Regulation Killed the Forex Star.

As video killed the radio star, regulation appears to be killing the FX star. The sight of a baying FX phone jockey bullying and cajoling, buying and selling, ripping and clipping started to fade years ago as communication shifted from phone to screen and pricing shifted from voice broker to e-platform. But the regulator may be putting the final boot in as new regulatory pressures arising from actual, political and reactionary needs does for FX what the window tax did for large houses. Namely start off with an honourable intention but end up creating dark institutions not fit for purpose.

The latest onslaught has gone mainstream, with front pages beginning to cover the issue loving to suggest that a market with over a trillion a day in volume is corrupt, but how can this regulation be made to work fairly in a market that is global and does not run on an exchange? Regulation has already taken its toll on the ability of sell side to offer a client what they have always demanded, namely advice and best execution.

Advice has already been hit by restrictions on what a sell side participant is allowed to say. For the research department, advice that is extreme of view is frowned upon and opinion is being watered down to a mushy mean wrapped in disclaimers and codicils that make them near worthless. If a client has a trade recommended to them and it turns out that the institution is positioned the other way in a different department, then cries of foul appear even if the salesperson recommending it had no clue of the distant position.  If a trader is to suggest that a currency may go up and he is long of it for whatever reason, the trader is now obliged to advise that client should his position change, which being a fast a fluid market can be so unmanageable the trader just won't bother engaging with clients to begin with. An individual on a desk when asked "what do you think?" now has limited upside in expressing an opinion should it by some unfortunate and unexpected link be later attached to something going on elsewhere in his institution he had no knowledge of and he be held for disclosing sensitive information. 

Researchers themselves can no longer give a client an opinion, such as an informal view on EUR/USD over a dinner, if that opinion hasn't previously been expressed in a formal public advice. Advisory may well have to split away completely into a subscription service and indeed has in many cases which has really tested the value of the service in the first place.

Best execution - What exactly is that? Hitting the best market bids at the instance of execution? Or is to encompass market timing and advice on short term direction?  Spoofing a market higher before hitting bids with the intention to actually sell a large tranche was de rigour in the past with much of the motivation being to supply the client with a better price than they would have recieved by "selling clumsily" and just hitting every bid in the market and seeing the price melt only to bounce once bids had time to return.  

This raises an interesting point as to how execution is to be governed in future. If every market trade has to be reported against a client execution then the incentive to finesse an order drops and the client ends up getting a poor but well reported fill rather than 'best execution' in the broader picture. 

With transparency of pricing and a regulatory requirement to provide 'best price' we are immediately at odds with the role of a spot trader whose raison d'etre is to make money, which can be done in a couple of ways.

- Take proprietary positions in the market
- Buy or sell to cover client trades at a better rate than the client receives.

The second statement will already be raising the hackles of both regulator and the 'little man' but in a broader light this is no different from any other business where price of product sold has to be more than purchase price plus costs. As FX stands at the moment a counterpart makes its own price (like any high street shop) and it is up to the client to trade on it or not, which is justifiable. But when it comes to exercising client orders confusion can creep in where the client will expect to be filled when a price trades one tick through his level. So if the bank has executed the trade on this basis and not made any money on the trade (bear in mind the key point that FX is not a commission based business, unlike equities)  the value has to come from somewhere else. This somewhere else has always been generally classified as 'information'. Which begs the question of how this information can be of value.

A clear and public example of this informational value has surfaced through the WMR fix investigations which are showing, allegedly, that banks have colluded in their trading based upon information they have about client orders. Thus this must be market manipulation. Market manipulation is the heinous charge that governs all outrage from Libor fixings right through sport betting scams to goldbugs who are convinced that the world is conspiring to suppress the value of their anti-fiat money doomsday hordes.

So when is trading market manipulation?  In the broadest sense any trade in a market is manipulation as it will have a direct impact on the next subsequent price available. In the regulatory sense manipulation is acting in the market to effect subsequent price for personal gain at the detriment of others (but then any trade's subsequent gain must be at the detriment of others or where did the profit come from?). The well publicised FX Fix fixing is a hard example of collusion and price manipulation which can easily be mended by changing the absurdity of trying to trade upon a hypothetical price. Views on that previously expressed at TMM -

The debate revolves around the WMR fix, which is a strange animal. It isn't
a real exchange rate you can trade on in a centralised exchange, it's one
which is drawn up by a private body and released after its calculation from
published dealable prices over the course of a preceding time frame. Many
asset managers and funds have their portfolios benchmarked against this
number and hence would like to see their execution done as close as possible
to it so as not to have annoying accounting disturbances in their
portfolios. As always, the greatest problem with benchmarks is that people
tend to get more worked up over variance from benchmarks rather than the
actual level of the benchmark itself. This then opens up behavioural risks
in the system due to the divergence of accounting from reality. Oh my word,
haven't we seen that before. As we regularly say - "Benchmarks are Bollocks"

But the expression of market manipulation could be reduced fractal style to include the translation of the 'value of information', mentioned above, with a single small client order into monetary value. If a trader can no longer position his book conditional upon the orders he sees in it because in regulatory eyes it could be seen to be interfering with the best interests of the orders themselves then the original value of information is removed. Which would therefore lead on to asking why the bank would offer such services at all if they couldn't take any value, monetary or otherwise, from the trade.

