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From the archive: Does FX need best-execution regulations?

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By:
Lee Oliver
Published on:

Euromoney’s investigation into the global FX market in 2006 – seven years before the fixing controversy - revealed the scale of the practice of banks’ pre-empting, or front-running, clients' FX orders.

FX dealers defended the practice of banks’ pre-empting, or front-running, client’s 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 year’s 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 world’s financial regulators are going to want to get their hands on its largest single market won’t 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 it’s not broke don’t 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 don’t 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

Clive Banks, BNP Paribas
Keith Richardson, deputy group treasurer at UK retail group Tesco, provides a perspective from the buy side. Asked whether he believe that he gets best execution, Richardson replies: “Yes, the reason being the speed and consistency of pricing. Market conditions don’t matter and you get good pricing in different markets.”

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 market’s 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 UBS’s 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 UBS’s 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 UBS’s FX Trader portal.

Jas Singh, Reuters

“The buy side is driving the market forward. They are very vocal when they are not getting best execution.”

Jas Singh, Reuters

Surprisingly, given EBS’s role at the market’s hub and as the de facto benchmark trading venue for currency pairs such as euro/dollar and dollar/yen, a spokesman for the company is remarkably even-handed on whether or not best execution exists in FX. “The meaning of best execution in FX depends very much on a customer or participant’s requirements. Both market maker and customer will evaluate execution in terms of the total service provided and its profitability. There is an abundant choice of providers in FX at every level. Should a customer of a market maker, broker or other service find execution unsatisfactory, it can take its business elsewhere,” he says.

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

Fabian Shey, UBS
“The question is if these need to be formal regulation or the informal rules of best practice and hard commercialism?” he adds. Nielsen also points out that defining best execution is no easy task. “If defining best execution in equity markets is considered difficult, defining it for FX is nigh on impossible because 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. The market has developed a series of execution styles including request-for-quote, streaming prices and benchmarked fixings as well as the traditional relationship channel. These trading styles represent the best execution style for the underlying client need for which they have developed, so a one size fits all approach to defining best execution in foreign exchange will risk being counter-productive,” he claims.

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 RBS’s 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. It’s an entirely professional market and there’s 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.

Mark Snyder, State Street

“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

It is not surprising that the market’s sell-side participants appear concerned by this prospect. In particular, the imminent imposition of Mifid in Europe is causing a lot of debate. Some of this is no doubt because of the likely cost of compliance. According to research group Celent, Mifid is going to force a technology spend of more than €1 billion, and at the moment that is mainly only to comply with the new market rules and regulations imposed on equity trading.

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 Mifid’s scope. Celent’s chief executive, Octavio Marenzi, says: “Any FX derivatives are covered by Mifid’s 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 Marenzi’s 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 dealer’s 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.

Mifid impact

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 UK’s 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

Peter Nielsen, RBS
When Mifid is in place, says Mark Warms at FXall, firms will need to have an order execution policy and make it available to clients. “The policy needs to include how the firm ranks certain factors, including speed, cost and size of transaction, and the execution venues it uses to obtain the best possible result on a consistent basis,” he says.

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 we’ve 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, we’ve 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, FXall’s 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.

Jim Turley, Deutsche Bank

“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

Another issue hardly anybody is prepared to speak about on the record but which has been referred to, is that many of the very practices that help make FX so efficient would most definitely be frowned on or even deemed illegal in other markets and will almost certainly not pass muster in a market that falls under Mifid’s scope. Pre-empting orders, if not even actually front-running them – and there is a subtle but important difference – is almost the norm in FX. However, very few banks are prepared to admit it.

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 Shell’s 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

Ken Dickson, Standard Life
Sell-side traders, when telling the truth, will admit that a decent sized order into the fix can often be like manna from heaven and provide a significant boost to their P&L. The strategy is not overly complicated. Build the position up in the short-term period before the rate, hold back a bit of ammunition to “massage” the fix rate, and make a few easy points here and there. And as British game show host Bruce Forsyth used to say: points make prizes.

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 don’t” 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 you’ve been unprofessional and they’ll 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 market’s participants will probably mean that this occurs without the need for heavy-handed regulation.

RBS’s 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.”