Bruised and blemished from scandals and controversies, the foreign exchange market took to introspection to re-emerge as a more transparent asset class.
Started in 2015 by the Bank for International Settlements and 21 central banks, a foreign exchange working group was established to design a single, cross-jurisdictional set of good practice principles for market participants. Since then, and with the support of the market participants group, which consisted of buy-side and sell-side participants and infrastructure providers, the FX Global Code of Conduct has emerged.
The code is a comprehensive framework of good practices that voluntarily applies to all those who participate in the wholesale FX market, whether that be an asset owner, an intermediary (such as a plan's investment manager), a dealer or a platform. The natural question is: Why should fiduciaries not only be aware of the code, but also comply with it and ask others to comply with it?
Why be aware of it?
First, why be aware of it? FX is the largest market and it facilitates investment diversification. Plan fiduciaries that invest in international securities, which are denominated in the local currency, will bear exchange rate risk. As a counter to that risk, fiduciaries will hedge so the plan's interest will only fluctuate on the underlying security's value and not because the U.S. dollar gained against the local currency, causing the plan to earn less than it might have. FX, therefore, is indispensable to the 21st century retirement plan. Although it is not perfect, the code represents a good faith and diligent effort to improve market practice in this vital market.
Here are examples of important principles:
a clear understanding of whether a market participant acts as a principal or agent in executing a transaction (Principle 8);
- a need to handle orders with fairness and transparency. This includes making clear whether the prices that are being offered are firm or indicative, a description of whether orders are aggregated or prioritized, the potential for orders to be executed manually or electronically, as well as the time-stamping policy and when it is triggered (Principle 9);
- pre-hedging as a principal only and in a manner that does not disadvantage the client (Principle 11);
- understanding how reference prices are established (Principle 13);
- ascertaining whether a particular markup is fair and reasonable, which may involve greater transparency on whether the transaction price will include a markup and how the amount of the spread is calculated (Principle 14);
- being transparent about whether "last look" is used as part of a transaction (Principle 17); and,
- having an effective compliance framework governing FX activities, including processes designed to identify and eliminate abusive or manipulative practices, escalation procedures once issues are identified and the inclusion of training (Principle 25).
These are just a sampling of the ways in which the code promotes better practice in the FX market. Importantly, the code applies (in a voluntary sense) to all participants in the wholesale market, which include dealers, currency managers, platforms and asset owners. From any participant's standpoint, then, the code not only could be a benchmark against which their own practices may be measured, but the code also could effectively be used to vet and monitor agents and counterparties of the participant. In other words, the code can lift the boats of everyone operating in the market.
Why comply with the voluntary code and why ask others to adhere to it? The code reflects a heartfelt effort on the part of the Foreign Exchange Working Group, the Market Participant Group and others to improve the functioning of the FX market and the behavior of its participants. Not all of the principles apply equally to each participant, and some may not agree with a particular principle for a number of reasons. Yet, the principles reflect a consensus; anyone operating directly or indirectly in the market should take the code seriously from a compliance standpoint. For example, a plan fiduciary might wish to review the code and compare the principles with how the fiduciary in fact conducts FX activity. One can imagine a plan committee asking its investment managers to explain how the code affects their portfolio and how the manager is working to comply with it. This analysis could be taken a step further, with the plan committee asking not only whether the investment manager itself complies, but also whether the counterparties the investment manager selects are aware of, and comply with, the code. Will investment committees insist that investment managers only trade with counterparties that adhere to the code?
Investment managers that are fiduciaries to plans might want to embrace the code and advertise that fact to their plan clients. If there is skepticism of FX as a transparent market, an investment manager could seek to allay these concerns by explaining the code to its plan clients and how the code aims to make the operation of the market less opaque. As a diligence matter, plan clients are likely to look favorably upon those investment managers who demonstrate an awareness of best practice developments and a willingness to raise this awareness with the plans. Adherence to the code may ultimately create a competitive advantage.
The code is in its early days. There is much enthusiasm about it and it may be revised every few years as the code becomes more and more mainstream and practices evolve. Although it is not a law, the code reflects a spirit and desire to make FX more trustworthy and honest. Its development has forced discussion and debate over how the market should operate and how participants should behave. For those plans that trade in FX at all, even just to hedge, the code sets forth good practice principles that apply to them, their service providers and their counterparties. The code can serve as both a discussion item and as a way to guard against abusive practices. Though FX does not take as primary a role as equities in plan operation and management, it is an indispensable market that is striving hard to be a better version of itself.
George Michael Gerstein is counsel at Stradley Ronon Stevens & Young LLP in Washington. He has previously worked as an attorney supporting the foreign exchange unit at State Street Global Markets. This article represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.