client stop-loss orders and limit orders.  The Code deals with these manipulative practices head-on, making clear they have no place in a fair marketplace.  

Several banks are also facing or have faced regulatory and civil action over inappropriate use of “last-look,” with fines in the hundreds of millions so far for failures to be sufficiently transparent around the process.  The new Code does not ban the practice, but requires that market participants “should be transparent regarding its use.”

Although the Code is voluntary in nature and non-enforceable, market participants are paying close attention, especially as regulators have used its predecessor, the Non-Investment Products (NIPs) Code, as well as other relevant guidance such as the ACI Model Code, the 2001 FX Good Practice Guidelines (which was developed by 16 leading FX market intermediaries), and the 2008 Federal Reserve Bank of New York’s Guidelines for Foreign Exchange Trading Activities as a basis for litigation.  

For example, the UK’s FCA, which levied almost GBP 1.4 billion in fines with regard to the FX scandal, dedicated an entire annex of its Final Opinions to “relevant codes of conduct,” citing the NIPs Code, the ACI Code, as well as the Good Practice Guidelines, and specifically highlighted that the relevant codes set out “the importance of firms requiring standards that “strive for best execution for the customer” when managing client orders.  

And just this past week a Consent Order issued by the NY Department of Financial Services (“DFS”) pointed to the Fed’s 2008 guidance that identified the need for dealers to protect client confidentiality and avoid situations involving or appearing to involve trading on nonpublic information.  The NY DFS foreshadowed the theme of the new Code, emphasizing that it is precisely because “there is no single regulator for the FX market, it is all the more essential that financial institutions take an active hand in supervising this business line.”

With this spirit of adherence in mind, the FXWG produced alongside the Code a very essential Report on Adeherence to the FX Global Code (“Report”), setting out a framework to promote awareness and incentivise adherence to the Code's standards.  This Report emphasises that it is the responsibility of market participants to take appropriate steps to adopt the Code in their day-to-day practices and culture, including establishing appropriate mechanisms to monitor this process.  This will include adopting new technologies that allow for effective compliance and cost analysis monitoring. 

A highlight of the Code is the new Statement of Commitment (Annex 3 to the Code) that market participants can use publicly, or bilaterally, to support key objectives of the Code such as enhancing transparency, efficiency and functioning in the FX Market.  The Statement of Commitment (“Statement”) provides a single, common basis by which each market participant can represent that it: (i) supports the Code and recognises it as a set of principles of good practice for the FX Market; (ii) is committed to conducting its FX Market activities in a manner that is consistent with the principles of the Code; and (iii) considers that it has taken appropriate steps, based on the size and complexity of its activities, and the nature of its engagement in the FX Market, to align its activities with the principles of the Code.  We anticipate that market participants who embrace the Statement will invest in new technologies such as FX best execution tools to support their Statement, and will also attract market share through this commitment to transparency and good practice.
The Code also seeks to accelerate the provision of accurate time stamping of orders and transactions by Market participants, both at the time of acceptance and execution (see Principle 36 in Risk Management and Compliance).  Market participants “should apply sufficiently granular and consistent time-stamping so that they record both when an order is accepted and when it is triggered/executed.”  Although they don’t have to provide this detail by default, they do have to make it available promptly on request.  If time stamping is not performed both at arrival and at trigger/execution, market participants must be clear on this fact to their clients, allowing clients the freedom to move their business to firms that provide more transparency around execution. 
The Code specifically recognises the importance of time stamps in enabling an "effective audit trail for review and to provide transparency to Clients,” which in turn should accelerate the direction of travel already prescribed within MiFID II, delivering the essential ingredient for any post-trade analysis.  With accurate time stamps, the transparency available to Market Participants through sophisticated technology, such as BestX’s Pre- & Post Trade analytics, can move to another paradigm, enabling comparison of actual and expected costs against a representative market data set sourced from multiple independent providers with millisecond granularity.  Where supplied, multiple time stamps per transaction can also be consumed to measure the slippage from order inception through to market arrival and execution.  Such “implementation shortfall” measures the cost associated with any latency around order processing.  Our unique “Trade Inspector” screen also provides a “Fill Speed” measure directed at algorithmic trades representing the time it takes to fill 1 million USD notional on average.  
Market participants have also focused on the explicit right to pre-hedge client orders when acting as a principal, with the caveat that this must be done fairly and with transparency.  Pre-hedging is the management of the risk associated with one or more anticipated client orders, and though it carries risks of front running, it is designed to benefit the client in connection with such orders by allowing the principal to manage its risk.  To make this principle fair and manageable, both buy-side and sell-side are likely to invest in technological tools to monitor adherence to best execution while still allowing for the practical necessities of pre-hedging.

Most significant among the principles is Principle 14, that the “Mark Up applied to Client transactions by Market Participants acting as Principal should be fair and reasonable.”  Mark up is the spread or charge that may be included in the final price of a transaction in order to compensate the market participant for a number of considerations, including risks taken, costs incurred, and services rendered to a particular client.  This Principle comes at the same time that MiFID II requires enhanced costs and charges disclosure, noting in Recital 79 to the Delegated Regulation that such disclosure “is underpinned by the principle that every difference between the price of a position for the firm and the respective price for the client should be disclosed, including mark-ups and mark-downs.”  Whether the FX market will go as far as other markets in transparency remains to be seen, but one thing is certain, and that is that technology will be necessary to meet this principle.  The Code is clear that “Market Participants should have processes to monitor whether their Mark Up practices are consistent with their policies and procedures, and with their disclosures to Clients. Mark Up should be subject to oversight and escalation within the Market Participant.”  Independent FX software with tools such as automated reports and exception reporting that analyse actual against expected costs will help both sides of a transaction make certain that best execution has been achieved and will become essential to those seeking adherence to the Code.   
Overall the Code is a significant step forward for the FX markets.  Yes, there have been global codes before.  Firms have signed up to them with a signature but not behaviour, never realizing they would be called to task or have that code set the standard against which regulators matched their behavior.  This Code will be different, not just because it comes on the heels of the FX scandal, but because that scandal and the evolution of Fintech have created a world of technology that makes it possible to monitor adherence to the Code, including advance communication monitoring, and independent best execution monitoring and transaction cost analysis software.  The best of these technologies are cloud based, and easy to deploy and use, making monitoring simpler, easier and affordable.  There is every hope therefore that this Code will be supported not just by statements of commitments but by real, measurable, change.