Any Other Business…

A wise person once said, “start as you mean to go on” and with this in mind I will keep my heartfelt thanks to all of you who expressed your support following the demise of P&L and have reiterated that support by reading The Full FX, brief, and set about upsetting people again! So…riskless principal…discuss.

I confess to being somewhat at a loss to explain why we needed to invent an expression for what is, to all intents and purposes, an agent. Perhaps we are trying to spare the feelings of firms who are no longer permitted by their management to play a full part in the FX market by making their role seem more than it actually is? Equally, we could be trying to embrace firms that have traditionally been brokers and DMA providers and pump up their tyres somewhat?

Either way, what we are doing, as an industry, is blurring the role of market participants and allowing firms to masquerade as something they are not – liquidity providers through thick and thin.

The riskless principal model has been on the radar of the Global Foreign Exchange Committee (GFXC) for some time now as the committee worked to include the business model in the FX Global Code, but it strikes me there are some flawed perceptions underpinning this effort – namely that the Code doesn’t need to specifically outline the role of riskless principle.

A friend shared a draft paper – and I want to stress it was a draft and not a final version –produced for the GFXC’s deliberation into the matter and in just a few lines the question is answered. The draft observed that the service provider declares they will not take market risk when executing the order and that all liquidity executed to fill the order will be passed directly to the client. It then summarised, “The RP effectively acts as a conduit to the market on behalf of the client”.

Intriguingly to me (it was a long break!), the paper then went on to ask the question, “how is this different to the agency capacity?” To which my answer is straightforward: it’s not!

The draft explains that the word ‘agent’ implies responsibilities that go “above-and-beyond” the mechanics of trade execution. That is as maybe, but surely one of the guiding principles of the Code is that service providers do the best they possibly can for their client?

I suspect the trouble is some firms, banks predominantly, are concerned that as an agent they are providing some sort of advice to the client, although I struggle to see that argument. Back in the day if the client trusted the relationship with salesperson and trader, they would leave an “at best” order over the phone and then await news. It was the bank’s responsibility to fill the order, work out the average rate and then do one trade with the client for the full amount.

In the current market the best example is the client enters an order for a bank’s algo to execute and again, the end result is transmitted back to the client. The only real difference is clients can often track the execution in real time on a screen and the TCA report (independent or otherwise) is provided automatically at the end of the execution.

At no time in these processes is any advice proffered unless the customer specifically asks for it – at which stage the bank salesperson or trader has other elements of the Code to comply with.

The other potential issue, and I think this is perhaps at the heart of the matter, is what happens to price improvements? If the execution is TCA-ed but the executing party hits a better price, who pockets the difference? Riskless principal seems to exist to allow the executing party to take those improvements and perhaps the absence of a fee justifies that position? If that is the case, should this type of execution be allowed without a fee structure?

Aside from this issue of fees, however, I am struggling to understand when the role of riskless principal and agent would diverge, but even more bizarrely, as was suggested in the draft GFXC paper how the former can be in any way be placed under the “principal” banner? The paper even stated later on, when recommending adjustments to Principle 8 of the Code, that the phrase “varying degrees: be inserted into the Principle to reflect “the principal freely decides how much market risk it wants to take from 0% to 100%”

Putting aside the obvious inference that cherry picking will be taking place, and I am less than convinced that is good market practice, especially as another line in the draft stated, “The word ‘riskless’ is shorthand and actually refers to market risk. It is understood by the market that a so‐called ‘riskless’ principal will take other risks such as credit risk.”

So one hand, riskless means you don’t take on market risk, but on the other the riskless principle can decide how much market risk to take? It just doesn’t make sense (at least to me). How can this be aligned as a service under the “principal” banner – the pure definition of which is the assumption of such risk? Surely, if anything, it should be a service under the “agent” banner?

Also, if the riskless principle is a principle because they assume credit and settlement risk, doesn’t this make them a prime broker? Or should a prime broker be re-labelled a riskless principal – even though the PB unit itself never actually trades in the market (aside from rolls of course)?

The crux of the matter – and this is not a first for the modern foreign exchange industry – is the use of language. Just as the phrase “pre-hedging” was introduced into the market lexicon to cover a grey area (one that has obviously led to a lot of problems in the industry), so too is this.

I understand the level of complexity and need for simplicity when creating a global code of conduct, but to me the GFXC is being dragged into some sort of legal hell by the people that write the disclosures (yes, I am back and having a pop at the lawyers again!)

Another popular saying coined by a wise person states, “If it ain’t broke, don’t fix it”, and I think the FX industry would do well to heed it. The fact of the matter is that the role of a principal, one who takes on market risk; and the role of agent, one who executes on behalf of another, along with “broker”, adequately cover the roles taken on by market participants. Why do we need to change this terminology? It is not a pressing matter, but it bothers me that the industry is taking what it thinks is an easy way out of a tricky situation, but which may turn out to be fraught with danger.

colin@thefullfx.com