The foreign exchange industry has always prided itself on
its ability to innovate and evolve and it does indeed have a positive story to
tell in these areas, but one area in which it clearly fell down badly was in
its inability to maintain control in an era of technological expansion.
It is hard to look back on the events of 2008-13 and not see
them as a direct result of the oversight function in the FX industry either
failing to understand, or failing to keep up with, the technological
Part of the problem is one of culture – which is a hard
thing to accurately define of course – more specifically how loose rules around
what can and cannot be done failed to take into account the changing market
structure. Put simply, the industry was trying to manage a 21st
century market with 20th century oversight procedures.
I was prompted to share these thoughts by last week’s report
from the Australian Securities and Investment Commission (ASIC), which,
although it focused on the local banks’ activities, stood out for me as a
microcosm for the failures around the globe.
ASIC noted that many young traders receive on the job
training, which is, obviously, very much dependent upon the standards of the
senior people on the desk providing the guidance. This is not a new phenomena
and I actually don’t think it is a real problem if – and it’s a big if
– the culture of the institution is strong enough.
I was one of thousands of traders who were sat down at a
desk and told to get on with it by their boss, who made sure they kept a close
watching brief until such time as the youngster was ready to be let off the
This oversight was informal but it was effective, mainly
because the people in charge ensured standards were high – I can recall on at
least two occasions being told in no uncertain terms that what I wanted to do
was not right and the lesson was learnt. The benefit of this approach is that
youngsters were allowed to make mistakes – it’s an important part of the
learning process – but they were also clearly (occasionally very bluntly) told
what was wrong and why.
The problem as reared its head in the middle of the first
decade of this century was, as I have previously noted, that whereas before the
senior traders could hear what was going on, it’s impossible to discern what is
happening when someone on the other side of the desk is tapping on a keyboard.
It also needs to be noted that it only needs one or two bad apples in the senior
ranks to undermine this entire approach.
Permeating the ASIC report, and again this is a global
problem – just look at the unfair dismissal tribunals taking place in the UK
and US which key on whether the trader was aware of conduct guidelines – is how
traders stated how they were unaware of, or could not recall, formal training
in a number of areas.
One of these is an old friend of the column – the Fix. Again
this reflects the inability of the institutions to keep up with the changing
market structure because it was in the early years of this century that what
was – and should be – a reference rate, was suddenly transformed into a
benchmark against which billions of dollars were both measured and traded.
Another area under the microscope was stop loss orders –
another old friend – and the issue highlighted to me that the network effect
played a role in the breakdown of standards. I was intrigued by the ASIC report
noting that some traders “engaged in inappropriate practices” by trying to
trigger stop loss orders. Intrigued because this practice has been happening
since the year dot, however there is a difference.
Historically traders with stop losses may have acted ahead
of time to protect themselves and their institution and, it should be noted, to
minimise customer slippage.
My experience was always that individual orders were not to
be targeted, but levels could be, especially those promoted by technical
analysts. This is a very grey area because inevitably there were a lot of stops
around technical levels, so by having a crack at that level was a trader acting
inappropriately? I suspect the answer is ‘no’ if they were not holding specific
orders – I would also point out that technical levels also produce a lot of
‘entry’ trades so actually triggering a level is not as easy as it sounds.
The key difference between pre-and post-2008 was the lack of
network effect. Prior to the advent of chat rooms it was much harder for a
trader to work with others to trigger stops – generally speaking they had to go
it alone and while this did not eradicate the practice, it did give several
pause for thought.
I have noted before when discussing the Citi trader tribunals
that I believed there was a genuine cultural problem, not least because once
the bank’s management explicitly told traders not to share information in the
chat rooms there were no instances of it happening.
Likewise, the ASIC reports notes that, “Employees were
generally aware that their communications were monitored by the compliance
While it points out that some employees sought to circumvent
communications surveillance systems through the use of codenames or jargon when
discussing confidential information with traders from other institutions, to me
this indicates that, yet again, the traders had not been made aware of what was
right or wrong. Or perhaps more pertinently, the oversight function was not
aware that the traders were even able to share this information?
On the latter point, ASIC observes, “At least some employees
felt that compliance staff did not have a sufficient understanding of the spot
FX business, including the language and jargon commonly used in the market. In
our view, this may have limited the institution’s ability to effectively design
and maintain a robust communications surveillance system (such as by using
appropriate lexicons for any automated surveillance) and to identify
inappropriate conduct through the review of communications.”
It is important to note that all of the events being
discussed in the ASIC report, as well as in several other documents from
authorities elsewhere, happened in the past. The foreign exchange industry is
in the throes of reinventing itself in terms of how it monitors behaviour and
manages trading businesses.
This is vital because to outsiders, reading the latest
headlines, it may appear that nothing has been done. It has – the Global Code
being the headline act in the new industry line up.
The reinvention is a work in progress and it will not be
easy – not least because I fear the problems no longer reside in the major sell
side institutions that had cultural problems 10 years ago. We have to ensure that
even the smallest player understands and adheres to the new ethics of the
industry. But progress this reinvention must and if one of the costs is that
some practices that have stood the test of time have to be discarded, so be it.
The core fundamentals of the foreign exchange market remain
unchanged – and meet the highest standards of any financial market – the real
work is to ensure that these fundamentals remain in place and that violations can
be detected, or in a perfect world, pre-empted.
To do this requires the oversight function and managers
generally to ensure that dropping behind the pace of technology innovation
never happens again. We have a lesson from history, let’s learn from it.
Twitter @Profit_and Loss