The Bank of International Settlements (BIS) has now published the completed FX Global Code (having initially published phase 1 in May 2016). A global code for the FX sector was one of the recommendations which came out of the Fair and Effective Markets review in June 2015. The Code has been developed through a collaboration of central banks and market participants in the key FX jurisdictions. The Code applies to all ”Market Participants”, defined widely to include sell-side and buy-side firms, platforms and benchmark administrators (but excluding retail participants). It is not legally binding but there will be a strong regulatory expectation that firms comply with it.
6 key areas
The Code is structured around 6 key areas as set out below. It is deliberately drafted as a principles-based code rather than a prescriptive set of rules, partly to avoid firms circumventing it.
- This section has some fairly high level and uncontroversial principles which are not unique to FX business e.g. acting honestly, acting with competence, addressing conflicts etc.
- There is a strong emphasis on senior management embedding the right values and giving appropriate advice to the front office.
- The governance requirements are also broad and of more universal application than FX e.g. ensuring appropriate oversight, supervision and controls, clearly defined lines of responsibility, sufficiently resourced control functions, training programmes, appropriate remuneration and promotion structures and mechanisms allowing for confidential whistleblowing and effective investigations.
- The Code places the responsibility for governance on the body or individual ultimately responsible for the firm’s FX business and strategy. For UK authorised firms, this is likely to be the relevant SMF.
- This is one of the more interesting sections and has been fleshed out from Phase 1 to include guidance relating to e-trading, swaps, forwards and options. It is of most direct relevance to sell-side firms, but the Code also places an onus on the buy-side to monitor compliance by their executing brokers.
- An overarching principle is that a firm receiving a client order as principal has discretion when executing but must exercise that discretion “reasonably, fairly and in such a way that is not designed or intended to disadvantage the client”. The FCA has welcomed the Code’s recognition that traders in principal markets still owe duties to clients when executing orders: “We welcome in particular the recognition that even where a dealer sets out that it is acting as principal, it still has important responsibilities to its clients when using its discretion on their behalf.”
- There is a significant emphasis on transparency and informing clients, for example, about how orders will be handled, reference prices used and the various factors that may affect execution (e.g. the firm’s positioning as well as prevailing market conditions). In practice, many sell-side firms will rely predominantly on disclosure statements or terms and conditions sent to all clients, but some order-specific disclosure may be required.
- Fair execution will involve different considerations for different types of orders. For example, the terms of a stop loss order should be fully clarified with the client (e.g. time period, trigger whether there is discretion for the executing broker etc) and the client should be made aware of the risk that genuine hedging trades could trigger a stop less level. Clearly, any trading deliberately designed to trigger a stop is improper, as made clear in recent enforcement action. Fixing orders may also give rise to specific considerations but the Code does not offer any detailed guidance on such orders given the range of FX benchmarks available.
- The Code suggests that firms should fully fill orders that are capable of being filled within the parameters specified by the client, subject to the priority of other client orders and the available credit line for the client. This was an area of uncertainty previously, as firms may have sought to monetise limit orders by keeping a portion of the client’s fill on their own books.
- Pre-hedging can be a legitimate practice provided that it is intended to benefit rather than disadvantage the client, and the practice is disclosed to the client.
- There is a requirement for mark-up to be fair and reasonable, for firms to disclose to clients the factors that may contribute to mark up and for firms to have policies and procedures to determine mark-up. While levels of mark-up can be different for similar trades with different clients, this must be based on fair and objective factors (e.g. volume of business with that client) and not discriminatory subjective factors (e.g. perceived level of sophistication of each client). Firms should inform clients when filling orders at an all-in price which includes a mark-up.
- It is noteworthy that the Code permits the use of ‘last look’ functionality on electronic trading platforms, subject to having appropriate procedures and transparency to clients. Last look functionality allows sell side firms an opportunity to accept or reject a trade request by a client against its quoted price. There are two principal concerns with the functionality: (a) it allows firms to make decisions on an asymmetric basis (i.e. reject any trade where the price has moved in favour of the client); and (b) the delay in confirming acceptance/rejection provides an potential for the broker to front run the client’s trade.
- There are a number of examples of good and bad practices in relation to execution set out in Annex 1. Firms are advised to review these and incorporate them, or similar examples, into staff training programmes.
4. Information sharing
- The section on information sharing was mostly drafted in Phase 1 last May, given the importance of clarity in this area. The opaque nature of the OTC FX market has fostered an environment where clients and counterparties readily exchange information with each other. The Code attempts to provide some guidance on when that information exchange may give rise to confidentiality or competition concerns.
