I see this week’s announcement that the UK’s Financial Conduct Authority (FCA) is to recognise the FX Global Code as a positive for the industry, not only because it may drag a few asset managers wary of their relationship with the UK regulator to the adherence table, but also because it highlights how a set of principles can work alongside regulation, thus meeting the concerns of those who believe the Code lacks “teeth”. To illustrate my point I will go a little off-piste to the credit derivatives market, and if that doesn’t scare you nothing will!

Earlier this week I wrote about regulators promising to continue targeting so-called “manufactured credit events”, not something I know a great deal about but something I found intriguing – not least because it highlights how there will always be limits to regulation, just as there will always be “clever” people who will find, and breach, the rules of engagement.

Notwithstanding my lack of real insight into how these things work – and yes, I know that has never stopped me before – I don’t see how the story that epitomises the issue can be viewed as anything other than market manipulation and a great example of poor conduct and practice.

Sadly for the genius who thought of the idea they omitted to take into account that the CDS market is OTC

The gist of the story is that Blackstone-backed hedge fund GSO agreed to refinance US real estate company Hovnanian’s debt (or part thereof) as long as the company missed an interest payment on its existing bonds. By doing this, it was apparently thought that it would constitute a default and as such pay outs would be triggered on Hovnanian’s credit default swaps (CDS), of which, GSO was, funnily enough, long. In return the company would be financed at a lower rate, thus easing its debt management burden – surely it’s a win-win?

Sadly for the genius who thought of the idea they omitted to take into account that the CDS market is OTC and therefore was not only was there a seller of the CDS, but that seller also knew the identity of the buyer. Surprisingly to those of us who were not blessed with the genius gene, at least one seller commenced legal action – equally surprisingly, GSO and Hovnanian went no further with their plan and settled the lawsuit before it went to court.

Notwithstanding this outcome, surely the very fact that someone saw fit to try to take advantage of the situation and create such a “manufactured” – and the name rather gives the game away – credit event means urgent action needs to be taken? The event took place just over a year ago and since then? Well, we have had this week’s statement that trans-Atlantic regulators are to “make collaborative efforts to prioritise the exploration of avenues, including industry input which will address these concerns and foster transparency, accountability, integrity, good conduct and investor protection in these markets” (no, me neither).

I am not, I should stress, calling for regulation here, but I think it is a good example of how a strong code of conduct can work with the regulators – as does, it seems, the FCA, which is planning a similar approach. One cannot get away from the fact that the strategy attempted in this issue was wrong, the institutions involved should be looking at how their staff conducted themselves and take action.

You can make an educated guess as to what went on in this case because apparently the customer was convinced to miss a payment on May 1; had 30 days to make it and was set to be in default if it failed to do so; a lawsuit was issued within days of the non-payment; and the whole thing was settled before May was out! You can just see the meeting in some nondescript office with someone uttering the words, “…well it was worth a try…”

Unfortunately for these “clever” people I think most right-minded individuals – and the firm itself which abandoned the idea – do not think this is worth a try and something needs to be done. Under the terms of a code of conduct this would surely be highlighted as poor practice and the whole issue could have been dealt with moments after the genius came up with the idea. If the firm persisted, then regulators could have stepped in, citing the same code, and taken action.

No code, to the best of my (limited) knowledge exists in credit derivatives, therefore the regulators are having to get involved – as, it must be accepted, they probably have to. This, above all else, illustrates why adhering to a voluntary code is much better than risking overly-proscriptive regulation in the chase of a few extra dollars.

There are those in the FX industry who feel – with some justification – that the FX Global Code has rather stagnated over the past year or two with little progress being made. There are also people in the industry who feel it needs to have “teeth” in the form of hard-wired rules, or, perhaps it needs to be abandoned in favour of regulation. They are wrong.

The event described here, to my mind, strengthens the argument for a code of conduct as a first line of defence, and the announcement by the FCA that it may take action over breaches of the FX Code demonstrates an approach that will allow that code to be given the required “teeth” if required.

As someone mentioned to me this week, regulation does not bring certainty, it offers people a chance to circumvent the rules. At least a code of conduct gives people pause for thought and an opportunity not to take a step on the wrong side of the line.


Twitter @lamboPnL

Colin Lambert

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