FX industry must act now or face regulation warns LMAX

Mercer: the market must pull together to pre-empt regulation

More transparency is urgently needed to restore trust in the FX industry, according to a new report by foreign exchange MTF LMAX Exchange – but to make that happen, the industry will have to collaborate.

In its report, Restoring trust in global FX markets, the exchange points out that the FX industry can restore trust if it responds to the principles outlined by the Fair Effective Markets Review carried out by UK regulators over the last year. That trust has been shaken by a series of disasters in recent times, including the forex scandal which came to public attention in 2013 and resulted in investigations by regulators into 15 banks as well as regulatory changes in the UK, Switzerland and other countries.

The FEMR recommended the creation of a new global code of conduct for FX and a review of market practices that are open to abuse.  But LMAX is suggesting three conditions will be need to be met if this goal is to be achieved: liquidity must be preserved, modern technology must be used to accurately measure market analytics, and international regulators will need to collaborate.

“If the market does not face up to these issues now, it seems inevitable that further troubles, similar to those of the last year, will force a reckoning sooner rather than later,” read the report. “Progress must not be allowed to stall.”

On the first point, LMAX is concerned that increasing transparency may, if taken too far, have a negative effect on liquidity. Therefore, it suggests that steps such as removing one-way pricing optionality from liquidity providers, must be counter balanced to reduce the risk of providing liquidity to the marketplace. However, LMAX acknowledges that this will mean spreads will have to widen and customers will have to pay higher fees, which it presents as a valid trade-off in exchange for transparency.

To the second point, the LMAX report notes that ultra-low latency technology can be used to improve pricing algorithms, measure risk more precisely and price more accurately; real-time market monitoring can reduce risk; standardised timestamping in milliseconds can help to ensure fairness of execution; and transaction cost analysis can help to compare liquidity.

“The market as a whole, from regulators to LPs and end users must embrace the new tools that technology has made possible if a more transparent marketplace is to be created,” read the report.

The third point is that given securities markets are effectively global, there has been too little collaboration – raising the possibility of regulatory arbitrage, in which multiple regulators release legislation on the same issue, causing confusion and duplication of cost to market participants. LMAX suggests that regulators such as the CFTC, the SEC and the Bank of England should work more closely to ensure the new global code of conduct is enforced everywhere.

In addition, standardisation of market practice issues such as definition of products, treatment of offshore regulated trading facilities, classification of counterparties and clearing requirements, LMAX warns that consistency in definitions and implementation is needed.

LMAX also carried out a survey of the FX market, which resulted in the observation that vulnerabilities currently remain. Most notably, 22% of all respondents were not aware of last look as a market practice open to abuse. Furthermore, 80% of respondents to the survey agreed that there was an overall concern about the lack of transparency in the market. LMAX pointed to the figures to support its argument that more transparency is needed in the FX market. The survey also found that 45% of banks and 85% of proprietary trading firms felt last look should be abolished. LMAX doesn’t have last look liquidity.

“While in the short term opaque trading practices can deliver greater profitability for market participants, in the long term the erosion of trust will permanently damage international capital flows – considering FX is the foundation upon which international trade is built, this could be catastrophic globally,” said David Mercer, chief executive of LMAX Exchange. “The FICC Markets Standards Board presents a unique opportunity for the FX industry to come together and implement solutions that work for all market participants. If the market doesn’t get together to implement change and continue to be self-regulating then the regulators are going to impose rules that won’t work in FX. It stands for us to start making changes and forge a new global standard.”