Banks might be putting the benchmark rigging scandal behind them, but regulators are still getting stuck into the mammoth task of scrutinizing the inner workings of the $5.3 trillion-a-day foreign-exchange market.
On Wednesday, the New York State Department of Financial Services (DFS) issued Barclays a $150 million fine for electronic foreign exchange misconduct, citing a "lack of transparency" about its last-look practice with its customers and even its own sales team.
Last look is a practice used by the banks to pull a price from a platform, even after a customer has clicked on it and placed an order – banks get the last look. It was initially introduced as a defensive measure by dealers to weed out "toxic flow", namely smarter, faster traders that could outwit dealers.
David Mercer, chief executive of LMAX Exchange, has campaigned for an end to last look and has brought it to the attention of regulators; he believes the practice is on its way out.
"Five years from now, it is inevitable there will be no last look," he says. "It doesn't exist in any other asset class."
Last look is widespread in FX. The practice has come under much scrutiny for being potentially open to abuse – now details have emerged of how the practice was mis-used at Barclays from at least 2009 to 2014, to the detriment of its customers. The DFS is investigating a number of banks' electronic FX businesses, making this an industry-wide issue.
Approximately 80% of Barclays' FX trading volume is conducted electronically, on its e-trading platform called Barx. Last look was imposed on client orders, which the bank says was to protect it against trading on stale prices and practices such as latency arbitrage, whereby high-frequency traders arbitrage minute price differences between multiple venues.
However, the DFS discovered that Barclays instead used it as a filter to reject customer orders that it predicted would be unprofitable to the bank.
In October 2008, a New York Barclays Client Services employee stated that last look would give its traders the ability to "profit check". The employee then went on to advise how to field a call from a client regarding their rejected trades:
"…it is important that you state in any communication ‘THE TRADE WAS REJECTED BECAUSE OF LATENCY.’ … DO NOT talk about P&L on trades.”
From 2009 onwards, a large number of rejected trades were not deemed toxic flow. The bank's electronic trading clients fall into two categories: those that trade using a graphical user interface (GUI) and those that trade using a financial information exchange application programme interface (FIX/API). GUI customers connect directly to a platform from their desktop, whereas API customers can plug in their own in-house system to the platform and, presumably, others.
According to the DFS, Barclays’ systems assumed the use of the API/FIX system was itself a "clear indication of customers' ability to engage in latency arbitrage and create toxic flow". All customers routing orders through such platforms were put on hold before their trades were executed.
During this hold time, if prices moved against Barclays in favour of the customer beyond a certain threshold, the order was considered toxic and rejected.
Blame it on IT
Senior FX managers ordered staff to hide the practice from Barclays' sales team and to even blame rejected trades on IT issues. A managing director and head of automated electronic FX trading said in a 2011 email:
“Do not involve Sales in anyway [sic] whatsoever. In fact avoid mentioning the existence of the whole BATS Last Look functionality. If you get enquiries just obfuscate and stonewall.”
Later that year, he also wrote in another email: “If there has been a spurt [in rejected trades] just blame it on the weekend IT release and say it’s being fixed.”
After the DFS started investigating, Barclays changed its systems in late 2014 to make it a more level playing field. Customers received the same privileges as the bank, in that trades that became sufficiently unprofitable to the customer during last look would also be rejected.
However, the bank neglected to update one of its trading platforms, meaning 7% of its trading volume operated under the old rules until August this year.
Far from over
In light of the benchmark rigging scandal, regulators are now examining the inner workings of the industry and rooting out bad practices. They are calling into question practices that, until recently, banks considered part and parcel of doing business.
The lack of time-stamping of trades in FX is a concern to market participants and regulators alike.
Meanwhile, FX is still very much relationship-driven – different clients get different prices from their bank. This is driving customers to exchange-like models where relationship pricing is not enforced, and even driving the growth of peer-to-peer (P2P) trading platforms such as Kantox.
However, trading volumes on these P2P platforms are a drop in the ocean of the $5.3 trillion market; moreover they still rely on wholesale liquidity from banks if a trade cannot be completed between platform users themselves.
Javier Paz, senior analyst at Aite Group, says: “It's too soon to write the obituary for last look, [but] unless banks have concrete, credible reasons for using the practice, they will be fined for mis-use of it."