Last month, a group of central bankers from around the world, operating under the auspices of the Bank for International Settlements, released the FX Global Code, “a set of global principals of good practice in the foreign exchange market.” Work on the Code began in May of 2015, after central bank governors directed their staffs to “strengthen code of conduct standards and principles in foreign exchange markets.” This clarion call came six months after six banks were fined £2.6bn by U.S and U.K. regulators for rigging foreign exchange benchmarks. Their actions were made all the more brazen by the fact that these same firms were also found to have been manipulating Libor just a few years prior.
The most important thing to know about the FX Global Code is that it is non-binding. As it states in the Code’s forward:
The Global Code does not impose legal or regulatory obligations on Market Participants nor does it substitute for regulation, but rather it is intended to serve as a supplement to any and all local laws, rules, and regulation by identifying global good practices and processes.
Given that market participants are not required to adhere to the Code, it is only natural to ask: “what difference will it make?” But before I attempt to answer that question, it is worth taking a look back at exactly how a relatively small group of traders manipulated key foreign exchange benchmarks. Armed with this knowledge, we will turn to the content of the new Code and the mechanisms in place to maximize the Code’s adoption by market participants.
Overview of the Foreign Exchange Market
The foreign exchange market is absolutely massive, with daily average turnover of just over $5 trillion. Of this amount, $1.65 trillion occurs in the spot market, where a purchase or sale of a foreign currency is made for immediate delivery. It is in the spot market where the fraudulent activity took place, specifically in the U.K., which has historically been the most important center for foreign exchange trading, and which accounts for 47% of spot transactions.
Spot transactions typically occur at a benchmark rate, commonly referred to as “the fix.” In the foreign exchange market, the two most widely used benchmarks are the 4pm WM Reuters (WMR) fix and the 1:15pm ECB fix. The construction of these benchmarks, coupled with the mechanics of the foreign exchange market, provided traders at a select group of broker-dealers an incentive to manipulate the benchmarks in their favor – and their clients’ disfavor.
As their names imply, the WMR and ECB benchmarks are set at their respective times of 4pm and 1:15pm. In the case of the WMR, the benchmark is based upon all the trades in a given currency pair that occur 30 seconds before and 30 seconds after 4pm. The ECB fix is based upon the market exchange rate at exactly 1:15pm.
The types of firms transacting in the foreign exchange market are diverse: from manufacturing businesses that need to hedge their overseas sales, to hedge funds attempting to speculate in the movement of a given currency. These firms will place buy or sell orders—often by voice—for a specified volume of currency “at the fix rate” throughout the day. The broker-dealers accepting these orders are exposed to market risk resulting from currency price movements leading up to the fix. For instance, a firm with net client orders to buy a given currency at the fix rate will have to go out into the marketplace and buy that amount of currency in order to deliver it to the client after the fix. If the average rate at which the firm buys the currency in the market is higher than the fix rate at which it sells it to its clients, then the firm will have a loss. Conversely, the firm will profit if the average rate at which it buys currency in the market is lower than the fix rate at which it sells the currency to the client.
Traditionally, broker-dealers have utilized several strategies to reduce this kind of market risk. One, known as “netting off,” occurs when a firm has a buying(selling) interest for the fix and trades with a market participant who has a selling(buying) interest for the fix. Firms can also hand off their client orders to be executed by another firm if that firm has client orders in the other direction. And of course, a firm may buy or sell currency on their own behalf before the fix to manage the risk.
The above techniques are all legitimate ways for firms to manage the market risk associated with facilitating foreign exchange transactions on behalf of clients. But these techniques can be pushed too far, beyond what constitutes standard risk management and into outright manipulation.
Foreign Exchange Benchmark Manipulation
Return again to the example of a firm with net client orders to buy a given currency at the fix rate, and recall that the firm will profit if the average rate at which it buys currency in the market is lower than the fix rate at which it sells the currency to the client. Thus, the firm has an incentive to push the fix rate as high as possible immediately before the fix in order to profit from this spread. But because the foreign exchange market is so large, it is nearly impossible for any one firm to do this in isolation. However, if a group of firms were to get together and work in concert, they could accumulate enough volume to manipulate the benchmarks in their desired direction, and this is precisely what happened.
