FX dealers defended the practice of banks pre-empting, or front-running, clients FX orders, back then, citing the need to fill orders, especially stop-losses, near the specified rate and to clear a large number of low volume tickets, though sell-sider traders acknowledged the lucrative gains from the practice when clearing large orders.
In the main, however, our investigation painted a remarkable picture of regulators and market players largely content with the lack of best-execution regulations for the FX market, buoyed by stable spreads, apparent price transparency, innovation and the belief that players had enough skin-in-the-game to ensure a clean market.
Ever decreasing spreads and soaring volumes suggest that there is nothing wrong with the huge global foreign exchange market. However, many leading market participants are starting to worry about the possible imposition of best-execution regulations.
Lee Oliver reports.
This years Euromoney foreign exchange poll provides further evidence that the market is booming. It is almost becoming a cliché that FX is now considered an asset class in its own right. This has helped it to attract a new range of participants and has also contributed to forcing many traditional buy-side institutions to manage their currency exposure more professionally and more actively.
Many view this growth, which for the moment shows no signs of abating, as clear proof that there is very little wrong with the industry. Participants from the sell side naturally enough believe that they are providing best execution and, probably more important, it appears that the buy side generally agrees with them.
And yet the nagging concern that, some day soon, the worlds financial regulators are going to want to get their hands on its largest single market wont go away. Bankers say that regulation would be bad news for the market and, most of all, their customers.
Clive Banks, head of corporate foreign exchange at BNP Paribas, is not alone in supplying an if its not broke dont fix it type answer to the question of whether or not the foreign exchange market should have best execution regulations imposed. No, he says. The market is self regulating and very transparent and competitive. In FX, most of the underlying currency stock is basically unlimited, unlike corporate bonds, for example.
The global head of FX at one bank in the Euromoney top 10 adds: We operate in a very transparent market in which the interdealer price is essentially accessible to the buy side. There are multiple points of liquidity and access available to the client. Also, given the nature of FX, there are no limits to the supply of one currency versus another. So I dont think there is a need for regulation in best execution.
Fabian Shey, global head of FX distribution at UBS, expresses similar sentiments. Does the FX market need rules and regs on best execution? he asks. The FX market is mature, liquid, highly commoditized and competitive. The market model that has evolved has market makers acting as principal and using their own capital quoting two-way prices, multiple distribution channels and request for quote. This has led to very transparent pricing and tight bid-ask spreads. Therefore, in general, best execution is delivered by default.
Mark Snyder, global head of FX at State Street and also chairman of the US FX Committee, an industry group sponsored by the Federal Reserve Bank of New York, points out that the structure of the FX market probably makes it impossible for it to be overseen in the same way a regulated exchange is. The vast majority of FX is OTC and conducted by significant market participants across borders, he says. This means that prescriptive regulation is unlikely to come into effect.
Excellent price transparency
He adds: Electronic trading is a lubricant for even more transactions more efficient and transparent. Cross-border trade and investment is facilitated by electronic FX trading, used by sophisticated end users. Many dealers are supervised, their conduct reviewed and compared to best practice. Snyder says he is much more in favour of the existing non-prescriptive, self-regulatory environment.
The market is self regulating and very transparent and competitive.
Clive Banks, BNP Paribas
Ken Dickson, investment director, currency, at Standard Life Investments, also believes that he gets best execution, primarily because the banks compete for his business.
We do the majority of our transactions on the FXall dealing system, where we are able to select from five comparative pairing quotes from banks. There is a lot of competition (for business), so price transparency is excellent. As a big client, our trades are valuable to the banks in terms of flow and so it is not in their interest to offer us poor prices, he says.
James Dyas, senior dealer at Shell International, agrees that competition ensures good execution but alludes to the fact that access to the markets hubs is restricted. Notwithstanding the fact that the underlying rate for most quotes comes from EBS or Reuters, from a corporate cost centre perspective I believe that we achieve best execution by trading in competition where appropriate, and squeezing spreads received from counterparties around these rates. In most cases, we benefit from very tight market spreads, he says.
