Next FX scandal: agency, principal or hybrid?

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By:
Solomon Teague
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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.

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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.”

Confusion

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.

The buy side might also be putting pressure on the banks to provide more clarity as clients prepare for increased agency trading, putting systems in place to aggregate FX liquidity more effectively.

This is leading institutions on all sides of the FX industry to ask where current practices could result in conflicts arising or clients challenging their banks’ handling of their trades.

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James Kemp, GFMA
Kemp says: “If the dealer is acting as principal, how might it need to adjust its activity in relation to accepting orders? If the dealer has discretion in execution, acting on behalf of the client, does this raise agency-like obligations or a duty of care? Does the bank take on the principal risk or does it work the order in the market, which may at times appear more agency-like.”

Generally, a bank and its clients have an established relationship governing how the bank trades on behalf of the clients, but how this arrangement is communicated varies between institutions, and in some instances can even vary on a trade-by-trade basis.

One observer notes there is little consistency in the fees that banks charge their buy-side clients for brokering access to spot FX liquidity on dealer-to-dealer or dealer-to-client trading venues, for example.

Different clients receive different fees depending on what currencies they want to trade, when they want to trade them and how they want those orders executed when trading on an agency basis.

The issue could be resolved through more precise regulatory standards governing the documentation that banks provide to their clients. The terms of an agency-trading relationship for spot FX business need to be fully disclosed, including for spot FX business done on a prime brokerage basis. It should be clear how fees for certain levels of service are calculated by the banks and agreed with the clients.

Kemp says: “The challenge is to enhance conduct across the market without undermining the market effectiveness – for example, not impacting critical market-making activities or reducing liquidity provision.

“The solution should be to create principles that ensure all market participants strive for a well-functioning, fair and effective market – given the importance of FX to global trade and investing, rebuilding confidence in the FX market is paramount.”

Ambiguity

Neither the FCA or ESMA were available to discuss their thinking about this issue, but are thought to be looking at how both models should be defined, clarifying instances where there is any ambiguity.

However, most market participants expect an industry standard to be set out in the forthcoming global code of conduct, which is likely to closely resemble thinking set out in the Fair and Effective Markets Review.

Also under scrutiny is “how to price fees for hybrid agency-principal trades compared to pricing structures for fees for just agency trade or just principal trades,” says Dinnage. “The definitions that the agency’s come up with for these types of issues could then trickle down and apply to definitions of principal versus agency trading in other asset classes.”

Both banks and clients will welcome further clarity: the last thing banks want is another FX-related scandal.

In the short term, banks might choose to continue in both agency and principal trading capacities, separating the desks, but some predict the industry will naturally go further than this.

GreySpark’s Dinnage says: “I expect that, in the near-future, sell-side principal spot FX trading models will disappear, first within the tier I, leading FX banks and then, eventually, in the tier II liquidity providers as well.”