A second working group set up by the Global Foreign Exchange Committee (GFXC) in 2018 to look at how market participants operating the “cover and deal” model utilise last look has published a paper highlighting areas in which it believes practice can be improved. Primarily, the report stresses the importance of those operating cover and deal models ensuring that there is adequate disclosure of the practice, the way in which it is being used, and the clarification of the role and capacity in which the participant acts.
Although the first major amendment to the FX Global Code was on Principle 17, which looked at the practice of last look, at the time the GFXC noted that there was still some confusion over the Code’s recommendations specific to those participants who operate cover and deal – whereby their provide liquidity to clients but are not seeking to take on market risk, therefore they back-to-back part or all of the trade with a third party liquidity provider.
Because the cover and deal party executes a covering transaction before accepting the initial client request they are effectively trading in the last look window, a practice that could see then in breach of the Code’s guidelines.
Although the cover and deal arrangement has very similar features to an agency model of execution, the GFXC points out two key differences. Firstly, the intermediate provider, the cover and deal operator, has some level of discretion in whether or not to execute the trade request. Secondly that provider is quoting prices to its client in a Principal capacity. “Consequently, by attempting to execute an offsetting trade through external action, the Intermediate Provider will be trading in the last look window as a Principal,” the report states.
The GFXC says that feedback from industry participants (including those from the buy‐and sell‐sides, and platform providers) confirms that trading on a cover and deal basis is being used by “hundreds of banks within the marketplace and across a range of jurisdictions”. It also indicates there is a wide spectrum of usage, ranging from exclusive use to none at all.
To be consistent with the principles of the Code, the report says that any cover and deal arrangements (however configured) must be managed in line with three characteristics. That there is an explicit understanding the cover and deal operator will first enter into an offsetting trade before accepting the client’s request; that the volume traded in the last look window will be passed onto the client in its entirety; and that the understanding is appropriately documented and disclosed to the client.
Although the report does not make specific recommendations around disclosing the cover and deal model, it does reiterate the values of Principle 8, which says participants should be clear about the role in which they operate. The challenge is, as the latest report observes, that participants operating the cover and deal model may not do so consistently and occasionally does take on market risk from client trades.
The report also says that to be consistent with Principle 19 of the Code, which looks at the use of confidential information, the cover and deal provider should ensure that the client understands at which stage of the trade process that provider interacts with a third party.
The ability to transact anonymously on trading platforms can raise additional challenges for participants seeking to understand the trading practices of their counterparties, the report notes, including the degree of information that is being disclosed about them to other third parties. “This is as relevant for cover and deal as for other trading arrangements in the foreign exchange market,” it states.
Similarly, cover and deal operators should be able to provide post-trade analysis in line with the recommendations in Principle 17 in the same fashion as other market participants.
Although the Code’s guidance on cover and deal is that all volumes are passed through to the client, it makes no such recommendations around price improvements and slippage. “Pricing is a commercial matter between the parties and engagement with market participants has confirmed that practices around passing on price improvements/slippage are not uniform within the industry and, in certain cases, will be constrained by the technology used,” the report states. “Principle 17 of the Code stresses the importance of clients having sufficient transparency around the market participant’s execution practices that would allow them to evaluate the handling of its trade requests. Information regarding the treatment of price changes during the last look window should form part of that discussion.”
Notwithstanding that, the report does note that feedback suggests that cover and deal operators are as capable of providing transparency to the clients in this area as other participants. “Notwithstanding variations in how price improvements and slippages are treated in ‘cover and deal’ arrangements, providers should be transparent regarding their last look practices in order for clients to understand and to be able to make an informed decision as to the manner in which last look is applied to their trading,” the report states.