Dyas makes an important point in highlighting the fact that there is no officially recognized central location to provide a benchmark price, a point that UBSs Shey is also keen to stress. You should avoid the myth that any ECN is the sole representative of the market, says Shey. These are electronic brokers fed by a series of liquidity providers, many of them feeding it manually and selectively. Usually, the dealing model on single-bank tools provides liquidity based on immediate risk transfer in exchange for a price, without a fee. Every client segment has different needs, leading to a variety of dealing channels and methods. This keeps the FX business challenging.
This is an interesting point the debate about whether or not true best execution can only be achieved by providing the ability, where required, to access and even market make rather than price take on a centralized pool of liquidity is one that could rage for ever.
Shey points out that UBSs experience has been that while some clients like to pay a fee for an order-driven screen sourced from multiple liquidity providers, others prefer the immediate risk transfer for full amount offered by single-dealer tools such as UBSs FX Trader portal.
The buy side is driving the market forward. They are very vocal when they are not getting best execution.
Jas Singh, Reuters
Defining what actually constitutes best execution is no easy task. Clients have differing definitions of the term. Best execution is not only about price, says Jim Turley, head of global currencies and commodities at Deutsche Bank.
Clients may also believe that certainty of trade execution or speed of confirmation or even post-trade processing are important factors in their benchmark of best execution. The definition is often bespoke to the client. It is therefore impossible to prove generic best execution in a product that is not traded solely on an exchange, adds Turley.
Not just about price
Price is obviously a key component in best execution, as those charged with regulating US equity markets would emphasize. But in the world of FX, even EBS is extremely even-handed about how relevant the price is, which is somewhat surprising given that the prices displayed for certain major currencies on portals around the world basically stem from its screens.
Price is only part of the story. Quantity is another part. Total relationship is another. Total relationship is especially important if you are trading across different instruments or asset classes, or if your FX requirements arise because of transactions in other asset classes, the EBS spokesman adds.
Consistency is another aspect, he says. A customer may be prepared to pay a spread even at more liquid times if it can have confidence of getting prices in the required quantity at less liquid times. Total relationship may also include a variety of post-trade services.
All of the above comments are essentially variations on the same theme. Transparency and competition would appear to be ensuring that most FX participants are getting very close to best execution, even if they do not all have exactly the same requirements. Nobody seems to be suggesting that because FX is not formally regulated, it needs to have strict rules imposed on it. As Peter Nielsen, global head of FX treasury and investor products at Royal Bank of Scotland, says, every marketplace needs rules and regulations to operate efficiently.
The market maker has to risk manage in advance of the fix. Also the fix rate is made up of rate cuts before the actual fix time.
Fabian Shey, UBS
But Nielsen makes an additional point, which seems to have escaped many others in the market. For some client segments where fiduciary responsibility exists, then certainly a clear and formal definition of best execution would be useful. Nielsen says that RBSs response has been to develop a fully automated benchmark, RBSFiX, which clients can execute against, as well as working on transaction cost analysis (TCA).
TCA is currently very much flavour of the month in the equity environment, most certainly because of recently implemented and imposing legislation on best execution in the US (Regulation National Market System RegNMS) and Europe (Markets in Financial Instruments Directive Mifid) respectively. In effect, TCA is an attempt to quantify what many consider unquantifiable best execution across the entire deal chain.
Even many of those charged with overseeing the FX market see no need for it to be regulated. One G7 central banker says: In broad terms, investors are pretty well protected, due to their sophistication and the tight spreads. In terms of pricing, investors are well protected. You have to consider cost, need, feasibility and the implications of regulation. Regulation tends to lock in certain practices. The FX market has evolved in stages with the advent of new technology, from the phone to portals. Regulation would impede that and it is highly unlikely that national governments can enforce it. Its an entirely professional market and theres honour among thieves. The participants are keen on a clean market, not least because of the risk to reputation. Complaints are mainly from sophisticated, large hedge funds, which complain about front-running, or on the retail end, but here operators have become more reputable.
