Stop Losses in the Spotlight as ECU Group Updates Lawsuits

Stop losses have always been a tricky issue in foreign exchange markets. On one hand the customer is looking for the highest possible protection but is unwilling at accept the slippage that “keeping them in” can entail, on the other, the banks holding the order are torn between a duty to protect the customer and the risk that the market gaps through the stop, leaving them with an occasionally hugely unprofitable position that was not of their own choosing.

Historically stops were been handled on a “best efforts” basis, the executing agent genuinely did their best and the customer accepted this – there was a basis of trust between the parties, underpinned, it has to be said, by the threat of losing the customer’s business thanks to a bad exit.

In recent years more structure has been put in place around stops, not least because they are increasingly handled in an electronic fashion and that requires data inputs. As the FX Global Code states, participants should “fully define the terms of a stop loss order, such as the reference price, order amount, time period, and trigger; [and] disclose to clients whether risk management transactions may be executed close to a stop loss order trigger level, and that those transactions may impact the reference price and result in the stop loss order being triggered.”

In addition, some parties have drawn up general agreements around issues such as maximum slippage on orders, however these have proven unhelpful during bouts of volatility.

Lawsuits

It is against this background of a diminishing of trust that a raft of lawsuits by currency manager ECU Group have been updated. The manager is deep into a case it brought in 2017 against HSBC for allegedly front running stop losses – it is expected to be heard in a UK court in June – but in November last year it brought similar cases against five other banks, three of which were updated last week. All the alleged misconduct relates to the 2006-2010 period.

The banks involved are Barclays, Citi, Deutsche Bank, Goldman Sachs and Natwest Markets (the filings against the latter three being updated last week), and the common denominator between the six, including HSBC, is ECU Group seizing upon regulatory findings as the basis for its arguments.

The core of the claims will make familiar reading for veterans of the chat room saga in FX – ECU Group notes that various regulators have found that dealers exchanged order information and client names in chat rooms, in addition to their more publicised chatter about impending fixing orders. In addition, ECU reveals it has analysed sample trades in each instance, and says they bear the “hallmarks of misconduct” when taken in the context of the regulatory findings.

In addition to filing allegations of front running, therefore the triggering of, stop loss orders, ECU Group is also claiming that some banks executed at a worse rate than they should have when the orders were hit. It has requested trade logs and more details from the banks concerned, the filings show, however the response appears muted, with Natwest Markets singled out as providing “limited information” and others nothing at all.

ECU Group reveals it has analysed sample trades in each instance and says they bear the “hallmarks of misconduct” when taken in the context of the regulatory findings.

The updated filings from ECU Group cite, amongst others, the findings of New York State Department of Financial Services’ (NYDFS) Consent Orders issued in 2018, with a key aspect of the case against Goldman Sachs being how NYDFS found that the inappropriate sharing of information “created the opportunity for Goldman Sachs traders to trade advantageously against other banks’ customers – and, likewise, to allow other banks’ traders to get a leg up on clients of Goldman Sachs.”

Equally, the latest amended cases rely upon a NYDFS Consent Order against Deutsche Bank and a Financial Conduct Authority Final Notice from 2014 against Natwest Markets. Using the same language in all filings, ECU Group states, “The regulatory findings are or ought to be largely uncontroversial as the Bank either agreed to or settled regulatory enforcement action and prosecutor’s charges on the basis of the facts and matters contained in the regulatory findings.”

Challenges

Notwithstanding the final decision made by the UK legal system, and acknowledging that the alleged behaviour was, again, historical in nature and in contravention of established policies by at least two of the banks (Deutsche Bank and Goldman Sachs), there is a sense of inevitability about stop losses becoming a focus for the legal profession. Equally, there are those who believe the banks are going to settle the charges thanks to, as one source puts it, “their initial rush to settle any and all charges”.

There may also be challenges for the FX Global Code in this issue, not least around pre-hedging. As has been noted many times previously, much of the conduct under the microscope was – even 15 years ago – expressly forbidden by banks’ internal policies and more public documents like ACI’s Model Code. While the filings clearly hold the banks responsible for what regulators found to be a failure to adequately supervise a rapidly changing business structure, especially the increased use of technology to communicate, inevitably there will be questions as to whether the individual traders concerned were merely pre-hedging the orders.

