I have been stating in recent months that one of the
challenges for the FX industry will be promoting the “good news” story that it
is reforming itself, while at the same time being on the end of negative
headlines around actions that allegedly took place a decade ago.

This week’s headlines around HSBC and the alleged running of
stop losses is a case in point, but the accusation from ECU Group against the
bank also raises an early question about one of the Global Code of Conduct’s
principles.

Worryingly for the bank and the industry is that this is the
third accusation made against HSBC for front running – Mark Johnson was
arrested in relation to front running the Cairn Energy deal and Stuart Scott
was, according to sources, dismissed by the bank for inappropriately sharing
information about a huge Cable order for Prudential – an order that also
attracted allegations of front running.

I have to say that I am not totally convinced by the
argument that the reversal once the stop was taken out indicates the order was
run. If, for example, a trader was buying in front of a stop loss buy order,
depending upon how much the trader bought, the order itself would square their
position as they would then sell to the client. The trader may have had to buy
more than planned and then sell some of that, but I am not sure the amounts
would be that large because the risk involved would probably not be worth the
reward.

We should all be worried that I can routinely describe how a
stop can be run by a trader with knowledge of the order (no I didn’t in answer
to your question), but equally I want to reiterate that this type of conduct
has largely been eradicated by the banking industry over the last three or four
years. Thanks to segregated order books and better supervision any trader
thinking of running a stop has more than one reason to pause and reconsider.

Which brings me to the challenge for the Global Code.

In my Insights call on Tuesday I suggested that I was
concerned about the challenges of pre-hedging a stop loss order, specifically
that it might lead to a legal action. On Wednesday, reading the Financial Times report, those fears were
realised.

So far, most of the banks that have suffered at the hands of
regulators and legal authorities have done so because they were not honest
about their actions – the specific actions, however, were not questioned.

What is different about the allegation from ECU Group is
that where previously the problem was a lack of transparency about, for
example, how last look was used, there seems to be in ECU’s claims a direct
reference to the running of the stops…which brings us to Principle 11 in the
Global Code.

I fully understand the intent of P11, when a dealer is
handling a large order it can often be beneficial for the client, and the Code
states: “Pre-Hedging is the
management of the risk associated with one or more anticipated Client orders,
designed to benefit the Client in connection with such orders and any resulting
transactions.

“Market
Participants may Pre-Hedge for such purposes and in a manner that is not meant
to disadvantage the Client or disrupt the market. Market Participants should
communicate their Pre-Hedging practices to their Clients in a manner meant to
enable Clients to understand their choices as to execution.”

If any UK court case (should it occur) gets into the details
of running a stop it will be an early test of the Code and, if things go in a
particular direction, it could lead to the new global FXC having to re-think
P11 as well as P17 on last look.

Assuming ECU does have a gripe about the stops being run,
the court will probably have to decide what constitutes pre-hedging. The lack
of transparency around the activity, if proven, will do for the bank in this
case but if the court also accepts that the stops were deliberately targeted
and dismisses the obvious defence of pre-hedging, where does this leave P11?

As I noted on Tuesday – I understand pre-hedging can play a
vital role around larger orders but I question whether P11 has enough detail
over stop losses. The fact is this type of order is almost guaranteed to create
an emotional outburst from one party or the other – either the customer thinks
their stop has been run or the bank feels it has been left holding a decent
chunk of slippage by trying to hold the customer in.

The fact is that every single trade that goes into
pre-hedging a stop loss order mathematically increases the chances of that
order being hit because the pre-hedged trades are creating market data for
machines to price and execute off, that in turn will dictate the direction of
travel – towards the stop.

The ECU Group case then – and I have to keep on stressing it
depends on it actually coming to a hearing – will represent an opportunity for
the Code’s current content in P11 to be examined in the light of a legal
decision. For just as any trader’s defence will involve pre-hedging so any
prosecutors will also invoke the practice as evidence of misconduct and working
against the customer’s best interests – even if the actions were fully
disclosed.

As I noted earlier, I fully understand the occasional value
of pre-hedging, especially non-stop loss orders, but it worries me greatly that
that the Code has left a grey area that could be tested in a court of law so
soon. Essentially such a case would come down to how you prove you acted in the
best interests of the client when every trade you did empirically increased the
chances of the stop being hit. I don’t like those odds.

I would feel a whole deal more comfortable with the industry
taking a “consenting adults” line and stressing that the risk associated with
slippage on a large stop loss should lie with the customer, not the bank
handling the order. We can TCA any execution so if the trader has to wait until
the order’s criteria have been met, i.e. all given/taken, one touch etc., the
bank should then be able to prove it did the best job for the client.

I prefer this approach because too many customers have over
the years taken advantage of their position and handed responsibility for a
large order to their bank. If you have positions in the hundreds of millions of
units then you should also accept that exiting that position will be much like
me on a running track – slow, cumbersome and anything but pretty. The Code
promotes responsibility for all
market participants and in my view this extends to customers accepting the
risks associated with holding large positions.

I would much rather hear of arguments between customer and
bank over how an order was executed – which can be settled by good TCA – than
of legal threats over whether pre-hedging actually helped trigger it.

The Code as a set of principles does a very good job and I
understand its creators do not want to make it overly-prescriptive, however as
the market evolves it will need a little more detail here and there if it is to
play its role as first line of defence against a breach of securities laws.

The ECU Group claim, should it materialise in a UK court of
law, could provoke just such a re-think.

Colin_lambert@profit-loss.com

Twitter @lamboPnL

Twitter @Profit_and_Loss

Colin Lambert

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