CFTC Hits Mizuho with Pre-Hedging FX Fine
Posted by Colin Lambert. Last updated: August 9, 2023
With The Full FX View
The US Commodity Futures Trading Commission has levied a $6.8 million fine against Mizuho Capital Markets for failing to disclose to clients it was trading in the markets before providing the rate on deal contingent forwards.
The US regulator says the activity took place over an 30-month period from June 2018 and the bank traded in the spot markets in the minutes and seconds prior to it providing the final outright rate to the customer, thus, CFTC alleges, it could have moved the market away from the client.
The CFTC cites 13 specific trades in which a Mizuho FX salesperson informed a trader on the desk that the client was calling to execute the deal contingent forward and the trader started hedging the bank’s exposure in the markets, “often through multiple price levels” before the bank gave the client the rate. “[Mizuho] did not adequately disclose that by trading in this way, [it] engaged in activity that likely at times contributed to moving the spot exchange rate in the relevant currency pair against the client,” the CFTC states.
The regulator further adds that in late April 2019, Mizuho changed its FX disclosures to state it “will always endeavour to avoid unreasonable impact on the market”, and will “appropriately manage any possible conflicts of interest that are anticipated from the information it acquires through relevant transactions”.
In October 2020, the bank added a policy requiring the trading supervisor to review the trade blotter for evidence that pre-hedging took place that disadvantaged the client or disrupted the market. It then conducted a review of activity during the relevant period of the CFTC Order and the regulator cites a Mizuho report which concluded, “FX Trading does not identify and review potential pre-hedging transactions to verify that pre-hedging was communicated to clients, commensurate with the anticipated risk and not done in a manner to disadvantage the client.”
Accordingly, CFTC says the audit group concluded that because there was no system in place at the time to identify pre-hedging trades for evaluation, “Pre-hedging may not be performed fairly or transparently, resulting in adverse outcomes for clients or unmitigated conflicts of interest.”
The Full FX View
Although the FX Global Code is not mentioned in the CFTC Order, or release, it is probably of some relief to proponents that what the Commission is taking issue with is not the act of pre-hedging, rather Mizuho’s failure to disclose it.
This is broadly in line with the Code’s guidance on the issue and while this is still something I have a problem with, at least there is some consistency between the view of one of the main US regulators and what is widely perceived to be best practice by the FX industry.
One concern, however, is the repeated observation in the CFTC Order that the pre-hedging cannot be to the detriment of the client (this is a core tenet of the Code as well) – specifically, what is deemed “detrimental”? To an experienced FX trader, larger tickets are inevitably going to have market impact and spreading the execution out over a longer period reduces that impact (but obviously increases market risk). The fact is, though, that in the vast majority of cases the pre-hedging is going to move the market – what matters is by how far and, less so, the intent. The trouble is, it is impossible to define what constitutes “good” pre-hedging because market conditions are so variable, therefore neither a regulator nor best practices guardian can lay down specific degrees of impact, and as such the problem will persist.
An interesting insight into this case comes from the CFTC’s apparent ignorance of the FX Global Code and its Principles – this reinforces the sense in some circles that the US remains somewhat lagging in adoption. One would have thought that the regulator would at least have acknowledged the industry’s code of conduct – not least because Mizuho didn’t adhere to it.
This raises a secondary point, looking at the GFXC Register, the entity fined by the CFTC – Mizuho Capital markets LLC – has not registered a Statement of Commitment, although it should be pointed out that the bank itself, its securities business and some regional Asia subsidiaries have done so. At any level the operation was engaged in the FX markets, and the broader organisation had adhered to the Code. Why then, barring the less than obvious but entirely possible chance that it is covered by the parent organisation’s Statement of Commitment, did the US operation not adhere?
Perhaps it is best that it is shown not to have committed any way – after all, what sort of signal does it send if a major banking organisation signs a commitment and then ignores best practice in such a systematic way?
In February 2022 Mizuho says it implemented new policies and procedures requiring its FX traders to specifically designate trades as “pre-hedging” if intended to offset anticipated exposure in connection with a client trade. In order to facilitate this, it told the CFTC that it made enhancements to its order entry system enabling traders to flag pre-hedging trades. This flagging allows the trading supervisor to more easily identify pre-hedging trades in the trade blotter. The trading supervisor will then review those trades for any issues of concern, including, but not limited to, whether they may have disadvantaged the client, and escalate such issues of concern to Mizuho’s compliance personnel if warranted.
The bank also updated its website’s pre-hedging disclosure to specify that pre-hedging “may be executed…before – including but not limited to, within the seconds and minutes before – during, or after the pricing or consummation of any directly or indirectly related transactions between Mizuho and you.”
The updated pre-hedging disclosure also advises clients that Mizuho’s pre-hedging may negatively impact price or liquidity and that “[t]his is particularly possible during times of low liquidity in the relevant market.”
The bank also told CFTC that it will implement a process to include a specific reference about its pre-hedging, along with a link to the pre-hedging disclosures on its website, in the long-form confirmations that it negotiates with clients in advance of every deal contingent FX forward. Mizuho also said it will agree to refrain from pre-hedging if requested by the client.