The world’s leading central banks have decided to raise integrity and transparency levels in the vast foreign exchange markets with a new code of conduct. And given the current mood music around market conduct, it probably has a good chance of being adhered to despite its voluntary nature. By Justin Pugsley

What is happening?

The foreign exchange working group (FXWG) run under the auspices of the Bank for International Settlements has finalised a code of conduct for the vast foreign exchange markets, which turns over about $5100bn every day.

The FX code of conduct sets out 55 principles covering six categories, which are: ethics, governance, information sharing, risk management, compliance, and confirmation and settlement.

Reg rage – acceptance

Central banks and regulators took the route of a voluntary code to avoid trying to thrash out a global regulatory framework for the FX markets, which would have proved enormously challenging given the over-the-counter structure and global nature of currency trading.

What is quite remarkable about this code is that it only took two years to draft, even though it involved hundreds of senior people across the world from different backgrounds working across public and private sectors. At its core, it is about transparency and doing the right thing.

Why is it happening?

The code is a response to numerous scandals in recent years involving the fixing of exchange rate benchmarks and front-running client orders by traders within certain banks, which has brought the FX markets into disrepute.

Central banks want to preserve the integrity of the FX markets in part so they can conduct their currency and monetary operations more smoothly. They also want more certainty that the exchange rates they see genuinely reflect market forces rather than manipulation.

What do the bankers say?

For banks, there is a strong self-interest in promoting integrity in the FX markets as ideally, they would like them to grow, which is good for business.

Overall, banks seem to accept the code, or at least accept its inevitability, as the political and public mood has shifted decisively against tolerating misconduct. Also, the banks had a strong hand in drafting it.

But one contentious issue does remain, called ‘last look’. This allows market makers, usually big banks, to reject or purposely delay a client order once they know the price their counterpart wants to deal at. That information can be abused in several ways, such as front-running the order or manipulating prices in some way, which has been done in the past and has led to regulatory and private legal actions.

The FXWG came up with principle 17 to address the way for banks handle this facility. If anything, the guidance is quite high level and lacks granularity, according to some participants, probably because getting too detailed would have undermined consensus. There are some, such as Andy Maack, head of FX trading at Vanguard Group, who do not understand why it even exists.

Nonetheless, the FXWG accepts the practice in the interest of liquidity, choice and maintaining tight spreads and larger potential trade sizes. But it strongly stresses that 'last look' must not be used for information gathering and to abuse counterparties.

The FXWG has launched a consultation that ends in September to get more views on ‘last look’ guidance.

Will it provide the incentives?

Everybody knows that voluntary conduct codes ultimately fail, right?

Actually, this one might already be working. The code’s guidance on information sharing, released in 2016 as phase one of the code, seems to have lubricated communication among market participants, making it easier to trade. Traders had become fearful of saying too much to each other in case it lands them in deep trouble a few years down the road.

Even with ‘last look’, providers are now being more transparent over their terms and conditions.

But there’s more.

For one, if widely flouted, individual regulators would quite likely cobble together their own national rules, which could fragment and undermine FX markets in the long run and impose all kinds of prescriptive requirements.

Second, the mood music these days is very much around being ethical and fair – so why would a global bank choose not to sign a code designed to protect users and market integrity? It would raise uncomfortable questions with regulators, investors and clients.

Third, the 16 central banks that sit behind the code will refuse to transact with commercial banks that are not signed up to the code. That more or less makes it obligatory for tier one banks to get on board and in turn they may impose that condition on smaller market players.

And fourth, thanks in part to the code, the buy-side is now much more aware of practices designed to pick their pockets and are asking a lot more questions than before.

In all, this code will probably work due to a combination of peer pressure and the threat of more unpleasant alternatives if it does not.

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