Regulation is inevitable
But it is important to realize that greater regulation is looming for the FX market. Whether the market wants it, and whether it actually needs it, is absolutely irrelevant. Regulators will always keep on regulating, and as FX moves towards a higher ground, it is inevitable that the market will come under scrutiny.
The vast majority of FX is OTC and conducted by significant market participants across borders. This means that prescriptive regulation is unlikely to come into effect.
Mark Snyder, State Street
Celent says: Mifid is a new set of regulations, due to take effect in early 2007, which promises to fundamentally alter the structure of the European capital markets. Mifid is the most far reaching reform of any major financial market ever undertaken. While much of Mifid focuses on the equities market, a broad range of instruments will also be affected.
Generally, most consider that FX is exempt, but that is not an accurate view. Celent says: Mifid is expansive in that it covers a broad range of instruments, namely all transferable securities (including equities and bonds), money-market instruments, collective investment undertakings, derivatives (including options, futures, swaps, forward rate agreements, and credit derivatives) on a broad variety of underlying instruments (including derivatives on securities, currencies, rates, commodities, climate, freight, emissions, and inflation). Basically, the entire waterfront is covered, with the exception of spot foreign exchange transactions.
Even though spot is apparently exempt, a firm might have to show it has delivered best execution if there is an FX component to a cross-border securities transaction. Other FX products are believed to fall under Mifids scope. Celents chief executive, Octavio Marenzi, says: Any FX derivatives are covered by Mifids best execution requirements and this will lead to a profound change in how those instruments are traded. For any currency option, future or forward, banks will be obligated to provide their clients best execution and to demonstrate that they done so. This will be a radical change from the current market structure, where it is more a question of caveat emptor than anything else. Interestingly, very few banks seem to have given the impact of Mifid on FX trading any thought at all.
Marenzi adds: Trade execution in FX markets is generally good for more sophisticated clients, who shop around for the best rates. However, banks frequently give less sophisticated clients poor rates, typically when the client executes a payment involving a currency exchange.
Even sell-side FX dealers will acknowledge Marenzis last point. Any retail punter can buy a handful of shares at the same rate as an institutional investor can. But trying to obtain a true market rate for any FX transaction, such as those for a dealers bonus repatriation or his second home in Courcheval, is impossible. Further money will then be paid away because the deal will not settle in anything like the T+2 that is standard in the industry.
With Mifid fast approaching it is expected to come into force at the end of 2006, with investment firms fully compliant by November 2007 it is not surprising that industry bodies such as the UKs FX Joint Standing Committee have spent time trying to ascertain its impact.
FX is a true market where buyers have to find sellers and each price has to be negotiated taking account of credit and liquidity pricing.
Peter Nielsen, RBS
He adds: The key thing is adhering to this policy, and being able to prove to clients that you have done so. That is why the post-trade analysis, reporting tools and trade audit trails provided by platforms like FXall are so important. The best execution requirements introduced by Mifid reflect a trend that weve observed for several years. Institutional investors are starting to demand proof from asset managers that they have achieved best execution on foreign exchange trades.
As a result, weve seen massive demand from asset manager clients for reports where they can see the bid-offer spread available in the market as a whole at the exact time they dealt, and compare that to the price on which they executed. Crucially, FXalls reports benchmark the rate achieved against other prices available for the size of transaction that they are executing.
There is enough leeway within Mifid to allow sell-side firms to define what they consider best execution is and they will not have to connect to every venue in existence. But they will have to tell their customers where they are dealing, whether it is internally for their own books, matched up against another client or routed to another execution venue.
