The Last Look…
Posted by Colin Lambert. Last updated: July 27, 2021
There comes a time in every walk of life where delivering required change takes leadership. I believe the FX industry is now in that position, and the leadership can now only come from two sources – the provider or the buy side.
I would say this is a new position for me, but it’s not, so I won’t – I think the five-minute fixing window is putting the foreign exchange industry, potentially even users of the benchmark, in harm’s way. Now is the time for change.
I believe in terms of its calculation and management, the 4pm London Fix is fit for purpose, but as a proponent of the broader foreign exchange industry, I have to say it no longer is thanks to the five-minute calculation – and in my eyes the recently-published GFXC paper on pre-hedging has heightened the need for change.
As far as the FX Global Code is now concerned, the Fix cannot be pre-hedged, it is a firm order and therefore can only be “hedged”. As I have pointed out several times, this means that trading is being done in front of the window, that materially effects the level of the market, but no benefit (or once in a hundred times, cost) is passed on to the client, because the vast majority of clients don’t want any benefit (or cost). It literally is the money that no-one really wants!
If you turn to a layperson with basic knowledge of financial markets and explain what happens ahead of the Fix, the chances are they will deem it front running or insider trading. This is important, because as Mark Johnson found out to his cost, it is people like this that make decisions over people’s guilt or otherwise. According to the latest GFXC guidance, what HSBC did in handling the Cairn Energy trade was largely by the book, the order was “firm” and therefore the risk was being hedged. The problem is explaining that to a jury of laypeople because to do involves very difficult to understand and complex processes. Comparatively speaking, explaining someone bought ahead of the rate being fixed, and benefitted from that trading, is much simpler – hence the decision in the Johnson case.
The problem is, as I have argued time and again, and been supported by people in the cutting edge of the business – the trading teams – the sheer volume expected to be traded overwhelms the fix-minute window. Why else do banks hedge ahead of the Fix? They can’t be stupid enough to see it is as an opportunity to make money, not overtly anyway, by changing the price through (pre) hedging, and they are certainly well aware of the potential cost of malfeasance.
So why do banks do it? Because their analytics tell them that the new order flow is simply too big for a five-minute window.
The GFXC has clearly found the whole hedging/pre-hedging issue incredibly difficult to hone down to one or two principles, hence the guidance paper, but even now there is a huge grey area that spans acceptable and unacceptable conduct – hence the statement I led with last week about intent being difficult to prove.
The situation now in the foreign exchange industry is that we have too many clients blindly ignoring the Code and continuing to use the Fix unquestioningly – and we have banks that are between a rock and a hard place, knowing they have to execute in what looks like a front running style, but genuinely isn’t because they need to reduce market impact. Both are now at risk, the former for potentially costing their investors millions of dollars, the banks for activity that one New York jury has already found illegal.
Sometimes you have to lead in this world, you cannot always sit back and wait for customers to tell you something is wrong
I can only see three exit strategies from this whole mess.
Firstly, a very large number of contracts have to be re-written explaining in legalese, what hedging ahead of the Fix is, the thresholds at which it may be done and, of course, a total indemnity for the executing party. This, of course, raises the spectre of executing parties caring less about what happens, they will pre-hedge at will and continue to make good money from it. It also opens up a can of worms the buy side would rather be kept close – re-drafting contracts.
The second option is for the executing parties to give us a prolonged demonstration of what would happen in a five-minute window by not trading ahead of it. It will be interesting to see what happens over the course of a typical month if these firms decided the FX Global Code is too unclear and that there is legal risk (which there is) in (pre) hedging the Fix. I suspect we will see some big blow outs in the market during these windows, as people try to cram too much through (on which note, Matt Clark at XTX Markets has published some interesting work on LinkedIn which suggests sensible execution takes longer than perceived in FX markets – it’s well worth a look).
The third option is one I have been arguing for over the past two to three years at least – use a longer window. As The Full FX has written over the past few months alternatives now exist. This column is not in the business of promoting one solution over another and we have to recognise the absolute dominance of Refinitiv Benchmarks in this area.
Sometimes you have to lead in this world, you cannot always sit back and wait for customers to tell you something is wrong – especially when it is so glaringly obvious as now. I believe it is time for Refinitiv Benchmarks to demonstrate leadership and be a good FX market citizen, by acting on behalf of the entire foreign exchange industry and extending its window.
The longer the FX industry continues with a five-minute window, the more it is being put in harm’s way and we’re at the stage now, with the GFXC effectively saying there is no more it can do on the subject, where the choice is stark – one firm makes a positive difference by changing, or the buy side assumes legal risk for blindly accepting a process that harms their investors. One is a “good” outcome, the other…?