The answer partly comes from an assumption that bid offer spread can be captured and this is where machines have overtaken men. An institution's e-platforms will execute orders at lightening speed matching buys and sells and taking a hair's breadth of margin from it. But if we think about what these machines are doing, all be it in fast computery way, it is exactly what a trader would do (many and maybe most trading algorithms have been derived from human behaviour). They analyse the orders they have, probe prices with micro amounts and use that information to set the prices they are dealing at and decide their own positions. Is there a difference in ethic? Should the algorithms and their programmers escape the potential jail sentences their human trader counterparts are subjected to?

Perhaps not, because this is where the pincer movement against High Frequency trading comes in. Enough has been said and written about that without having to dwell any further, but if the push is to dehumanise trading on one hand due to errant human ways then we had better watch out that the computers the trading is devolved to haven't also been removed through separate legislation. We have the anti High Frequency groups crying for more human intervention and those that don't trust human trader nature calling for more computerisation. 

So why is this the case with FX and not with every other traded commodity? In many ways it is and the evidence for manipulation in the FX market is minuscule compared to some of the price swing evidence seen in other markets around closes or option fixes, but the key difference is that FX is not traded on an exchange. It is a sum of a myriad of market stalls. Is this different to the bond market? Not in that respect but the bond market has an advantage - it is nowhere near as reliant on credit lines as FX is.

The requirement for credit lines to be established in order to deal with a counterpart not only limits the availability of choice (though the network of prime brokerage agreements that can be established by big players makes their access broad enough to catch most names) but it also affects the transparency of pricing.

Forward pricing already has to take into consideration credit functions as any forward deal carries settlement risk (chance of default at settlement date) against delivery as well as market risk (cost of unwind of the trade if the counterpart collapses before contract date). The chance of default will have to be priced into the forward price and this will be subject to individual credit assessments which will vary across institutions. Without an exchange to standardise and collateralise credit assessment, forward pricing is always going to vary across institutions making it very hard to pin down what the correct reference market price is for a trade.  Where CDS and other tradable credit hedging products are available it is easier to agree credit pricing but for the man on the street it's impossible.

The problem of transparency also occurs in the spot market where a price may be visible on electronic platforms yet untradable as the credit rating of the entity showing the price is so appalling no one has credit lines to deal with the institution showing the price. But the reference agencies won't know that.

Now let's get on to the next can of worms with respect to market manipulation. Options. Hedging of options is calculated mathematically but there is a huge amount of human intervention (otherwise why would a good options trader be a good options trader) and the most intervention occurs close to strikes at maturity or in the case of binary options close to barriers whenever they are close. You don't have to dig deep to hear market chatter of "barriers at xxx" influencing behaviour. If the bloodhound of public and political retribution is on to the WMR it surely won't miss the scent of binary options. Indeed the press are just picking up on it. So far the FT but it wont be long before mainstream lap up the large face values involved and infer that the public is being ripped off to the tune of billions. But
the banks are not alone in the way they defend or attack barriers. Many clients themselves will act with equal aggression leaving this a less clear 'them and us' bank vs rest of world argument with a strong risk that the 'scandal' would engulf 'nice' institutions rather than the already tainted banks and hedge funds.

So let us assume that the regulator and politician get their way in trying to regulate towards a fair and even market. Free from manipulation by computer or human, providing tight pricing in a non volatile way, how are they actually going to do this short of setting up a global exchange?  I really don't know but I am pretty sure that along the way to building their ideal machine they are going to break the current one to such an extent that the provision of both pricing and service to the world's FX clients takes a much greater turn for the worse. Very much like the way a rail company increases prices to pay for improvements whilst reducing services to implement them.

I am very keen to see how this pans out but in the mean time - "We apologise for the late running of your trade and general poor pricing, this is due to suspension of the dealer and regulators on the line"

——

Late addition - Having been asked since writing this how I think the regulator would like to see the market operate I can only point to what I wrote nine months ago somewhat tongue in cheek (but now becoming frighteningly more real) Regulator's Perfect Market Hypothesis. !