At the moment it is merely conjecture whether or not this will apply to all FX products, and spot appears exempt. That might not remain the case, which has implications for every trading venue in existence. It might well hasten the process of long-awaited consolidation and perhaps even finally force the market to adopt a fuller exchange-like structure.
The definition is often bespoke to the client. It is therefore impossible to prove generic best execution in a product that is not traded solely on an exchange.
Jim Turley, Deutsche Bank
When this article was being researched, a senior FX figure in New York asked whether Euromoney seriously expected him to answer truthfully the set of questions posed, saying they were too close to the bone. Every sell-side trader will have at least pre-empted or front run orders at some stage in his career. Ironically, as any FX dealer will tell you, this is often the only way to get an order filled, especially stop-losses, at anywhere near the specified rate.
The growing popularity of trading on a fixing rate has ensured that the practice continues. UBS is one of the few banks with the courage to admit that its traders deal ahead of fix orders. The market maker has to risk manage in advance of the fix. Also the fix rate is made up of rate cuts before the actual fix time, says Shey. But he stresses that the bank does not front-run client orders in order to make money.
Another senior figure makes the same points but will not go on the record. Anything that prevents a client order from being done (front-running) is not in our interest, in our clients interest and is actually illegal, he says.
As for the fix: A regular order goes at a price, a benchmarked price gives the trader a position at a point in time. He then has to use his judgement about management risk, so the trader will be trading before and after the fix. What he cannot do is push the market in one direction to manoeuvre prices. We have compliance involved in auditing and monitoring the process to ensure traders manage their positions, not the price.
The fix sounds like a licence to print money; for large orders it probably is. Why anybody would wish to entrust a decent-sized order to be done against a fix, especially when it is a simple version such as a print-out of where a market stood at a point in time, is almost incomprehensible and basically smacks of either incompetence or an unwillingness to take charge of risk.
But there are some advantages to the fix, as Shells Dyas points out. We use a fix to manage large numbers of low volume tickets to take away the administrative burden of these low value trades, and to take advantage of the additional liquidity around fix times, he says. Fixes also provide an auditable, transparent market based rate that all of our operating companies can access and validate. Large ticket items would not, however, be traded this way. I believe that there will always be some flows within a corporation that will benefit from this process, with the efficiencies it brings.
As a big client, our trades are valuable to the banks in terms of flow and so it is not in their interest to offer us poor prices.
Ken Dickson, Standard Life
Fixing the fix
However, no trader can ever know what orders exist the other way around. It presents a damned if you do and damned if you dont scenario. If the dealer does not start shipping in (or out) the order before the fix, which can be called risk management, he will inevitably find that everyone has orders the same way around and the rate will disappear in the seconds after the fix is posted. If he does, he will inevitably run into someone who has a bigger order the other way around.
In the past, it was common to see big stop-loss orders deliberately triggered. This still goes on but here again competition seems to have served to clean up the market. Most banks will do everything they can not to take clients out, says one senior figure, who declined to be named. The concentration of liquidity means that they can often easily find out if youve been unprofessional and theyll take their business elsewhere.
Despite the lack of formal regulation, FX has evolved into a marketplace where execution is excellent. Transparency and competition have forced institutions to clean up some of dubious practices that were once widespread. That does not mean it could not be improved but the genuine professionalism of most of the markets participants will probably mean that this occurs without the need for heavy-handed regulation.
RBSs Nielsen is not alone in believing that the imposition of rules is not necessary. A one-size fits-all definition of best execution in FX would be a retrograde step that will add costs to an already efficient and very low margin market along with constraints that come from a complex economics of workflow FX, he says.
Jas Singh, head of treasury at Reuters, says: The market is transparent, and has never been unfriendly to investors. Most clients have access to streaming rates from banks. The transformation from phone based to electronic systems has made the market quicker, more transparent and more efficient. Now the buy side is driving the market forward. They are very vocal when they are not getting best execution.