Guy Debelle: The global code of conduct for the foreign exchange
market
Speech by Mr Guy Debelle, Assistant Governor (Financial Markets) of the Reserve Bank of
Australia, at the FX Week Europe conference, London, 25 November 2015.
* * *
Thank you for giving me the opportunity to talk to you tonight about two important pieces of
work currently occurring in the foreign exchange market. First, I will summarise developments
in FX benchmarks. Second, I will talk about the global code of conduct for the foreign exchange
market.
But before that, let me step back and ask why is the work going on? The reason, as many of
you are painfully aware, is that the foreign exchange industry is suffering from a lack of trust in
its functioning. This lack of trust is evident both between participants in the market, but at least
as importantly, between the public and the market.
Trust is the lynchpin of all financial market transactions. Without trust, markets do not function
well.1 At an FX Week conference earlier this year,2 my colleague Simon Potter outlined the
important role that the foreign exchange market plays in the global economy. We clearly need
the market to be functioning as effectively and efficiently as possible. But for that to happen,
we need to restore the trust in the foreign exchange market.
FX benchmarks
I will start by summarising the current state of play in FX benchmarks, reiterating remarks I
made in Sydney last week.3 Roberto Schiavi has talked about this from a European perspective
earlier today.
From early 2013, concerns were increasingly raised about the integrity of FX benchmarks,
particularly around the potential for market misconduct in the trading around the time of
benchmark fixings. Accordingly, the Financial Stability Board (FSB) formed a group co-chaired
by Paul Fisher of the Bank of England and me to firstly analyse the structure of the FX market
and the incentives that might promote inappropriate trading activity around a fix, and then come
up with some potential remedies to address the problems we found.
After talking to participants from all sides of the FX market around the world, in September
2014, we proposed 15 recommendations to reform the FX benchmark process, which were
endorsed by the FSB.4 These recommendations were in four main areas: benchmark
methodology; execution of benchmark transactions; market conduct; and guidance on
reference rates produced by central banks.
Earlier this year, at the request of the chair of the FSB, Mark Carney, I chaired a group that
summarised the progress in implementing the 15 recommendations one year on, drawing on
information gathered by the foreign exchange committees (FXCs) and central banks in the
major FX centres. We put out a progress report on FX benchmarks just over a month ago.5
I will provide a quick summary of what has happened in this space over the past year and
briefly highlight some areas where there is still more to be done.
In terms of benchmark methodology, we made a number of recommendations concerning how
WM calculate the London 4pm fix. In particular, we recommended widening the fixing window,
and as a result, from February 15, WM widened their calculation window from one minute to
five minutes.
This widening of the window appears to be helping to achieve the intended outcomes and the
progress report contains some data analysis to support this. It is early days yet, with only a few
month-ends (where flows through the fixing window are generally the largest), but so far, it
would appear, so good. If you are interested, I would recommend reading Section 3 of the
report which compares the exchange rate dynamics before and after the change in the window
for a number of currency pairs. It is likely that the dynamics will continue to evolve as
participants adjust their execution strategies and it will be interesting to see how that goes.
There are also a number of propositions in the market in terms of netting of fixing transactions
which will also shape these dynamics going forward.
The wider window has helped to highlight the risk transfer involved between the buy side firm
initiating the transaction and the sell side firm executing it for them. This in turn was very helpful
in the communication of another of our recommendations, which garnered quite a lot of
attention, namely that fixing transactions should be charged for. Previously, transactions were
often executed for free, at least notionally. The "free" cost of the transaction probably increased
the incentive for manipulation as trading desks sought to generate greater profitability to
compensate for taking on this risk.
The widening of the window in February served as a focal point for sell side firms to start
charging for these services. Most sell side respondents to the FXCs' surveys report that they
are now charging for fixing transactions, particularly those linked to the London 4pm fixes and
especially the most liquid currency pairs. That said, some respondents, who tended to be
smaller banks less active in the fix, reported they were still reviewing their pricing structure for
benchmark orders.
Moreover, while there had been good progress in terms of the London fix, there was much less
progress for other fixes. However, the scope for benchmark manipulation is there for all fixes,
not just the London 4pm fixes, and hence it is important to reiterate that the recommendations
of our report are intended to apply to all FX benchmarks.
So how are fixes being charged for? A mix of pricing strategies is being used. Some are
applying a bid-offer spread, some a fixed fee, where the fee is based on an assessment of the
risk transfer involved. Others are pursuing a strategy which could be called "rent my algo",
where a firm provides access for a fee to an algorithmic trading tool to directly execute their
fixing transaction in the fixing window.
This in turn, leads me to another of the recommendations of the report, namely that banks
should establish separate processes for handling and executing their fixing orders from other
orders. This recommendation was designed to address potential conflicts of interest arising
from managing customer flow. A sizeable number of banks have implemented this
recommendation by shifting the execution of fixing orders from the spot voice FX trading desk
to electronic trading desks that execute them with algorithms.
As a result, the share of fixing orders executed by algorithm has increased substantially, as
we document in the progress report. There is also considerably enhanced internal scrutiny
from senior management around fixing transactions. Some firms have physically separated
their fixing desk from other desks. This segregation of trading functions has involved some
cost. Other participants regarded the cost of implementing this recommendation as being too
high, given the size of their business, and have not implemented it to date. Others have
decided to cease offering this service directly, in some cases offering customers a portal to
other fixing services instead.
Again, I would like to emphasise that the intention of our recommendations was that it was to
apply to all participants, with appropriate consideration to the size and structure of the market.
