Next FX scandal: agency, principal or hybrid?

Solomon Teague
Published on:

A lack of clarity around the definitions of principal and agency trading, and the evolution of the grey area of the hybrid could give rise to further foreign-exchange scandals if the issue is unresolved. Markets and regulators are pro-actively putting these FX trading practices under the microscope.


Global regulators, including the European Securities and Markets Authority (ESMA) and the UK’s Financial Conduct Authority (FCA), are working on providing clear definitions to clarify what constitutes agency and principal trading in FX.

A considerable amount of FX trading is conducted on an agency basis, meaning essentially the banks act as brokers for their clients, helping them source liquidity in the market, but without taking on principal risk themselves.

By contrast, a bank acting as a principal would execute a trade with its client itself, taking on the risk, which it could then warehouse or lay off via another trade.

There are advantages and disadvantages to both models. Principal trading requires the bank take on execution risk, so should cost the client more.

However, agency trading opens up the bank to potential conflicts of interest: the client’s order should be anonymous while the bank fills the order, but if this is not effectively managed there is potential for other parts of the bank to trade against the client.

"In some instances, you have clients doing two transactions within a single call, with the bank acting as agency in one trade and principal in the other," says Phil Weisberg, head of FX at Thomson Reuters. "It is not clear that either the client or the bank always understands the consequences of this.

"It is important to clarify the definitions around principal and agency trading so the industry has a common nomenclature."

Russell Dinnage, senior consultant at GreySpark, says: "The spot FX trading industry is rapidly heading toward an agency-only trading model, but for the time being principal spot FX trading models are still widely utilized.

"There are now many banks experimenting with innovative hybrid agency/principal spot FX trading models, and these are a sign of changes afoot."


This hybrid, or riskless principal trading, gives rise to perhaps the greatest potential for confusion. This model is when a bank acts as a principal to the trade – ie it takes the risk on itself rather than acting as a broker – but then has the discretion to trade the position itself.

In this way, a bank effectively acts as an agent, or a broker, by finding a counterparty wanting to take the other side of the client’s trade, but instead of letting the two sides trade against each other, it executes the two trades, with each of them, itself, rather than warehousing the risk fully.

One view is that this 'riskless’ principal trading is tantamount to agency trading, and should be treated as such. However, others argue a bank has discretion, when it has acted as principal to a trade, to actively manage its risk, warehousing what it wants and selling on what it doesn’t.

Where you stand on the debate influences whether you think it’s appropriate for a bank to charge agency or principal fees.

James Kemp, managing director of the global FX division at the Global Financial Markets Association (GFMA), says: "Issues can arise if the counterparties are not clear as to the nature of the trading relationship – both parties need clarity as to what their obligations are and what they can expect.

"The FX market has historically worked well, delivering a cost-effective solution for end-users – but following recent conduct issues we have to accept that questions have been asked of us and enhancements in evidencing and monitoring will be needed."

Market participants stress there is nothing inherently wrong with the hybrid model, as long as there is full disclosure about the banks’ policy, and clear and appropriate documentation is used for each trade. A number of banks are said to be a considerable way down the road in resolving these issues internally, at least.

The fixing issues and other scandals that have dogged FX in recent years have played a part in forcing banks to think about this issue, and to review all their practices to ensure no more skeletons are found in the closet.

Thomson Reuters’ Weisberg says: "We are in a market of generally rising conduct standards, and both liquidity providers and takers are increasingly aware that they will be held to higher standards than they would have in previous generations."

Regulation is playing an important part, too. In the US, the Volcker rule, parts of which came into effect in July, defined the scope of what principal trading activity banks could engage in. In Europe, regulations such as Mifid are similarly teasing out these potential conflicts.