- The Code requires market participants to identify and limit access to Confidential Information (and the buy side should not be soliciting Confidential Information from their brokers). Confidential Information is defined broadly to include “information relating to the past, present and future trading activity or positions of the Market Participant itself or its Clients.” The examples include order books, axes, fix orders and spread matrices.
- Some in the market were concerned that the enforcement action and subsequent remediation activity would lead to a less transparent market which in turn would negatively impact liquidity. It is therefore explicitly recognised in the Code that sharing market colour can make markets more efficient and open. Market colour is described as information on the general state of the market, views and anonymised and aggregated flow information.
- The onus is on firms to provide guidance to their staff as to how to share market colour appropriately e.g. not disclosing client names or information specific to any client, making information sufficiently general to prevent the recipient from gleaning Confidential Information, not disclosing trading positions and only disclosing flows by price range rather than using exact rates relating to a single trade. There are some examples of appropriate and inappropriate market colour in Annex 1 to the Code.
5. Risk management and compliance
- This section expands on some of the themes in the governance chapter. Again, many of the points raised are not universal to FX business and overlap with existing regulatory obligations, for example the segregation of trading from risk management, compliance and operational functions, training on all applicable laws, regulations and standards, a robust risk management framework, automated or manual monitoring systems as appropriate and timely reporting and incident management.
- The Code outlines some examples of good practice with respect to the various types of risks inherent in trading. Whilst it is important to review this section in detail, much of it will be familiar to firms and applicable to other areas of sales and trading. Some of the more notable points include the use of stress testing to regularly monitor market risk, the use of quoted market prices where possible to measure P&L and risk, clear procedures for monitoring all technology systems on which the firm relies, consistent time stamping and making trade data available to clients on request.
6. Confirmation and settlement
- Firms are required to have “robust, efficient, transparent, and risk-mitigating post-trade processes to promote the predictable, smooth, and timely settlement of transactions”.
- The supporting principles set out a number of practical steps that Market Participants should implement. For example:
- implementing “straight-through” automatic transmission of trade data from front office to operational systems;
- sending trade confirmations in a secure manner using automated trade confirmation matching systems rather than email communications; and
- sending regular updates to senior management in relation to unconfirmed deals.
Adherence to the Code
Some commentators have questioned how effective another voluntary code will be. Previous voluntary codes (e.g. the Bank of England NIPS code) have not been embedded into firms’ policies on a consistent basis across the market. However, with the recent enforcement action fresh in minds, there is a sense that this Code may gain greater traction. Regulators in different jurisdictions have been encouraged to adopt it as an appropriate market standard. The FCA has welcomed the Code and said it expects “firms, Senior Managers, certified individuals and other relevant persons to take responsibility for and be able to demonstrate their own adherence with standards of market conduct.” The FCA is likely to equate most of the Code to proper standards of market conduct pursuant to Principle 5.
The “Report on Adherence to the FX Global Code”, prepared by the Foreign Exchange Working Group, places the onus on market participants to embed the Code into their own operations, policies and rulebooks, monitor the effectiveness of this exercise and demonstrate their adherence to the Code. It is anticipated that this process will take 6-12 months from publication of the Code. As part of this process, market participants are encouraged to sign the Statement of Commitment annexed to the Code representing to other market participants that they support the Code and have aligned their activities to it. There are ongoing discussions about setting up a public register of firms that have signed a Statement of Commitment. It remains to be seen whether firms will seek to qualify the statement in any way, or incorporate it into their standard disclosure statements.
Central Banks have announced their intention to adhere to the Code except where it would inhibit the discharge of their legal duties or policy functions. They will also require their FX trading counterparties and members of Foreign Exchange Committees to adhere to the Code.
It is recognised that the Code will inevitably need to be updated on a uniform global basis as markets develop. Responsibility for updating the Code rests with a global association of Foreign Exchange Committees.
Whilst some sections of the Code read more like a checklist of standard systems and controls issues in a financial institution, there is also some welcome guidance on some of the thorny issues prevalent in the FX sector – most notably in relation to information exchange and the execution of client orders. Many firms will have grappled with some of these issues over the last few years in the wake of enforcement action and subsequent industry remediation exercises. Firms should nevertheless ensure that the positions they have reached on these issues, and their resulting policies and procedures, are consistent with the guidance in the Code. Some of that guidance may also be applicable to other asset classes beyond FX. Firms should not take too much comfort from the voluntary nature of the Code - the FCA has already indicated that it will link the Code to the Senior Managers Regime and clients may also demand adherence.