In the case of smaller, less actively traded currencies, separation of business is clearly more
complicated than for large actively traded currencies, but in these cases participants should
still be able to demonstrate to their customers that appropriate processes are in place, in
keeping with the fundamental motivation of the recommendation to reduce the scope for
benchmark manipulation.
In terms of market conduct, we made a number of recommendations around appropriate
sharing of information, including around trading positions (beyond that necessary for a
transaction) and particularly customer information. As Roberto talked about earlier, these were
picked up in a statement of Shared Global Principles that was published following the Global
FXC meeting in Tokyo earlier this year.6 Many market participants have reflected these
principles in their internal policies and codes of conduct, as well as revised policies around
benchmark execution consistent with our recommendations.
FX code of conduct
More broadly in terms of improving market conduct, in May this year, the BIS Governors
commissioned a working group of the Markets Committee of the BIS to facilitate the
establishment of a single global code of conduct for the FX market and to come up with
mechanisms to promote greater adherence to the code.7
There are two important points I want to highlight: first, it's a single code for the whole industry
and second, it's a global code. It's intended to cover the whole gamut of the industry. This is
not a code of conduct for the sell side. It is there for the sell side, the buy side, non-bank
participants, the platforms; its breadth is both across the globe and across the whole structure
of the industry.
I am chairing this work, with Simon Potter of the New York Fed leading the work on developing
the code and Chris Salmon of the Bank of England leading the adherence work. Our group
comprises representatives of the central banks of all the major FX centres.8 To repeat, it is
very much a global effort reflecting the global nature of the foreign exchange market.
This work is also very much a public sector-private sector partnership. In that regard, we are
being supported in this work by a group of market participants, chaired by David Puth of CLS.
The group contains people from all around the world on both the buy side, including corporates,
and the sell side, along with trading platforms and non-bank participants, drawing from the
various FXCs and beyond. Hence all parts of the market are being involved in the drafting of
the code to make sure all perspectives are heard and appropriately reflected.
The work in drafting the text of the code is well and truly underway. There are two aspects to
this. First is harmonisation of the existing regional codes. There is a lot of good material in
them and there is no point in reinventing the wheel there.
The second part of the work addresses those aspects of the foreign exchange market not
adequately covered in the existing codes. We need to fill those gaps; for instance, in providing
more detail around various aspects of order-handling and execution. We are also addressing
mark-up and last look. We are aiming to provide language around what it means to participate
in the market as principal rather than agent. In these areas we intend to describe what is good
practice as well as what is not good practice.
While the content of these regional codes is pretty good, it is very evident that they were often
ignored, wilfully or otherwise. Hence the critical need to come up with mechanisms to achieve
greater attention and adherence to the global code. We will have more to say on this later as
our work in this area proceeds.
At this stage, it is worth reiterating a point I made at an FX Week Conference in Sydney earlier
this year in the context of the FX benchmark work:9 "if these recommendations were not acted
on, authorities could conclude that a regulatory response was necessary to generate the
desired improvement in market structure and conduct." Mark Carney made a similar point in
his Mansion House speech in June,10 as did Simon Potter in July.11 I think the message should
be pretty obvious. This process of establishing a global code of conduct for the FX market
provides an opportunity for the industry to work with the public sector to improve the FX market
and restore confidence in it, rather than having a (possibly sub-optimal) solution imposed on
it.
That said, an overall aim of the code is for it to be principles-based rather than rules-based.
There are a number of reasons why we intending to proceed in this manner, but from my point
of view, an important reason is that the more prescriptive it becomes the easier it is to get
around. Rules are easier to arbitrage than principles. If it's not expressly prohibited or explicitly
discouraged, then it must be ok seems to be the historical experience. The more prescriptive
and the more precise the code is, 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.
The intention is to have this work of developing a single code to replace the various regional
industry codes completed by May 2017, with a new framework for adherence completed at the
same time. However, we intend to put out some parts of the global code, including drafts of
material on order handling and execution, by May 2016. We recognise that there is a need for
greater clarity around some of these issues sooner rather later.
We will be providing this draft material to the various FXCs and other market participants for
their input in the first quarter of next year. At the end of the process, for the code to be effective
and for it to achieve what we want it to achieve, it will need to be accepted and endorsed by
the FXCs and market participants more generally. That said, the process does not really end,
because as the foreign exchange market continues to evolve, the code will need to evolve with
it.
Conclusion
As market participants, regardless of which side of the market you are on, it is important that
you are aware of the changes that have occurred, and are still underway, in the foreign
exchange market.
If you are on the sell side, I am sure that you are well aware of these changes and hopefully, I
have provided you with some of the background and motivation for them. In terms of
benchmarks, there is a fuller articulation of this in the FSB benchmark report.
If you are in the asset management business, you may not have paid so much attention to the
details of the FX aspect of your business. But it is important that you also understand the
context for the changes that are occurring. Some practices and services that you were
accustomed to in the past, or maybe were unaware of, may no longer be available, and you
cannot expect your counterparty to provide them.
The motivation for the changes to the foreign exchange benchmarks is to reduce the incentive
and opportunity for improper behaviour by market participants around benchmark fixes. The
implementation of the recommendations in the FSB benchmark report, together with the
enhanced scrutiny externally and within organisations on fixing transactions, appears to have
moved the market in a favourable direction.
As we develop the single code of conduct for the FX market, the intention is that the market
will move further to a more favourable and desirable location and allow participants to have
much greater confidence that the market is functioning appropriately. We need this to occur,
as it very much in all our interests to have a well-functioning foreign exchange market. As
Roberto said earlier, we central banks care as much about this as anyone.
As it is in all our interests for trust to be restored to the FX market, I very much trust that you,
as market participants, will work with us constructively in this important endeavour.