The Swiss based Financial Stability Board (FSB), has published an interesting consultative paper, Foreign Exchange Benchmarks Consultative Report.
The paper looks at FX market structure, and how that created incentives for market malpractice – mainly in the form of allegations of front running client orders, collusion between bank dealers sharing information on client orders, and manipulation of rates during fixing – linked to the structure of trading around the benchmark fixings. The paper makes recommendations to address these adverse incentives as well as examining how to improve the construction of the benchmarks themselves.
The main FX benchmarks used by market participants are the WM/Reuters London and ECB reference rate. Unlike Libor, these benchmarks are based on actual trading activity during a fixing window. FX benchmarks are used by market participants for a variety of purposes, but most notably for valuing, transferring and rebalancing multi-currency asset portfolios.
This market structure creates what the report terms as an:
Optics of dealers ‘trading ahead’ of the fix, even where the activity is essentially under instruction from clients. Worse, it can create an opportunity and an incentive for dealers to try to influence the exchange rate – allegedly including by collusion or otherwise inappropriate sharing of information – to try to ensure that the market price at the fix generates a rate which ensures a profit from the fix trading.”
The result of this activity by their clients leads to a concentration of trading orders being transmitted to dealers, in large part shortly ahead of the fixing time. In order to manage the risk associated with this client order flow, dealers hedge by executing foreign exchange transactions in and around the calculation window, which results in the large spike in trading volume. This creates a market where the dealer is agreeing to execute these orders at an unknown price, which is established subsequently during the fixing calculation window. That price should be the clearing price which reflects the balance of supply and demand going through the market at that time and therefore prices should move as necessary in response to these flows. In most cases, the dealer agrees to give the client the mid-rate of this (as yet unknown) fix price, whether the customer is buying or selling.
The report makes 15 draft recommendations with participants having till 20th August to respond before final recommendations go to the G20 leaders in November. One of the more interesting ideas being:
Development of an industry-led initiative to create independent netting and execution facilities, and the development of a global/central utility for order-matching to facilitate fixing orders from any market participants – maximizing netting opportunities and reduce need to provide advance information on client flows to dealers.
Other key recommendations are shown below, with full list on page 5 of the report.
- Widen the fixing window from current one minute period, and examine alternative benchmark calculations VWAP, TWAP benchmark price calculated over longer time periods of up to and including 24 hours
- Fixing transactions be priced in a manner that is transparent and is consistent with the risk borne in accepting such transactions (either via a bid-ask spread, or clear fee structures)
- Banks establish and enforce their internal guidelines and procedures for collecting and executing fixing orders including separate processes for handling such orders
- Market-makers should not share information with each other about their trading positions beyond that necessary for a transaction. This covers both individual trades, and their aggregate positions
- Market-makers should not pass on private information to clients or other counterparties that might enable those counterparties to anticipate the flows of other clients or counterparties, including around the fix
- Banks establish and enforce their internal systems and controls to address potential conflicts of interest arising from managing customer flow
- Codes of conduct that describe best practices for trading foreign exchange should detail more precisely and explicitly the extent to which information sharing between market-makers is or is not allowed. They also should, where appropriate, incorporate specific provisions on the execution of foreign exchange transactions including fixing order
Report summary here and full report here
