Cracking the Code
Last week in London, the Foreign Exchange Working Group and the FX Markets Participants Group released a global Code of Conduct for good practice in the FX markets. Over two years, the consortium of more than forty central banks and private-sector market participants designed the guidelines to promote a “robust, fair, liquid, open, and appropriately transparent global FX marketplace.”
In introducing the FX Global Code, Guy Debelle, Deputy Governor of the Reserve Bank of Australia and Chair of the FEWG, stated that the aim was to make the code “principles-based rather than rules-based. The more prescriptive the Code is, the easier it is to get around. Rules are easier to arbitrage than principles. The more prescriptive and the more precise the code, the less people will think about what they are doing. If it’s principles-based and less prescriptive, then market participants will have to think about whether their actions are consistent with the principles of the Code.”
At Chatham, we welcome the Global FX Code that promotes greater fairness and transparency in financial markets. Here are a few of the most salient principles codified therein:
Market Participants Should Be Truthful in Their Statements
In litigation over the last few years, traders accused of mis-stating the prices at which they purchased securities they later sold gave this consistent defense – everyone lies in the bond markets. The iconic example of this was Jesse Litvak, whose chat history contained such self-incriminating nuggets as “So we bot bonds from [X] at 41-4… she thinks we sold at 41-16… we really sold em at 42-8.” (In fact, this example became so legendary in finance that publicly disclosed evidence for a current, unrelated litigation in Connecticut contains a chat room transcript with this line from a potential buyer: “Ok don’t litvak me!”)
The FX Code could not be clearer: market participants should be truthful in their statements. Lying about market depth, current volume of trades, or direction of market demand directly violates the code, and the “everyone lies in financial markets” defense is clearly inconsistent with the code.
Market Participants Should Transact with Fairness and Transparency
Last year, we wrote about the anatomy of a front run, where several traders selected by RFP for their lowest risk, best possible execution on 2.25 billion pounds allegedly provided nothing of the sort. On recorded lines, the two discussed how high they could “ramp” the GBP-USD rate before the client would “squeal,” and as the rate jumped 103 pips in 30 minutes leading up to the 3 pm fix, explained to the client that the jump was caused by a fictitious “Russian name.” Rather than seeking to minimize the impact of a significant transaction, they are alleged to have extracted $8 million in profits, including those “profits generated from front running.”
The FX Code calls for market participants to trade in a way that benefits their clients by lessening the market impact of a trade execution, and by not using their prior knowledge of clients’ trades to gain profits for their own book, potentially disadvantaging their clients. Pre-hedging a transaction in a pre-agreed fashion transparent to one’s client to obtain a better economic result is suitable; front-running to gain excess profits at a client’s detriment is not.
Financial Transaction Markups Should be Fair and Reasonable
Contrast these two statements from the FX Code:
A bank charges corporates of similar size and credit standing different Mark Ups because the broader Client relationship differs. For example, the volume of business these Clients transact with the bank is of very different magnitudes.
A bank charges a corporate higher markup than other corporates of the same size, credit risk, and relationship, exploiting the corporate’s relative lack of sophistication in understanding and challenging the pricing of its bank.
The first statement connotes reasonable commercial behavior of the sort the FX Code’s authors affirm and encourage; after all, banks do need to set prices based on overall relationship profitability. However, the second statement describes conduct that is not suitable, namely, for a bank to set variable prices solely based on counterparty expertise in the FX markets, even though other corporate attributes are the same. Markups should be based on a fair return on capital employed, rather than based on the exploitation of information asymmetries.
The Code of Conduct lays out useful principles for the appropriate functioning of the global FX marketplace. But given that it does not impose any legal or regulatory obligations on market participants, will it have transformative impact? There are good reasons to think it is only part of the answer. The great financial crisis accentuated a significant breach in trust between society and firms active in financial markets, and subsequent scandals and bank settlements have further exacerbated this breach. We sincerely hope actions like this aimed at defining and encouraging trust based behavior will improve the trust conditions within this important segment of the capital markets.