The Last Look…

The failure by former HSBC head of cash trading Mark Johnson to have his conviction vacated in the US effectively brings the whole sorry episode to a close, which makes it timely to ask the question, ‘are there any lessons for people in today’s market?’

Probably the number one lesson is “don’t get convicted in the US’, because in spite of the fluid approach by the prosecution – which made different arguments in the appeal than it did in the original hearing, and accepted that some of its accusations in the latter were wrong – it seems clear that it is very hard to overturn a conviction. The onus moves from the prosecution to make the strongest case, to the defence. On several occasions, the message from the judiciary has been that the argument for overturning has not been strong enough legally – the original arguments have often seemed secondary to the process.

The most surprising aspect for me was the last chapter – after a superior court had ruled that “right to control” was no longer adequate for a wire fraud conviction, and the US government halted its attempts to extradite his former colleague Stuart Scott because of that ruling, it seemed like Johnson was going to be judged on the “new criteria” – after all, “right to control” was a key plank of the government’s case. Instead, we got yet another instance of one part of the prosecution case being dropped, but another being given sufficient prominence to allow the conviction to stand.

This moveable feast is probably the biggest concern for anyone that will face court over alleged FX market misconduct – the use of multiple charges allows the prosecution a lot of room for manoeuvre. There is also the whole fiduciary duty aspect. Here are two extracts from the mandate letter that were part of the government’s evidence for prosecution.

“HSBC is not responsible for providing the recipient with legal, tax, or other specialist advice and the recipient should make its own arrangements accordingly. The recipient is solely responsible for making its own independent appraisal of and investigation into the products, investments and transactions referred to in this document and should not rely on the information in this document as constituting investment advice.”

Secondly:

“The issue of this document is for information purposes only and does not constitute any form or part of (i) any invitation or inducement to engage in investment activity, or (ii) any offer, solicitation or invitation by HSBC or any of its officer, employees or agents for the sale or purchase of any securities or other investments described herein.”

There are two aspects to this which may be of concern – firstly the letter is not signed by Johnson, so why was he nailed with the allegations? Secondly, it seems to state, from my legally-naïve viewpoint admittedly, that the bank has no fiduciary duty to the client – the very thing he was convicted of breaking.

If HSBC had executed the Cairn trade as the prosecution argued in the first hearing, then the bank would have been in breach of the modern-day Code for accepting an order that was clearly going to be disruptive

We should always judge events from more than a decade ago carefully – the world moves on – but it is worth looking at the bare bones of the case, as well as look at how it would sit in today’s FX Global Code world, not least because there will be lessons there for today’s traders and managers.

The first point is that we are still putting traders in harm’s way by using a fixing window that is too short for the amount of volume traded, and that means (pre)hedging.

In the Johnson case, HSBC had to buy over two yards of Sterling in what was a one-minute window. Clearly, it was too much, therefore the bank traded ahead of the actual window to smooth the execution. In today’s market, a bank faced with a large fixing order does what? They trade ahead of the five-minute window to smooth out the execution. In both cases, the customer does not receive the actual execution rate, they receive one arrived at via a TWAP mechanism over part of the trading window.

So where are the differences that led to Johnson having to spend time in a US jail and still face obstacles to a normal life? Well, there is little doubt his case was damaged by the HSBC Cable trader at the time, Frank Cahill, using the word “ramp” to describe part of the order. No matter how it was meant, it doesn’t sound good. Secondly, and this is where things get a little grey, was the customer warned that pre-hedging would take place? The answer seems no, not specifically, but evidence at the original trial suggested that the Cairn treasurer certainly knew it would take place – hence his comment that HSBC will make its money buying ahead of the Fix.

As a small digression, some have suggested to me over the years that the recommendation to use the 3pm Fix, rather than the more popular 4pm, didn’t look or sound right, but I am not sure I agree. It was not a month-end, therefore while there might have been higher flows an hour later, they would not have been anywhere near the magnitude of a month-end. More pertinent – and this is something for the world to consider as they ponder greater use of a 4pm New York Fix – there was likely to be deeper liquidity at 3pm in London than 4pm, because European banks were still up and running. This may have made the pre-hedging a little easier, because the speculators weren’t looking at that window.

The second lesson form the Johnson case is very relevant today – be careful what you say and write, especially in chat rooms. The “Christmas” comment could easily have been about how the customer had, with its choice of the Fix, taken the channel with, ironically given how things turned out for Johnson, the least risk for HSBC. The risk transfer option gave the bank a safety net of up to 100 points from spot, so while most would agree that should be enough to ensure the bank made money (we need to remember this was in December, not always the most liquid month), there was a greater risk there, than executing the trade around the Fix. The comment was taken in a very different context by the prosecution (and, seemingly, the jury).

The third lesson is the need to be very clear with clients. As noted, there seems to be no fiduciary responsibility here on the part of HSBC, but that didn’t stop the prosecution trying to describe one. Look at what has happened recently with cases of alleged mis-selling of derivatives – a lot of the companies involved had people in their Treasury function who claimed to know the product, but when it became clear that the deal had gone wrong, the companies often sacked their “expert” and sued the bank that sold the options.

The Code states that communications should be clear and set out exactly what the client is doing – that seems good advice.

Incidentally, on the Code – as I have pointed out before – if HSBC had executed the Cairn trade as the prosecution argued in the first hearing (and that was the most important stage of this case remember), then the bank would have been in breach of the modern-day Code for accepting an order that was clearly going to be disruptive in the market. It was the first, and still the best, argument I made against the government’s case – try buying over two yards of Sterling, in December, in one minute. Mayhem does not even begin to describe it.

None of this helps Mark Johnson, of course, but it is important that those responsible for training and oversight are aware of the risks that remain.

On that point, this year marks the latest review of the FX Global Code and we have already covered the survey used as the basis for the impending assessment of its value. In that survey, the number one concern, as measured by respondents’ unhappiness, was pre-hedging, with 13.5% of respondents observing an occasional lack of transparency around the practice.

We can help avert a repeat, genuine bad actors aside, by cleaning up our guidance on the practice and investigating properly the use of fixes and pre-hedging of large orders

The Code is pretty clear on the need for transparency, but this was, of course, a fixing order – something on which the Code is less clear, preferring to differentiate between fixing and other orders in a guidance paper. I can’t help but think, in spite of the tediousness of the whole process in some eyes, that we, as an industry, need to do more around the issue of pre-hedging and hedging ahead of a Fix. A bank in Australia has just been fined for its “unconscionable” handling of a large interest rate order, and Mark Johnson is probably the only FX person to lose their liberty for a couple of years. Both cases had one thing in coming – pre-hedging or hedging ahead of a FIx. Including all the information sharing in the Bloomberg chat room cases (which also involved hedging ahead of the Fix), this is the most common factor in attempted and completed lawsuits and trials.

Mark Johnson may just have been unlucky through timing, the mood of the world post-GFC, and the US’s desire for a “head” from the financial industry, but there is nothing to say that someone else won’t be as unlucky in the future. We can help avert that, genuine bad actors aside, by cleaning up our guidance on the practice and investigating properly the use of fixes and pre-hedging of large orders.

Too many people think the issue of pre-hedging has been dealt with – I disagree. And if we are to avoid someone else going through eight years of hell like Mark Johnson, we should do something about it.

colin@thefullfx.com