The murky world of foreign exchange trading could be about to get a bit more transparent.
A few days ago, the sovereign fund of Norway (NBIM) – the largest in the world, with over $1tn under management – published a report calling for improvements in the foreign exchange (FX) market. It feels that the market’s friction and opacity tilts profits unfairly towards the dealers, and that the lack of transparency is weakening trust in the system.
It points to three particular aspects of FX trading, specifically: last look, algorithms, request for quote feeds and their relationship with interdealer prices.
While each is intriguing and worthy of further digging, I want to take a closer peek at “last look”, since it exemplifies how new technologies can both improve and complicate trading, and how evolving infrastructure requires a regular re-think of established processes.
What is “last look”? It’s a “way out” for the dealer, who can renege on an agreed trade if certain conditions are not met. It could be that the client doesn’t pass the credit check. Or it could be that the price moves against the dealer.
This last aspect gives last look the whiff of unfair advantage. Critics claim that it can be used to “cherry pick” trades, only following through on the profitable ones, which would negatively impact market confidence and liquidity. It could also lead to “front running” of trades, whereby information from client orders is used for the dealer’s own profit.
Others argue that its use as a latency buffer – protecting against price moves between order agreement and order execution – is no longer necessary given technology improvements that make that time gap almost negligible. And the lack of information – often clients are not told why their trades fell through – weakens confidence, which could impact order size and even willingness to operate in the market.
Proponents claim that the practice allows dealers to quote better prices – with less risk in a trade, the spread can be narrower, which implies a better deal for the clients.
What’s more, the option of backing out of a trade enables dealers to post their price on several exchanges at once. Without that option, the dealers run a higher risk that the market will move against them. With posts on several exchanges, changing all of them takes time (seconds, but that’s a long time in FX). So, last look encourages a wider spread of trading venues, which in theory enhances liquidity.
Wait a second
Norway’s sovereign fund is not alone in its concerns about the practice, which has been coming under increasing scrutiny.
Vanguard (the world’s largest mutual fund manager), Citadel (one of the world’s largest alternative asset managers) and others have called for its elimination. Several exchanges have echoed that sentiment. XTX Markets Limited, one of the world’s biggest spot currency traders, officially stepped back from the practice in August. The Bank of England has been publicly questioning the practice since 2015.
Global regulators are also taking a closer look. In 2015, Barclays was fined $150m for what was deemed abuse of the practice – not only did the bank filter all trades in which the market moved against it (as opposed to using last look as a sporadic protective measure), but it denied doing so. (2015 was a ripe year for FX manipulation – Barclays was fined a further $2.3bn for other FX infractions, and penalties levied on Citigroup, JP Morgan, UBS, Bank of America and the Royal Bank of Scotland brought the total to almost $6bn.)
However, removing the practice will leave end users vulnerable to predatory manoeuvres, especially given the prevalence of high-speed trading. It could also constrict liquidity as dealers protect themselves against risk.
Why can’t the regulators step in and establish certain rules? Because the FX market is notoriously difficult to regulate, largely due to its cross-border nature. Which jurisdiction would apply?
In an enlightening example of self-regulation, the Global Foreign Exchange Committee (GFXC) was created in May 2017 as a forum for FX market participants (including central banks). Its first act was to issue an updated FX Global Code, a set of “best practices” for the foreign exchange community.
It does not rule out last look, but does ask practitioners to disclose the criteria, in order to allow end clients to make the appropriate adjustments. The GFXC simultaneously issued a request for feedback on the practice, demonstrating a willingness to contemplate adjustments.
So why are the Norwegian sovereign fund and others protesting now? Just two years ago, NBIM publicly came to the practice’s defense, citing its potential to improve available liquidity for investors.
It turns out that their positions are not inconsistent. Even now, it is not advocating the removal of last look. What it wants is more transparency.
Furthermore, it is no doubt aware of the deteriorating levels of trust in FX trading. The previously mentioned scandals and fines are probably the tip of the iceberg when it comes to abuse, especially since the rules have been vague and the FX market is opaque to begin with.
And, the protests could be influenced by fund managers’ need to increase revenue and lower costs through narrower spreads and more transparent pricing. Quoted in the Financial Times, the co-author of the report said:
“We want to be more explicit about the risk sharing between us and the dealer. The client is providing optionality for the dealer. We would like to be rewarded for this option.”
Large market participants no doubt understand that the system is changing, and so are expectations. Calls for market reform are both timely and self-serving, contributing to a cleaner image and hopefully a more robust system.
So, what would a solution look like?
While blockchain technology is by no means the solution to all things financial, it could offer a useful tool for a platform that allows transparency, immutability and decentralized (but permissioned) participation. A major drawback would be the latency – it’s not the fastest way to share data, and the FX market is used to split-second speed.
It is clear that enhanced disclosure is a stop-gap remedy. Once the goal posts start moving, it’s impossible to see where they will stop. What’s more, temporary solutions are not conducive to a lasting realignment of trust. And with self-interest up against community fairness, and a huge economic sector in play, a more durable solution is urgent.
Will blockchain technology end up playing a part? It’s possible, perhaps even probable, especially as new features emerge and work-arounds gain strength. It’s unlikely to be the only solution, though, as database technology and communications infrastructure also continue to evolve. And as long as speed remains a competitive advantage, decentralized resilience and transparency are unlikely to be the main priority.
What’s more, the FX sector is unlikely to see a sweeping change in the near future – it’s just too big and important for that. However, the processes that keep the system running need revision and updating, to continuously improve efficiency and trust.
And eventually, the patchwork of solutions to specific problems will point to a deeper evolution, one that favours interoperability over universality, reliability over speed and trust over profit.