FSB Updates FX Benchmark Progress

The Financial Stability Board (FSB), created in 2009 by the G20 to reform international financial regulation, includes as part of its mandate a role in standard setting and in promoting members’ implementation of international standards. In September 2014 it issued a report highlighting recommended solutions to prevent a repeat of the FX benchmark scandal. Today it released an update to look at progress made since that report.

The update is fairly positive ("having moved the market in a favourable direction"), highlighting improvements, but also mentioning areas where it believes that more work needs to be done.

The points made include:
1) There have been useful reforms in the methodology used in the WM Reuters (WMR) fix but that more can do done, and mentions certain central banks adjusting their fix methodologies as well. The FSB reiterates that all fixes need to be reviewed, not just the WMR fix.

2) "Recommendations suggested to increase transparency in pricing for fix transactions have seen good implementation among the largest market participants and for the most used benchmarks, but that elsewhere there is scope for further improvement".

3) "Steps to separate dealers’ fixings business from other activities are being taken by the larger participants and in the most active markets, but again there is room for further implementation in other areas of the FX market. For the execution of benchmark transactions, industry-led initiatives to promote greater use of independent netting and execution facilities are seeing welcome progress".

4) "Work is underway to improve market conduct practices, both within individual firms and through market-wide initiatives, including the global effort underway to develop a single code of conduct for the foreign exchange market through the Bank for International Settlements (BIS) Markets Committee working group on FX markets".

5) "While many index providers and end-users have increased their focus on the due diligence around FX benchmark use, there is scope for greater follow-through on this on the part of some market participants".

All in all, it appears that while some additional fix changes may be seen, for the most part fix reform will primarily involve broadening the changes already made to cover additional fixes and additional market participants. The probable exception will be the new international code of conduct being created by the BIS. This will replace the many different codes currently in force in markets around the world and will impact bank behavior.

All Announced on One Day: Five Banks Fined for FX, One for Precious Metals and BOE Chief FX Dealer Fired

As had been rumored for a few weeks, FX settlements between multiple regulators and several FX banks were announced on the same day, today. The banks prefer not to be singled out for misconduct but just to be one of many, so that this is viewed as more of a market problem. The banks were not found to have attempted to manipulate FX rates but instead found to have had ineffective controls allowing traders to engage in manipulative behavior. However, the DOJ is still looking into criminal charges, the New York regulator would not sign on to this agreement as it was felt to be too weak and penalties against many other banks by these same and other regulators will be forthcoming.

The Swiss regulator FINMA also fined UBS for precious metals misconduct, finding "clear attempt to manipulate precious metals benchmarks", particularly in the silver market. As FINMA also fined UBS for FX market violations, UBS would certainly have wanted both announcements at once.

Then the Bank of England hopped onto the bad news train today as well. They have been quiet for several months after announcing that an unnamed employee had been suspended for misconduct regarding FX. Today they announced that the chief FX dealer had been fired yesterday, but still provided little information, other than misconduct was discovered as part of the FX manipulation probe but the behavior itself was not related to the probe.

A Bank Bailout Plan to INCREASE Systemic Risk ?!

Eighteen global banks agree not to terminate derivative contracts when regulators seize their failing bank counterparty.  Is that a bad idea?

(Adapted from A Bailout Plan that Could Actually Increase Systemic Risk, a Quant Perspectives column published by the Global Association of Risk Professionals)

ISDA (the International Swaps and Derivatives Association) reports that eighteen large global banks have agreed not to terminate derivatives transactions when regulators seize the bank counterparty with the goal of “resolving” the failing institution.  Both the ISDA announcement and another news article claim that this agreement will “reduce systemic risk.”  The FSB (Financial Stability Board) had requested this accommodation in the September Consultative Document “Cross-border recognition of resolution action.”

What about the healthy banks?

But what about derivatives risk management for the healthy banks that are counterparties to the failing bank?!  Termination of derivative trades before failure has been a standard tenet of risk management for decades.  See, for example, this BIS (Bank for International Settlements) 1994 document “Risk management guidelines for derivatives” that explicitly discusses early termination.  On its face, this new FSB-ISDA opposition to early termination drastically increases risk to the healthy banks in the name of assisting resolution of the failing bank.

The risk to a healthy bank in a derivative trade with the failing bank is that the former cannot know if the latter will ultimately perform on the derivative hedge or not.  If the failing bank does default on the trade, the healthy bank will have an unhedged risk position and will lose some or all of the positive value of the trade.  The healthy bank cannot hedge its risk with another derivative counterparty as long as the original trade remains in place.  Given the critical importance of hedging to bank operations and stability, this hedge uncertainty to a large global counterparty is a huge threat to safety and soundness.  Systemic risk increases due to this hobbling of risk management at healthy banks.