The six offending firms utilized chat rooms to share confidential information about client orders in order to manipulate the fix to the group’s benefit. Traders in the chat room referred to themselves as: “the players,” “A team,” “1 team,” and “the 3 musketeers.” To get a better sense of how these firms interacted with each other and utilized information about client orders to their advantage, it worth reproducing in its entirety an example that was included in the U.K. Financial Conduct Authority’s final notice to Citibank:
On this day, Citi had net client buy orders at the fix which meant that it would benefit if it was able to move the ECB fix rate upwards. The chances of successfully manipulating the fix rate in this manner would be improved if Citi and other firms adopted trading strategies based upon the information they shared with each other about their net orders. In the period between 12:51 and 1:10pm on this day, traders at five different firms (including Citi) inappropriately disclosed to each other via chat rooms details about their net orders in respect of the forthcoming ECB fix at 1:15pm in order to determine their trading strategies.
- At 12:51pm, Citi disclosed that it had net buy orders for the fix of EUR200 million. Since Citi needed to buy EUR at the fix it would profit to the extent that the fix rate at which it sold EUR was higher than the average rate at which it bought EUR in the market.
- At 12:53pm, Firm A disclosed that it had net sell orders for the fix of EUR47 million. At this time Firm B also offered to transfer its net buy orders for EUR26 million to Citi. Citi agreed. The effect of this transfer was to increase (or “build”) the volume that Citi needed to buy at the fix by this amount. This is an example of “giving you the ammo”/”building”.
- At 12:56pm, Firm A informed Citi that it had netted off its sell orders with another counterparty. Firm A told Citi that “u shud be nice and clear to mangle”. This is an example of “leaving you with the ammo”. The Authority considers that the reference to “mangle” referred to the opportunity for Citi to attempt to manipulate the ECB fix.
- At 12:57pm, Firm C disclosed that it had net sell orders for the fix of EUR39 million and offered to “shift it” (i.e. to trade the order with a third party outside the chat room). At 1:01pm, Firm C told Citi that it had “matched on fix here… you’re all clear”. This message communicated that Firm C had netted off its sell orders with a third party and that Citi was “clear” to trade at the fix without Firm C’s orders being traded in the opposite direction. This is an example of “leaving you with the ammo”.
- At 1:06pm, Firm D confirmed that it needed to buy an unspecified quantity of EUR in the market at the ECB fix. Firm D offered to transfer these net buy orders to Citi or execute this order in a way that would assist Citi (“u can have oir i can help [sic]”)
- Following discussion within the chat room, Firm D transferred its net orders of EUR49 million to Citi at 1.10pm, whereby Firm D bought EUR49 million from Citi at the fix rate. The effect of this transfer was to increase (or “build”) the volume that Citi needed to buy at the fix by this amount. This is an example of “giving you the ammo”/”building”.
Citi’s net buy order associated with fix orders placed by clients was EUR83 million. In the period leading up to the ECB fix, Citi increased (or “built”) the volume of EUR that it would buy for the fix by trading with Firm B and D (as described above) and by a series of similar trades conducted with other market participants. This trading increased the volume of currency that Citi would seek to buy for the fix to EUR542 million, well above that necessary to manage Citi’s risk associated with net client orders at the fix.
Immediately prior to the ECB fix, Citi placed four buy orders on the EBS trading platform. Citi had previously indicated to others in chat rooms that it believed the ECB rate for the EUR/USD currency pair was based on the first trade that occurred on the EBS trading platform at 1:15:00pm. Each order placed by Citi was of increasing size and price, and was priced at a level above the best offer price prevailing on the EBS platform at the time.
During the period from 1:14:29pm to 1:15:02pm, Citi bought EUR374 million which accounted for 73% of all purchases on the EBS platform. At 1:15:00pm, the bid (buying price) and the first trade for EUR/USD on the EBS platform was 1.3222. The ECB subsequently published the fix rate for EUR/USD at 1.3222.
The information disclosed between Citi and Firms A, B, C and D regarding their order flows was used to determine their trading strategies. The consequent “building” by Citi and its trading in relation to that increased quantity at the fix were designed to increase the ECB fix rate to Citi’s benefit. Citi bought EUR prior to the 1:15pm fix in anticipation that the fix rate at which it would sell EUR would be higher than the average rate at which it had bought. The placing of large buy orders by Citi immediately prior to 1:15pm was designed to achieve this outcome by improving the chance that the first trade on the EBS platform at 1:15:00pm, which it believed to be the basis for the ECB fix, was at a higher level. Citi’s trading in EUR/USD in this example generated a profit of USD99,000.
FX Global Code
Even if you know nothing about financial markets, you could read the Citibank example and understand that what they did was unethical. In essence, they shared privileged client information with a select group of cohorts so that they could use this information to collectively benefit at the expense of their clients. You would also recognize that Citibank traders had a monetary incentive to collude with other firms, and that there appeared to be little by way of internal controls that prevented them from doing so. So, any attempts to prevent this type of fraud from occurring again would have to address the incentives, the control environment, or both.
