Ethical e-FX: self-policing and supervision versus regulation
Mark SnyderExecutive Vice President,State Street Global MarketsChairman, the
Foreign Exchange Committee
Ethical e-FX: self-policing and supervision versus regulation Mark
Synder outlines why ethics matter in the foreign exchange market
and how market-based discipline plus supervision equals a healthy
Foreign exchange markets are a remarkable success story. With the
rapid expansion of world trade, increased cross-border investment
flows and the arrival of newly liquid, tradable currencies, the
worlds largest financial market is a constantly evolving 24/365
digital network that seamlessly ties together the global economy.
Since 1989, global foreign exchange turnover has more than tripled
to over $2 trillion per day. According to the October 2005 report
of the Foreign Exchange Committees Survey of North American Foreign
Exchange Volume, average daily volume in that region totaled $440
billion a remarkable 31.2% increase over October 2004.
There have been bumps along the road -- scandals involving
unauthorized trading, fraud, and unprofessional trading practices.
But, despite the fact that the OTC forex market is essentially
supranational and not proscriptively regulated the ethical
character of the currency market is as good as or better than that
of any other financial market. The FX market has withstood the
dynamic changes of modern markets well. Currency market
participants have provided abounding liquidity to other markets,
have stimulated the emergence of new technologies, risk approaches,
products and services and have ensured a smooth market environment
for the greatest boom in cross-border finance that the world has
Volumes have grown exponentially. Margins are razor-thin. Liquidity
is deep and competition is vigorous. Essentially every enterprise
on earth -- from tiny factories to global asset managers -- can
obtain the currency they need when and how they need it at
transparent prices. These are the attributes of a thriving
Impact of electronic trading
Electronic trading has done much to make this possible. The
currency arena was one of the earliest adopters of electronic
messaging and today is arguably the most digital capital market of
all. Much of the wholesale bank-to-bank market is entirely
electronic, and dealer to client and retail trading is aggressively
migrating online either to bilateral standalone platforms or to
multi-party networks of various types.
This is almost entirely a good thing; in fact, given todays
exploding currency volumes, electronic trading is a sine qua non of
a thriving and growing marketplace. But it does raise issues. The
same qualities that make e-forex such a success speed, efficiency,
flexibility, scalability mean that mistakes or malfeasance can
easily expand and multiply.
Leaving aside the operational questions of transactional errors and
fat fingered trading, e-forex raises important issues regarding bad
trading practice. For example, the introduction of autodealing
techniques into the FX interdealer market and other electronic
trading venues, together with the rise of prime brokerage services,
has raised concerns that unprofessional trading behavior may take
place under the cloak of anonymity--undermining the reputation of
the foreign exchange market and impeding its successful
Traditionally, almost all FX transactions have been manually
initiated by an individual trader. But over the past 18 months or
so, the FX market has witnessed the rapid expansion of automated
program trading strategies that facilitate complex, high-frequency
trading, risk management, the aggregation and execution of trades
and algorithmic and arbitrage trading.
Autodealing has had no discernable impact on overall market
liquidity or pricing. The market is still characterized by
increasing numbers of counterparties, large numbers of individual
quotes and expanding volume and trades at every price point in
almost all market conditions.
But concerns have been raised over participants ability to transact
automatically on electronic broker platforms through prime
brokerage services. In traditional prime brokerage, clients trade
in the name of the prime broker but execute their transactions
directly with the dealer.
In the electronic prime broker model by contrast, there is no
identification of the trade as being prime brokered at the time of
execution so the end user is able to trade anonymously. While
inappropriate trading techniques can be executed manually, the
greater speed and anonymity of autodealing may impede the
self-policing capacity of the OTC FX market, with potentially
negative implications for its overall risk profile.
Bearing this in mind, and continuing its tradition of forthright
identification of potential forex market issues, the Foreign
Exchange Committee has established an Autodealing Subcommittee
which is reviewing the rise and impact of autodealing, as well as
identifying potential risks. This review will build upon earlier
work of the Committee which identified more than 20 best practices
for the prime brokerage sector.
The same qualities that make e-forex such
a success speed, efficiency, flexibility, scalability mean that
mistakes or malfeasance can easily expand and multiply.
New FX Market Segments
Todays FX market is witnessing growing trade volumes dedicated to
FX as an investable, independent asset class. Many observers have
noted that hedge funds and other leveraged investors have
introduced new dynamics into the market, as have banks through
their use of algorithmic trading. But its also relevant to focus on
the role of the new retail aggregators who facilitate electronic FX
trading by thousands of individual investors.
Retail foreign exchange traders have gained greater market access
through new trading technologies and business models that are
delivering price discovery, liquidity, execution, confirmation, and
reporting services in near real time. In the foreign exchange
distribution channel, transaction services that were historically
bundled together and offered by a single provider have been broken
out into their components, with specialized entities providing the
These innovations may have the effect of separating foreign
exchange dealers from retail end users - a development that may
complicate the dealers execution of their responsibilities.
Retail aggregators depend on the major foreign exchange market
makers as liquidity providers. Many are banks or registered brokers
and most are futures commission merchants regulated in the United
States by the Commodities Futures Trading Commission (CFTC). As
such they must have internal controls, know-your-customer policies
and procedures, anti money-laundering programs and independently
audited compliance. However not all retail aggregators are
registered as regulated entities.
Wholesale foreign exchange dealers need to be aware that they may
face significant reputational risk if they are linked to a
transaction chain that results in dissatisfaction, litigation or
both. Bearing in mind this apparent blurring of the demarcation
between the wholesale and retail foreign exchange markets, the
Foreign Exchange Committee published a letter to market
participants in December 2005 that calls for good legal
documentation and stresses the importance of know-your-customer
obligations and contractual relationships.
Market-Based Discipline + Supervision =
a Healthy FX Marketplace
The foreign exchange market itself is not regulated. That said, the
major participants in the market are well-supervised by banking and
other authorities. The currency market is, by definition, a
transnational market in that 100 per cent of its volume moves
Imposing a regulatory compliance regime over the whole market would
not be practicable and would unavoidably lead to an increased cost
of doing business and higher trading and profitability margins,
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