Major changes are coming following FX crackdown

Last month's $4.4 billion in fines against six major banks over foreign exchange price manipulation has spurred FX trading along the same path as trading in equities and fixed income: more transparency and greater use of electronic venues.

It also meant a move toward more 24-hour FX pricing and less use of traditional FX benchmarks.

What's spurred the latest move is the announcement in November that Citibank NA, HSBC Holdings PLC, J.P. Morgan Chase & Co. Inc., Royal Bank of Scotland PLC and UBS AG received a combined $3.4 billion in penalties from U.S., U.K. and Swiss regulators for manipulating foreign exchange benchmark rates to benefit certain traders from 2008 to 2013. Separately, the U.S. Treasury Department's Office of the Comptroller and Currency issued a combined $950 million in penalties against Citibank, J.P. Morgan Chase and Bank of America Corp. for “unsafe and unsound” FX trading practices.

The penalties come as asset owners are paying closer attention to their FX trades, a trend that began after lawsuits in the late 2000s, including those filed by the state of California and the $177.8 billion Florida State Board of Administration against custody banks over FX pricing.

“Foreign exchange is still viewed as somewhat of an ancillary market, but the fines were another wake-up call,” said John Halligan, president of Global Trading Analytics LLC, a Rutherford, N.J.-based trading cost analysis consultant.

Added Steven Glass, president and CEO at Zeno Consulting Group LLC, Washington: “The bank fines have raised the issue onto (asset owners') radar screens. They will reach out to their asset managers and ask what they're doing to get best execution on foreign exchange so that they're not being taken advantage of.” Zeno monitors trading issues for asset owners.

While foreign exchange is getting a closer look from asset owners, William Atwood, executive director of the $14.1 billion Illinois State Board of Investment, Chicago, said even with more transparency, the FX market is still dodgy for asset owners because it's not heavily regulated.

“We were closely monitoring our FX program” since the spate of custodian lawsuits, Mr. Atwood said. “We re-examined our approach to how we monitor foreign exchange trading. We now require our managers to seek best price and execution away from our custodian (State Street). So (FX) trading has improved, but it has kind of created a false sense of security. The market is fairly unregulated. I'm not that entirely comfortable with FX. We keep a close eye on it.”

What made the announcement of the fines so concerning to institutional investors is that banks were shown to have manipulated the World Markets Reuters Closing Spot Rates, the most widely referenced FX benchmark globally, according to the Commodity Futures Trading Commission. The benchmark is used to set the relative values of different currencies, which reflect the rates at which one currency is exchanged for another.

The use of electronic trading venues allows more 24-hour FX pricing away from benchmarks like the WM, sources said, although the dependence on the WM spot rate would be tough to shake.

“WM is so ingrained in everyone's investment process; it's a colossal undertaking to change that,” said James McGeehan, co-founder and CEO of FX Transparency, a Framingham, Mass.-based currency risk consultant. “The use of WM rates is written into many investment mandates and fund prospectuses for valuation and index tracking purposes. Additionally, it's the FX rate of record in many derivative contracts, options and products such as total return swaps. There are other firms pitching alternate fixing solutions to the WM, but there will be a long period to vet these solutions and the eventual adoption may take longer than anticipated, given the aforementioned legal and operational entrenchment of WM.”

However, Ross McLellan, founder and president of asset servicing analytics provider Harbor Analytics, Hingham, Mass., said transition managers have been among the first to shift to using electronic venues and take advantage of a 24-hour FX market. “In transition management, when large trades are made in a short period of time, many transition managers have moved away from benchmark trading ... to trading in unison with the equities. Three or four years ago, banks would guarantee the 11 a.m. (Eastern time) WM benchmark for all your orders. That would aggregate more liquidity and let the banks make money for larger orders. Most market participants knew the banks were making more, although what was more concerning was that banks were working in conjunction with each other. We obviously don't know the extent of that, but we do know, because of the fines, it was going on.”

While most in the FX market might have known about the collusion that eventually led to regulatory scrutiny, many asset owners were more focused on how their custodians were pricing FX trades under standing instructions. What the bank fines did was widen scrutiny by asset owners of the entire FX trading process.

“Not long ago the focus was on custodian markups on standing instructions trades, now it's on the whole process,” said Mr. McGeehan. “From currency risk inception at asset purchase, to measuring market risk undertaken until execution time, to how major market-making banks price risk transfer, to the benchmarks used for trading and valuation such as the WM — in essence the entire foreign exchange pricing mechanism.”

“The first step everyone can take is to let your managers know that you're watching,” ISBI's Mr. Atwood said.

Mr. Halligan of Global Trading Analytics said among asset owners, transparency is “what they really want. With that, people are much more comfortable, they have something concrete in terms of numbers to hold on to.” The Illinois State Board uses GTA to monitor its foreign exchange trades.

Richard Kos, founder and president of investment and fiduciary consulting firm Kos Consultants, Madison, Conn., said he expects to see the agency model of trading, where the broker just executes trades without holding inventory, to become more prevalent in FX trading, as it has with fixed-income trading. “No plan sponsor is an expert in foreign exchange,” Mr. Kos said. “That's not what they do. You have to make sure the agent is trustworthy.” n