Who needs Flash Trading when we have the FX London Close?!

The hotly debated, headline story of the moment is whether some HFT (high-frequency trading) firms are front-running all other U.S. equity investors by paying fees to the exchanges.  Good question .... but let's look at another topic in the news:  allegations of front-running and collusion in the London Close for currency trading in the WM/Reuters index.

Quoting an earlier and detailed Financial Pests account:

"Many banks provide a service to their customers where they guarantee to trade for them at the London Close rates. Customers provide the trade amounts to their banks within the one hour prior to the London Close, also known as “the fix”.  Those banks that have agreed to make transactions for funds at the London Close need to push through the bulk of their trades during this window where possible to minimize losses from market movements."

Instead of several MILLISECONDS of potential front-running, the London Close provides ONE HOUR of potential front-running!

Focusing on the London Close, what strikes us is that there's an easy answer.  First and foremost, it's a risk management issue.  Banks and dealers should not "guarantee to trade for [clients] at the London Close rates."  It's simply not possible to achieve the last price whereas giving a "guarantee" of last price is a difficult-to-quantify risk exposure.  With both this quantification difficulty and the appearance of manipulating markets that arises from trading as much as possible in the final minute, prudent risk management dictates "don't offer the London Close guarantee trade to clients."

As an alternative to banning the London Close trade, permit the pairing of such trades for clients on opposite sides.  Prior to close, the client may commit itself to executing a stated maximum notional at the fix price subject only to the dealer finding a client for the other side.  If confirmed prior to the market close, this trade execution can be posted to the exchange for all participants to see.  If no client materializes for all or part of the stated notional, then the original client order is not completely filled.