And so, dear readers, we commence the second 500 of these columns by returning to a theme that has dominated the past 100 – and which remains the biggest single issue facing the foreign exchange industry at this time. I refer of course, to the appeal against Mark Johnson’s conviction, which is now underway in the US – specifically the US legal system’s apparent view that pre-hedging is front running.

As we report in this issue of Squawkbox, two Amicus Briefs have been filed, one by ACI – The Financial Markets Association, the other by Professor Torben Andersen, and – while wishing to praise both, especially ACI – I find myself wondering where associations like ISDA and AFME are? Why have they not stepped up and involved themselves in a case that is crucial to the people and institutions who pay their salaries and costs?

The under-valuing of risk takers has been a regular theme of these columns, especially as more and more institutions became averse to it. And this, to me, is one of the key themes underpinning the Johnson case, the ignorance on the part of the prosecution and their expert witnesses over the risks involved in FX trading. Again, though, I find myself returning to the silence from associations like ISDA and AFME who could – perhaps should – have made it clear to the prosecutors how risk works. 

It is also important to note that while this case is about the foreign exchange market, which has longed been viewed in some quarters as less important and sophisticated that other asset classes, the arguments being put forward are just as fundamental to any market, including equities and fixed income.

The filing of appeal documents means it is timely to remind everyone why this case is important and of what I consider to be some of the flaws in the prosecution, whose case seemed to be all about HSBC executing the trade in the wrong fashion (it was described as a fraudulent scheme – in which case there are countless “frauds” taking place every week in the interests of the end user client), but never actually came up with a manner in which it thought the trade should have been executed. 

The real concern that needs to be reiterated here is that the US legal system’s current position on pre-hedging (and remember Johnson has been found guilty therefore this is that mechanism’s official stance) is that it is front running. Precedence has been established, subject to appeal.

Given the prosecution’s failure to come up with an alternative execution method, one can only assume that they believe that the order should have been executed strictly in the one minute window – that would have been fun, assuming your definition of fun is a flash move similar to that in October 2016 in which Cairn Energy pays about 700 points (or more) above what it should.

The only way to execute such an order is with disclosed and transparent pre-hedging – and Cairn Energy’s treasurer clearly understood that. He observed in an email that buying ahead of the Fix (with discretion of course) was how he expected the bank to make money on the transaction. He also told the court during the original trial that his definition of best execution of the deal was HSBC trading “in an orderly and efficient manner so as not to create market volatility”. 

Trading in a one minute window would in no way have satisfied those best execution requirements. 

It also needs to be stressed to those hearing the appeal that pre-hedging also involves risk, although it does not mean that every single trade done in a week before a largish order, is related to that order.

For the prosecution to argue that trades executed one week, or even one day before the Fix execution represents front running is nonsensical. Yes, as head of the trading business Mark Johnson may have had greater leeway on stop losses but according to the Bank of England’s FX Joint Standing Committee’s semi-annual survey of FX turnover taken in October 2011 (the closest to the Cairn trade), average daily turnover in spot sterling was just over GBP 70 billion per day in London alone. 

The Cairn transaction was only ever going to be disruptive to the market if it was executed over a very short time horizon – i.e. the one minute Fix window. The Cairn transaction would represent approximately 0.5% of total trading activity in the six intervening days, so to argue that Johnson was buying sterling a week before represents an insult to his professionalism. He understood that he was likely at some stage to receive an order that would influence the market for a period of a few hours (maybe slightly longer in December), but it was hardly likely to play a role one week out.

This is the misunderstanding around risk. Traders are paid to anticipate market movements, make money for their institution and service the needs of the client base. This requires risk taking based upon several different factors – not just one. A trader is not doing their job if they merely sit around waiting for the next customer order, they have to be proactive in assuming risk in the interim. If, thanks to this conviction, traders are now to be hamstrung by the relative proximity of an order (or the promise of one), they might as well shut up shop and go home. 

And where will that leave the customers? The phrase I am looking for involves the absence of a paddle.

