If you want an example of how some in this industry, and the media, are reactionary, stuck in (literally) a different decade and prefer to cast blame than accept some responsibility – look no further than this week’s quarter end Fix.
I have raised the subject a few times over the past week and quite a few of my chats have been about the issue and I am genuinely astonished, indeed a little angry, at those I hear and those I see write, that on Tuesday “we have to watch the banks”. Let’s get things clear – any problems at Tuesday quarter-end Fix will have nothing to do with the banks – this is almost exclusively a buy side issue.
With liquidity getting very tricky in FX markets there are genuine concerns about how the market can handle what will probably be the biggest single flow event of the year-to-date as the 4pm London Fix establishes the quarter end rate. Normally I would be optimistic that the industry can handle such a problem, after all it has spent quite a few years showing how well it handles the “known-unknown”, but these are, as we all know, very different times. There is still hope that more liquidity can be found to soak up the demand, or indeed that more buy side firms follow the enlightened path of some of their brethren by hedging differently due to the current extraordinary circumstances – all will be revealed in Tuesday.
To me, though, it beggars belief that some people think this Tuesday is an opportunity for the banks to exploit. Every bank that handles orders for clients at benchmark fixes now has tried and tested policies in place to protect the client, and they have robust oversight to ensure things are done right. Compare that to some buy side firms who, and this is becoming a sadly familiar tale in recent days, are too busy complaining about the spreads they are being quoted (in competition I would point out), to worry about what they could, and perhaps should do, ahead of Tuesday’s fix.
It’s the age if entitlement wrapped up and presented in one issue – I will do what I want to do regardless of the consequences, and it’s your job to make sure it doesn’t go wrong. If, or when, it goes wrong, we all know who will get the blame – it’s already starting now with those warnings to “keep an eye on the banks on Tuesday”. To give an indication of how this thinking goes, after the Global FX Committee issued a release last week reminding market participants of their obligations I received several messages stating that this was the GFXC “warning” the banks.
Absolutely the banks were warned to handle orders fairly and with transparency – and we can never forget why we are where we are now, because a group of banks let their standards and controls drop and generated a poor culture in their FX businesses – but there was something else that these people forgot to mention. Let me quote from the release:
“To reduce the potential impact of this volatility on market functioning, and market participants’ execution outcomes, the Global Foreign Exchange Committee (GFXC) encourages market participants to:
- Give appropriate consideration to market conditions and the potential impact of their transactions and orders [see Principle 12, FX Global Code];
- Be aware of the risks associated with the transactions they request and undertake [see Principle 9, FX Global Code];
- Clearly understand how orders will be handled and transacted [see Principle 9, FX Global Code].
To reiterate, the release then goes on to warn that orders must be handled appropriately, but those three bullet points are firmly targeting those participants providing orders, not executing them. In other words, the buy side. This was not a “warning to the banks”, it was a warning to every market participant. It was timely, it was appropriate and it should be heeded by all market participants. The statement highlights just why the FX Global Code is not just a sell side document, it is relevant to all sides of the market, it’s a pity that all sides don’t quite, or don’t want, to appreciate that.
Now if there is a group of market participants rubbing their hands in anticipation of events on Tuesday it is not those banks with Fix orders, and it is not the buy side – it is the vast number of speculative traders out there who are just waiting for 3:57:30pm London to see which way the Fix is going. They can do this because the buy side insists it can’t have tracking error and has to match the Fix, even if there is slippage in double digits, therefore the TWAP algos are lined up and signal away to their hearts content. In other words, using the Fix on Tuesday especially, in current conditions, is, I would argue, anything but giving appropriate consideration to market conditions or the potential impact of the transaction and I doubt it is showing awareness of the risks involved.
I mentioned earlier that we could be hopeful that something will happen – perhaps banks, with the permission of their clients, will free up more liquidity and allow their principal businesses to be more involved. Equally, I know there are buy side firms working urgently on different one-off (hopefully) solutions, such as executing over the course of a much longer window or hedging early.
Given the extreme volatility in equities there is a lot of daily rebalancing going on anyway when it comes to hedges, but that does not alleviate the potential problem on Tuesday, because that same volatility makes it very difficult to predict hedges to execute them early. There is also one other potential concern and that is what happens if a lot of the natural netting takes place before the window involving a limited number of firms? There are, no doubt, some nets available within the buy side flow, but as the Fix demonstrates most days, it is by no means an efficient net, there is always a significant imbalance. There has to be a concern that if some of the natural nets are taken out ahead of the window, we end up with just the reactionary, head-in-the-sand managers who are mostly tracking the same indices and will, naturally, be hedging the same way.
That is the nightmare scenario for everyone (except the speculators), wherein half the market acts early and prudently, but the bloc that is typically one way (and not keen to change their hedging ways), does not and all tries to hit a thinned out market with fewer nets available than usual.
I believe the solution to this is simple enough, and here I can raise another misrepresentation that bugs me – that I have a problem with WM Company. I don’t, and have stated this before. The company provides a robust, transparent mechanism for providing an indicative rate for firms to value their portfolios across multiple currencies. The problem is not the tool, it is how people are using it – change that and things can work out well.
The change I think should be considered is for WM to calculate using a much longer window, preferably measured in hours in the European trading zone. That would allow the buy side to access much more liquidity, with much reduced market impact, and still have the same measurement as everyone else. I have to stress, I don’t know if this is possible, but I would have thought given the company’s experience and infrastructure, WM can pull it off. The question then would be, can the buy side firms be able to take such a Fix into their systems? If it ends at 4:02:30, I don’t see why not.
So, let’s see what happens on Tuesday. With luck things will work out and the slippage won’t be too bad, but if it doesn’t I think we need to be very clear on one thing. On this occasion the fault will not lie with the sell side, it will be with those who knew there would be a problem and did little or nothing about it.