There can be no doubt that the global FX market is undergoing a period of unprecedented change and with the overriding push by regulators to bring greater visibility to the over-the-counter markets and get as many standardised instruments into regulated trading venues as possible, in the wake of several serious misconduct cases in recent years, it is likely that much more change is to come. What shape these changes should take, and how it can be achieved, has prompted a thought-provoking report and one of the first polls of its kind in the industry from LMAX Exchange.
In a bid to move the debate around fairness and transparency in the FX market forward, the report, ‘Restoring trust in global FX markets’, takes a stance on the changes needed within the FX market in light of technology innovation, market sentiment and international regulation.
The report seeks to answer three burning questions facing the FX market, which need to be addressed if the market is to move forward. They are:
• Will the over-the-counter (OTC) trading model continue to dominate an industry which is increasingly subject to demands for greater accountability and certainty of execution?
• Can the modern technology introduced by recently emerged FX venues enhance transparency in the FX market?
• To what extent can regulation and standardisation of FX market practices improve fairness?
The FX market has already undergone significant structural change with the rapid growth of electronic trading, non-bank market participants and exchange-style execution, and the report argues whether, in a market where the burden of accountability has risen and technology has made a fairer trading environment possible, the OTC model continues to dominate. It concludes that while it seems inconceivable that OTC will be eclipsed as the dominant style of FX trading, it is equally unlikely that it will carry on without changes. The most likely outcome is that it will be altered and become more rules-based, adapting to the changing needs and demands of market participants.
The report and survey reveal, for the first time, that across the board the industry agrees that greater transparency is desirable and that the technology exists to enable it. However, it will come at a price and preservation of liquidity is central to sustaining a healthy FX eco-system. The report veers towards the need for a balance to be struck between increasing transparency of execution for end-users, and protecting liquidity. Transparent price discovery and firm liquidity will come at a cost that customers will need to pay. Fair execution must come at a fair price, and transparency cannot come at the cost of destroying liquidity provision.
Arguably, steps towards greater transparency, such as removing one-way pricing optionality from LPs, must be counterbalanced to de-risk the provision of firm liquidity and ensure sufficient liquidity for the wider marketplace. According to the report, this will require customers to adapt their expectations of artificially narrow spreads and accept that higher fees are a price that must be paid for transparency.
To support its investigation into the future of the FX market, LMAX Exchange conducted an anonymous survey to obtain a representative view from industry participants about the transparency and fairness of FX market practices today. The survey was distributed to institutional industry participants and canvases the views of 450 respondents, ranging from banks, brokers, funds, asset managers, industry experts and technology providers.
The key findings clearly suggest that a widespread sentiment in the market is that change is needed, despite the fact the results show that there is only limited agreement on how FX market practices need to change. While 80% of respondents said they thought the FX market should be more transparent (fig.1), only 60% agreed with the need for a global code of conduct overall in contrast to the majority of the non-bank respondents being in favour of having one (fig.2); and while 85% of respondents considered ‘last look’ to be open to abuse (fig.3), only 65% thought it should be abolished outright (fig. 4).
The analysis of the results by segment revealed some divergence in views. Banks indicated the strongest support that ‘last look’ is open to abuse. At the same time, banks expressed mixed views, relative to other segments, that both relationship pricing and bi-lateral trading are open to abuse (fig. 5). Qualitative feedback from some respondents indicated concern over loss of client trust, with one asset manager commenting that “Everything can be manipulated by market makers.”
However, the survey also revealed that more than one fifth of respondents were unaware of ‘last look’, and some respondents, notably asset managers, suggested they did not understand the correlation between ‘last look’ and higher total cost of trading (fig.6).
Respondents strongly supported the benefits of introducing trading practices from the exchange world, and agreed that trading practices prevalent in the OTC marketplace are open to abuse, with asset managers leading the support for FX to be traded on exchange (fig.7). Widespread agreement was indicated that market practices drawn from exchange trading, such as ‘one public rulebook’, no ‘last look’ and ‘price/time priority order matching’ could increase transparency (fig.8) but the analysis of the results by segment revealed some divergence in views among banks, as they indicated that the top priority for enhancing transparency is the introduction of ‘one public rulebook’ (fig.9), although the strong support for ‘one public rulebook’ was counterbalanced by disagreement over whether FX should be traded on exchange, with just 33% of bank respondents in agreement.
Best execution and TCA
The survey also quizzed respondents on their perceptions around best execution and the use of transaction cost analysis (TCA). For the vast majority (83%), the overall cost of trade (transparent price discovery, no ‘last look’ execution and post-trade transparency) mattered more in assessing best execution than a tight spread. There was a similarly broad consensus, of 81% overall, on the usefulness of TCA in assessing best execution but by contrast, there was some disagreement on whether FX would benefit from a single source of reference price for the industry, with just 29% of banks and 74% of the non-bank respondents in agreement that it would be beneficial.
Many of the questions addressed by the LMAX Exchange report have arisen from the increased regulatory scrutiny of the FX market. The Fair and Effective Markets Review (FEMR), conducted over the last year by UK regulators, concluded in its final report that “market effectiveness has been impaired and public trust has been severely damaged.” It has recommended the creation of a new global code of conduct for FX, for market practices that are open to abuse to be reviewed and the development of standardisations in trading practice that are long overdue – such as on the time stamping of orders.
The report concludes that, “the FX industry needs to look ahead to the challenges it will face and develop regulation accordingly, not simply solving those faced by the market today.”