Codes of conduct and market standards address poor behaviour in FX markets far more effectively than formal regulation − which has inadvertently altered the balance between liquidity providers and liquidity consumers, and could even discourage prudent behaviour. But, buy-side commitment and improved data transparency are recommended strategies to further improve behaviour.
In the first FX session at Sibos 2019, moderator Gavin Wells engaged with Mark Yallop (Chair, FICC Markets Standards Boards), Michael Dawson (Head of Liquidity and FX, Shell), Neill Penney (Managing Director and Global Head of Trading, Refinitiv) and Richard Turner (Senior Trader, Insight Investment).
This is the first in a series of articles based on panel discussions at Sibos 2019, where industry figures came together to examine the issues impacting FX markets.
Why FX is unique in regulatory terms
FX is a completely fragmented market, with trading done mostly over the counter (OTC) and, to a large extent, without the need for regulation. "There has never been a regulated FX Market because no one global regulation could exist," Wells told the Sibos audience. "Market participants are regulated but not the market itself."
Banks participating in the FX markets have certainly not escaped the indirect consequences of the increase in regulation following the global economic crash of 2008. The higher cost of capital under the Basel IV capital adequacy regime, for example, has reduced the number of banks making genuine two-way prices in currency pairs.
The unintended consequences of regulation
"We have ended up with a market with a small number of people who are genuinely market-makers − almost too big to fail − and a large number of people who are using that liquidity," explained Neill Penney, managing director and head of trading at Refinitiv. "That wasn't the market structure people intended ten years ago when they set out to make fair and effective markets. It is an unintended consequence, and one that has not been for the better in terms of healthy global markets."
These unintended consequences are also evident in the one area of the FX markets to be regulated directly, OTC derivatives. Users of currency swaps are now expected to shift transactions into central counterparty clearing houses (CCPs), report transactions to trade information warehouses and collateralise uncleared trades.
These measures are prompting concern that buy-side firms are being discouraged from hedging currency risks because of the costs to make a derivatives trade.
"We were forced to margin our derivatives from early 2017," said Michael Dawson, head of liquidity and foreign exchange at Shell. "The swing that has created to our cash flows as the mark-to-market moves has been quite significant. As that derivative book builds up over time – and we are still very much at the shorter end of the curve − this is going to get ever more painful."
Mark Yallop, chairman of the Fixed Income, Currencies and Commodities (FICC) Market Standards Board (FSMB) agreed that "hasty judgments" made by regulators in 2008-09 had led to unintended consequences.
A more flexible approach required
Yallop added that these hasty judgements were “why regulators now favour less rigid approaches, such as the 55 principles of good conduct enshrined in the FX Global Code and the market standards published by the FMSB.”
The public authorities in this country, and indeed central banks and regulators all over the world, recognised three years ago, when FMSB was set up, that formal regulation and hard letter law could not solve the behavioural and ethical challenges in wholesale markets. The asymmetry of information, the speed of innovation and the global nature of markets are all factors which work against being able to rely on regulation. Regulation is essential as a prerequisite for fair and effective markets, but it is not enough. "What you need beyond that are codes which set out in principle form how people should behave when you reach a fork in the road, and you have a choice of going left or going right."
This is why regulators are disappointed by the lack of buy-side support for the Global Code, because client insistence on adherence would accelerate sell-side adoption.
The difficulty of publicly committing to some standards
Adoption of the Code would also help buy-side firms avoid over-paying for FX. Unfortunately, the buy-side lacks the time and money to invest in a code they regard as a matter for providers rather than consumers of FX services. Their compliance departments also warn of the risk of making a public commitment to certain standards.
And yet, public commitment remains the only method of enforcing informal measures such as the FX Global Code and the FMSB standards. "It is not regulation," explained Neill Penney. "There is no regulator. It is the community maintaining its own standards."
Data the most effective standard
Michael Dawson highlighted data as the most effective discipline, as it can show buy-side firms which sell-side banks are living up to the standards and enable them to benchmark the performance of the banks they use.
"It is the responsibility of the buy-side and the sell-side to ensure that they are actually practising what they preach," explained Dawson. "We are certainly doing that. We spending more and more time looking at our market behaviours, our practices, ensuring that we are actually complying with what we said we would comply with. Data is a massive facilitator of that. As data becomes ever more prevalent in these markets, we can actually − in a very granular way − assess, ‘Did we actually meet the expectations that we set out to meet?'”
Two more articles covering highlights of the FX discussions at Sibos 2019 will be published over the coming weeks.