If the orders were triggered, as is inferred by ECU Group, by another party based upon confidential information provided by a trader at the bank holding the order things seem clear cut, but what if the trader had “triggered” the order themselves? “Every time you pre-hedge a stop loss, you increase the chances of the level being hit,” observes a UK-based salesperson. “We live in a different world now where every stop loss execution is heavily scrutinised, so I don’t think there are traders out there – in the institutional world at least – that are deliberately targeting them. They know they’ll probably be found out so why bother?

Stop loss orders are more trouble than they’re worth…as a bank, there’s no value there for us, it’s all downside.

“The ongoing problem is what happens around larger stop losses, where waiting for the level to go means you’ll drop potentially big money unless the customer is willing to accept the slippage?” the salesperson continues. “We really need some template for how pre-hedging should work so that dealers can follow it closely, but in reality that’s impossible because market conditions and orders are always different.”

There is no better way to highlight the challenge of stop losses than the desire on the part of some banks to decline to accept them. Multiple banks spoken to by The Full FX have disclosed that they have either imposed stricter conditions under which they will accept a stop, severely reduced the number of stops they accept, or refused to accept them at all. “They’re simply more trouble than they’re worth,” explains the head of trading at a bank in Asia. “Customers want to have their cake and eat it. They won’t accept pre-hedging – and I don’t blame them incidentally – but they also want to impose a maximum slippage that is unrealistic in many cases.

“Looking at it as a bank, there’s no value there for us, it’s all downside unless it is a very important customer for the wider organisation, we’re on a hiding to nothing – either accused of triggering the stop, or wearing a horrible position that is instantly out of court.”

A trader in London reinforces the message by noting, “A lot of customers are very clever with their stops. They know they are at critical technical levels for example so they want to pass off responsibility to someone else when that level breaks. If you want to look at the value of a customer to the FX business look at the balance of stop losses versus take profits you get. There are very few that are even, it’s regularly the aggressive stops they pass on, while holding the easier, passive take profits.”

A senior manager at a buy side firm that does leave stops takes issue with this. “The levels may be tricky, but it’s not deliberate on our part, as a systematic manager we have very little say in where the stops are placed. I would also argue that the banks, who tout internalisation rates in the 80 percents, rarely lose any money on these orders.”

Good News…and Ideas

The good news, if there is any, in the resurfacing of stop losses as an issue, is that thanks to the FX Global Code, there is a framework in place that highlights the importance of transparency and open discussions with clients about how their orders are handled. No longer should a client be surprised by how their orders are handled. Equally, some institutions, Natwest Markets prime amongst them, operate non-profit centre segregated order desks to reduce or eliminate potential conflicts of interest.

The less happy news, is that pre-hedging of stop losses will remain an issue. “The Code’s guidelines very much revolve around whether an order is “confirmed” or “anticipated” when it comes to the rectitude of pre-hedging,” says the head of e-trading at a bank in London. “The problem is whether or not a (stop loss) order is “confirmed” when it relies upon a trigger, therefore is contingent and thus falls into the “anticipated” category?”

As another dealer noted when discussing this issue, there is still risk held by the bank if it is pre-hedging, “the customer could cancel the order one pip out”, and that in itself reinforces the “anticipated” nature of the order. Getting the industry to agree on exactly what type of order a stop loss is would clearly be a significant achievement for the Global Foreign Exchange Committee.

While disclosures and greater transparency around order handling means that further lawsuits are unlikely (at least concerning current day activity, there is still the threat of a rash of similar cases depending upon the outcome of the ECU Group litigation), one potential way to solve the issue is for customers to accept that certain orders will attract slippage, especially sizeable stop losses that will create market impact.

Given general attitudes, this is unlikely, however, because there is still the sense that customers want nothing to do with pre-hedging of their stop losses but refuse to countenance they may have to wear the five point slippage rather than the executing agent. The question has to be asked, however, in the age of independent TCA, surely claims of best efforts can be supported? Equally, executing parties could consider providing proprietary trade data (anonymised) if and when a customer raises a query about an execution and the trading around that time.

Finally, an independent body could be established to deal with potential complaints, that would have access to the appropriate public and private data to make a ruling.

Whichever way the industry goes, the ECU Group lawsuits remind everyone that stop losses as an issue remains a problem that is not easily going away – and as one source remarks, “Imagine how much more complicated this gets when the orders are not only managed electronically, but AI and machine learning tools are in charge?”