Pre-hedging is just another factor that involves assuming risk. Yes, a trader can accelerate buying into the Fix if they find they are having no market impact, but just as equally, an event can shift the market view and see them wearing a substantial loss – that is why pre-hedging takes place in the hour prior to a Fix, rather than days. It is a reflection of a trader assuming prudent risk.

A one minute buying frenzy – which is what we have to assume the prosecution wanted and the judge and jury found appropriate – would have failed miserably to acquire the required sterling, it would only have succeeded in triggering a flash move of the proportions of October 2016.

Other things that still bother me about the case (and I need to be balanced and reiterate my concerns that HSBC staff – not Johnson as far as I can see – apparently lied to the client and their advisor on one or two things) are the use of code words – any rational observer would see the benefit of keeping a large order quiet from desks that had no involvement; and the idea that Cairn was an innocent and naïve victim.

On the latter, (during the RFP process) Cairn’s treasurer Robert Scriven discussed asking the winner of the trade about sharing any profit from beating the Fix. Not only does this indicate someone well aware of how the market works, but allied to his stated views around how the bank will make money, he has to have understood that a profit share would only likely to come about through either that bank holding the position and hoping it comes back post fix, which is ridiculous (and yes, the US government’s “expert” suggested that); or pre-hedging. 

I used the word “expert” in inverted commas deliberately of course, because clearly this person is out of touch with the modern world. Let’s assume that HSBC was able to buy one billion sterling in the one minute window, and had a market impact of perhaps 10 points on the Fix (and I think I am being conservative here), then the bank would have been left with a post-Fix position of one and quarter yards, 10 pips out of court. That’s one and quarter million pound loss built in before the bank even tries to buy the balance back – and don’t think for a minute the bank would have been happy with a position of that scale overnight, so the buying would probably have been in the next hour or so…and have cost at least another 10 pips, thus doubling the loss.

Where is the rationality in that? Banks – and regulators – in the modern world, will not tolerate a mechanism that incurs repeated and unavoidable losses. And remember that if this “expert” analysis is taken on board it will be recommended practice for all fixes, so the losses will be in the billions. Foreign exchange had little or nothing to do with the GFC, if FX desks are subject to this type of risk and losses, the next crisis could be in corporate-world, where huge currency-related losses could undermine confidence.

So there is an irrationality to the prosecution’s arguments, allied to a fundamental misperception of risk – on which note I would also point out that Frank Cahill, the Cable trader who executed the trade, has worked at several large banks and he testified to the court that this was the largest transaction he had been involved in, before and since. That kind of tells you this type of order comes around relatively rarely and, into the bargain, highlights what I believe should have been another key element of the defence case – the unlikeliness of a counter order large enough to stymie a flash event, which in turn demonstrates the need for pre-hedging.

I suppose one other thing to highlight at this time – there are countless I have to say, but we don’t have the time or space to list them all, just what I consider to be the most crucial – is that it was made clear to Cairn’s advisor Rothchild, and therefore Cairn itself, that a notice period was needed. 

If HSBC was going to merely buy at the Fix, then all it needed was probably one minute’s notice – clearly the advance notice is to prepare the strategy and execute against the liquidity over a period of time. Rothschild was aware of this, it discussed the risk of market disruption during a compressed window – so it was clearly aware of the likely chaos resulting from a one minute buying frenzy.

So to me, it all comes down to people expecting service providers to give away something for nothing and the absolute lack of understanding as to how the FX market works. Above all, the message simply has to get through in this appeal that risk takers are fundamental to a healthy market ecosystem and even the most cautious pre-hedging comes with the risk of something going wrong.

If you doubted the importance of this case to the FX industry (and clearly some industry associations do) then read this line in the defence appeal documents – I think it aptly explains the problem. It says the government’s…failure to explain how a bank can permissibly execute a fix transaction, continues to leave traders “in the dark about what the law demands.” 

Unless that uncertainty is cleared up with a successful appeal, the FX market globally, but particularly in the US, faces a very challenging time that could ultimately leave it isolated in an otherwise connected global economy.

Twitter @lamboPnL

Twitter @Profit_and_Loss

Colin Lambert

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