At the Exchange Forum

FX Market Structure Changes Loom in Wake of Scandals

Electronic trading is changing the game across asset classes, with FX getting caught in the middle of a transparency debate.

Libor and FX rigging scandals have attracted scrutiny to market behaviour, adding to the bulk of global regulations since the financial crisis set loose industry watchdogs.

It hardly needs to be said that those conducting market abuse are harming the functioning of the markets and moving prices away from fundamentals, a sentiment expressed by David Lawton, Director of Markets, Policy and International, for UK regulator, the Financial Conduct Authority (FCA), at Mondo Visione’s Exchange Forum in London.

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“Fines for the attempted manipulation of Libor, and even criminal convictions in the UK and US earlier this year, show that benchmarks are also a key part of the market where fairness and effectiveness have been lacking,” said Lawton. “This was further enforced when the FCA and other regulators identified similar failings taking place in the FX market.”

In FX, what is considered “front running” in the equity trading markets is often thought of as prudent hedging

In the UK, reforms have been introduced, in particular the regulation of key market benchmarks. And similar steps are being taken at the European level, Lawton added.

Is it manipulation?

At the same time, some questionable but widely accepted market activities continue with regulators yet to determine the best way of tackling them.

Sean Hunter, Forward Deployed Engineer at Palantir, the CIA-backed data analytics firm, said that market arbitrage is fine if it helps determine an accurate price, but if it’s a “zero sum game, where people are trying to game each other and the system, it’s not helpful.”

Right now, market regulators are focused on conduct risk related to benchmark manipulation, or behaviour that results in major price dislocations that cause volatility events, like a ‘flash crash’, for example, said Hunter. But there’s also “borderline order book manipulation” that doesn’t get noticed “if it doesn’t result in a flash crash.”

Overall, what constitutes “non-economic behaviour” is part of the “fuzziness of regulation of fair and orderly markets,” he added.

In terms of market structure, FX is just not welcome anymore as an “archetypal OTC market”.

Recent cases brought by the US regulator, Commodity Futures Trading Commission (CFTC), and FCA for spoofing and layering are trying to answer just that, with many in the industry arguing the charges are misguided, and that testing exchange pipe latency is a legitimate activity in a world where queue position has ended up becoming a source of alpha.

Meanwhile, class action lawsuits against exchanges for allegedly providing advantages for so-called high frequency trading firms, at the expense of investors, are being dismissed and moving onto appeals.

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The outcomes of these cases will likely be closely watched to determine what is and is not legitimate activity, particularly as electronic trading accelerates across markets and asset classes.

Are transparent markets electronic?

Experts generally predict that high speed trading will be the inevitable result of electronic markets, a reality that has buy side firms and brokers in the stock markets crying foul.

Yet, when regulators call for “transparency”, electronic markets seem to be the order of the day.

In FX, what is clearly considered “front running” in the equity trading markets is often thought of as prudent hedging, said Dave Tolladay, Director at Alerts4 Financial Markets, a surveillance platform used in various exchanges and tier 1 brokers.

“Are FX traders purely dinosaurs clinging onto outdated and dubious trading practices? Or are the two market places just not comparable?” he said, speaking to Finance Magnates.

In terms of market structure, FX is just not welcome anymore as an “archetypal OTC market”. And as far as regulators and politicians are concerned, the drift of new regulation is unremittingly towards imposing an on-exchange electronic model and a common set of regulations across every asset class – one size fits all, he added.

Real liquidity is often something of an illusion in the market

But the outcome of doing so may well be much more dramatic and damaging than is realized.

“The FX business was not well understood in regulatory and supervisory circles and the shock of the exposure of blatant abuse in the form of benchmark fixing caused a seismic shock that some are only just recovering from,” he said. “The push towards better defined electronic trading was already well underway before the scandals started to break and the tide will only flow one way now.”

There are a couple of very large players who already dominate the market – EBS and Currenex – but there are also a multitude of other platforms and players that make it a very fragmented and varied market, noted Tolladay.

“Conditions should promote competition and aid liquidity and transparency. In actual fact, real liquidity is often something of an illusion in the market and the absence of full market data for many is a real issue,” he said.

The traditional FX eCommerce model is one of distributing tiered prices to different types of customer. The airport bureau de change is at one end of the spectrum and the high volume corporate market at the other, Tolladay explained.

“If an equity based best execution regime was to be imposed on FX, the impact would substantially destroy the business models of many who currently participate in the market and would cause an exodus,” he said. “Will that result in fairer, more liquid, more stable, more transparent and better FX markets?”

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