Enter the FX Global Code, a set of 55 principles, contained within 70+ pages, that fall under the following broad categories: ethics, governance, execution, information sharing, risk management and compliance, and confirmation and settlement. And while the principles thoroughly address the risk management and control environments within broker-dealers, they do not—and cannot—remedy the incentives problem, which is a built-in feature of the foreign exchange market. The Code’s three principles pertaining to ethics are an implicit acknowledgement that the incentives problem still exists.
If every major participant in the foreign exchange market implemented the FX Code’s 55 principles, the unethical behavior that Citibank and others engaged in would largely go away. The problem however, is that firms are not required to adopt the code.
The designers of the Code included several features intended to maximize firm adherence. For starters, the private sector, through the Markets Participant Group, played a critical role in developing the code and will continue to play a key role in keeping the Code up to date. The Code will be maintained by the Global Foreign Exchange Committee (GFXC) which was launched on the same day as the Code. The GFXC includes one central bank representative and one private sector representative from multiple regional and country specific Foreign Exchange Committees. Involving the private sector in the Code’s development and maintenance serves two purposes: it ensures the Code will always reflect current market best practices and two, it helps facilitate industry buy-in.
On the same day the Code was launched, central bankers released a companion piece titled: “Blueprint for Achieving Adoption.” The Blueprint lays out four simple tenets that will help facilitate broad industry compliance with the Code. Arguably the most important of these tenets is central bank adoption. Most central banks are very active in the foreign exchange market, so by committing to adhere to the FX Global Code, the central banks responsible for its drafting are leading by example. In fact, a number of central banks plan on requiring members of their local foreign exchange committee, which they sponsor, to adhere to the Code. In the U.S., that would be the Foreign Exchange Committee, which is sponsored by the Federal Reserve Bank of New York and whose members include representatives from the Country’s largest financial institutions as well as New York Fed staffers.
Finally, an annex to the Code provide a “Statement of Commitment” that market participants can “use on a voluntary basis to express their commitment to conduct their wholesale FX activity in a manner consistent with the Code’s principles.” It remains to be seen if any firm will include this statement in their standard disclosure documents.
Will it Work
I am skeptical that any of the above mechanisms will prove effective in getting firms to implement the Code in a meaningful way. My skepticism stems from the fact that this is not the first time central bankers have put forward a code of conduct designed to promote good behavior in the foreign exchange market. Various foreign exchange committees (FXCs) around the globe have long had their own codes to promote best practices. In 2013, many of these FXCs came together to publish Best Market Practice and Shared Global Principles which subsequently became the Global Preamble in 2015. As we know, these documents had little impact on individual behavior.
Nor am I confident that the FX Global Code will assist in disciplining any firms or individuals who engage in misconduct in the foreign exchange market. In a Law360 article, Matthew Kulkin and Micah Green summarize how U.S. courts have traditionally looked upon best practices documents in the finance industry. They found that “courts have rarely relied on these publications to determine guilt, innocence or liability.”
Perhaps the best way to promote good behavior is to harshly punish bad behavior; and I’m not talking about issuing bank-level fines which are typically a drop in the bucket for most large banks. U.S. prosecutors appear to be trying in this regard. Earlier this week, it was announced that three former traders in Britain agreed to waive extradition and appear in a Manhattan court room next month to face charges of rigging bids in the Euro/Dollar market. This comes on the heels of Jason Katz, “a former Barclays and BNP Paribas trader, pleading guilty in January to a conspiracy charge, becoming the first person to admit wrongdoing in the currency-rigging investigation.” In addition, a former HSBC executive is awaiting trial for his role in the scandal.
In the U.K., no charges were filed against any individuals although legislation was passed that “introduced unlimited fines and prison sentences of up to seven years” for those found guilty of manipulating key financial market benchmarks in the future.
It is a sad commentary on the state of the global financial system when it takes regulators from around the world over two years to come up with a 75-page document that essentially instructs banks on how not to screw over their clients in the foreign exchange market. It would be sadder still if we expected this document to make any difference.
 Settlement typically occurs in two business days time.
 Firms typically want to transact at the fix since that is the benchmark their fx investments will be compared against. Thus, it helps eliminate tracking error.
 To be fair, the first phase of the Code was released last May. It contained the principles on ethics, information sharing, confirmation and settlement, and certain execution topics.