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Global Regulator Proposes FX Benchmarks Reform

The Foreign Exchange Benchmarks Group (FXBG), an independent working group set up by the Financial Stability Board, has published its interim report and opened up a consultation period on a number of proposals aimed at reforming the market practices around the use of FX benchmarks.

Its main proposals for consultation are to widen the calculation window; explore alternative benchmark calculations, such as a volume or time weighted benchmark price calculated over longer time period; and develop a global/central utility for order matching to facilitate fixing orders from market participants. It also calls for feedback on the centring and exact timing of the fixing window, as well as establishing internal controls to “address potential conflicts of interest arising from managing customer order flow”.

FX benchmarks, such as the 4pm WM/Reuters (WMR) Fix, have come under scrutiny since concerns about possible manipulation were first raised last year. Since then, around 30 individuals have been suspended, placed on leave or dismissed from global banks in connection with ongoing internal investigations into the allegations, although one has been reinstated (Squawkbox, 9 June).

The FXBG report sets out 15 draft recommendations for views and feedback from market participants, focusing on four broad categories:

1. The calculation methodology of the WMR benchmark rates.
2. The publication of reference rates by central banks.
3. Market infrastructure in relation to the execution of fix trades.
4. The behaviour of market participants around the time of the major FX benchmarks (primarily the WMR 4pm London Fix).

In addition, it will take into consideration recommendations from a forthcoming International Organisation of Securities Commissions (IOSCO) review of the WM fixes.

The report recognises the important role the fixings play for different buy-side participants, eg valuing, transferring and rebalancing multi-currency asset portfolios, and indicates the global regulator’s willingness to tweak market practices, in place of abolishing the fixings.

Openly welcoming the consultation paper, James Kemp, managing director of the global FX division of the Global Financial Markets Association (GFMA), says, “The draft recommendations outlined are likely to have an impact on all participants offering or making use of FX benchmarks as part of their FX trading activity, including dealers, institutional investors, companies and governments. We will continue to work with regulators and supervisors to support measures designed to preserve and enhance confidence in the FX market, given its role in underpinning global trade and investing.”

Simon Wilson-Taylor, president and CEO, Molten Markets, however, disagrees with many of the proposals, for example extending the calculation window, which he believes may give participants more time to game the market; and moving to VWAP, which may create a bigger problem for the banks’ hedging.

In addition, he doesn’t support the proposed centralised matching facility. “Currently, there is an imbalance between buying and selling in any currency, and a much bigger imbalance, as shown in the report, is seen at month and quarter ends. That is the consequence of fund managers rebalancing their portfolios and redoing their hedges,” Wilson-Taylor explains. “At the moment, the market does a good job of absorbing that imbalance, even though the banks may complain about ramming orders through at 4pm.

“However, if you take that risk position and require it to be transparent and executed like an exchange model by matching demand and supply, we are going to see increased volatility in the markets, which the report shows is not there at the moment.”

He points to the example of the equity markets, where a typical matching facility matches only 16%, leaving an 84% tail. “That is probably where we will be in FX, which is not pretty.”

In the report, the FXBG emphasises the need to change the behaviour and practices of market participants. Six of the 15 recommendations deal with strengthening banks’ internal guidelines and controls. In addition to bolstering their internal systems and guidelines, the report also tackles information sharing between market makers and with other counterparties and clients. It advocates developing greater detail in codes of conducts and “explicitly the extent to which information sharing between market makers is or is not allowed”.

Marshall Bailey, president, ACI International, says this chimes in with what the ACI – The Financial Markets Association has been advocating with its Model Code. “We have consistently argued it is not the Fix that is broken but rather it is the manner in which it is used by certain market participants that must be scrutinised,” he says.

"In all cases in markets, ultimately it comes down to the behaviour of individual market participants, and the ability of their supervisors to enforce high standards through effective oversight and governance. We welcome clarity on the current concerns in order that the market can benefit from the leadership guidance provided on matters of ethical conduct in wholesale financial markets.”

Bailey also warns that creating a central utility is not without risk. “The use of a central utility, such as the ones providing CCP benefits to the market currently, must be well governed and capitalised, with the risks understood. The unintended consequences of further concentration of FX flows may not be what the regulators and supervisors want. We would have to be careful in the formation of such a utility, and ensure that all parties understood their role and their obligations.

“Ultimately, the widespread use of the fix has been to benchmark performance of FX managers. A central utility may facilitate this improvement, but there is a risk of further complacency on the part of asset managers to prove their own alpha-generation if the central fixing utility draws in more volume,” Bailey adds.

Although asset managers have largely stayed out of the media spotlight during the Fix investigations, the FSB used the report to reaffirm their fiduciary responsibility. The final recommendation of the report says: “Asset managers, including those passively tracking an index, should conduct appropriate due diligence around their foreign exchange execution and be able to demonstrate that to their own clients if requested. Asset managers should also reflect the importance of selecting a reference rate that is consistent with the relevant use of that rate as they conduct such due diligence.”

Mankash Jain, director of Ten Rings, which is a Dubai-based financial company that performs a mixture of prop trading and investment management, believes that there is still “a long way to go” before the buy side is tackled by the regulators. “Until FX becomes – or if it does become – a fully exchange traded product, which I don’t believe it will be in the short term even though a shift has begun, then I don’t believe that it is possible to regulate or report FX in the same way that you can with other products.”

The deadline for responses is Tuesday 12 August and should be sent to with “FXBG comment” in the email title. The FSB, which is chaired by Mark Carney, governor of the Bank of England, will submit the group’s final conclusions and recommendations to the Brisbane G20 Leaders Summit in November.

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