One may sympathize with the dilemma of the regulators

If one believes that a proper role of regulators and governments is to control the resolution or liquidation of large financial institutions, then the FSB-ISDA initiative has its merits.  It would likely be easier to “save” a failing bank if it has all hedge (derivative) agreements in place.  Just as we noted above for healthy banks, evaporation of derivative trades would leave the failing bank with ruinous open risk positions.

The FSB resolution plan appears to be to transfer some debt, some assets, and all derivatives to a “good bank” and leave distressed assets, shareholders, and bailed-in creditors in the “bad bank.”  In this positive scenario, the healthy bank derivative counterparties would find themselves facing the “good bank” such that, in the end, they would have suffered no harm.  But there are too many assumptions here.  First, the bank resolution may fail.  Second, it is unreasonable to project that all derivative trades should go to the “good bank.”  Since some assets and debt will remain in the “bad bank,” there should certainly be “bad bank” derivatives as well.

Perhaps the goal is to guarantee the derivative trades?

The FSB and ISDA do not state or hint that governments will guarantee the performance of the derivative trades as the quid pro quo for the agreement of the healthy banks not to terminate upon regulator seizure.  But this is our conjecture.  Otherwise, it is all too clear that the FSB-ISDA removal of early termination merely aids one weak bank – which likely deserves to fail – at the risk to and expense of the entire banking system.  Surely the FSB would be averse to increasing systemic risk.  Thus, our ansatz that governments will guarantee derivative performance rings true.  Perhaps the regulators will simply squeeze bailed-in creditors to whatever degree is necessary to honor derivative contracts.

The irony splashes all around us!  Once again, we find ourselves witnesses to governments bailing out and protecting the banks!  The plan appears to be that regulators will protect the bank counterparties.  At risk of raising a past controversy without room to dissect the details, this is AIG all over again!  AIG the insurance company would have withstood the failure of AIG FP (the “financial products” affiliated entity).  The true AIG FP bailout beneficiaries were the bank counterparties.

Returning to more sober considerations, our conjecture implies that the FSB-ISDA plan gives higher priority of repayment to derivative liabilities than to senior debt liabilities.  Derivatives and senior debt are currently pari passu.  We remain unconvinced that derivatives merit such super-priority.

What about CCPs?

We wonder how the FSB-ISDA gutting of early termination impacts CCPs (central counterparty clearing facilities).  The failing bank subject to regulatory resolution might be a counterparty to the CCP or a member of the CCP or even the CCP itself.  In any of these cases, forcing a prolonged period of hedge uncertainty on all other presumably healthy parties would be chaotic.

(The author acknowledges numerous helpful conversations with Ce Shi, a graduate of the Quantitative Finance and Risk Analytics Master’s program at the Lally School of Management of the Rensselaer Polytechnic Institute.  Mr. Shi is now a candidate for a Master’s in Applied Mathematics at Rensselaer.)

Outline of FX Fix Reforms is Clearer

The recommendations of the Financial Stability Board last week regarding changes to the WM Reuters fix will be presented at the G20 meeting in November.  These include extending the fix window (they support a move from from 1 minute to 5, but want the WM Reuters company to set the period), making prices transparent and appropriate for the risk borne (meaning that banks should be paid for fix trades, unlike past practice) and codes of conduct and internal guidelines should be more explicit.

While fully agreeing with all of the above, we see the two remaining major recommendation as problematic.  First is the recommendation that "banks establish ... separate processes for handling such orders".  Handling fix trades separately from other fx trades will be costly, probably causing some smaller players to eliminate their participation in the fix.  An article from FX Week (subscription or free trial) refers to banks considering the possibility of creating sealed trading rooms, away from other fx traders and order flow.   While it is unclear how seriously this is being looked at, such a possibility appears a bit absurd to us, as enforcing more explicit codes of conduct and internal guidelines as already suggested, should improve the outcome without the costs or need for quarantined traders.

The other problematic recommendation of the FSB is "the development of industry-led initiatives to create independent netting and execution facilities for transacting fix orders". While a longer term recommendation, this continues on the path of much higher cost and uncertain outcome.  Just to mention one issue, commonsense dictates that the largest incentive for manipulating rates is when there is a large discrepancy between buy and sell orders for a currency pair.  At such times, the only way to clear these separate trades is to trade with the rest of the market, the same traders that this recommendation is trying to avoid.

All in all, we approve of the recommendations as promoting that which Financial PESTs stands for - ethics, simplicity and transparency, albeit with the two exceptions discussed which require additional scrutiny before any implementation.

Who Likes the Financial Stability Board's Recommendation of a Fee for FX Benchmark Trades?

The Financial Stability Board released a consultative study on FX benchmark rates that includes several items for the industry to consider as well as a couple of recommendations.  One recommendation was to widen the period of the window for calculating rates.  Another was that the banks should charge for the service of filling fix orders.

As it currently stands, the WM Reuters rate, the London Close benchmark which is the fix with by far the largest daily volume, includes a bid, mid-rate and offer rate for each currency pair.  Most large and many small users of the fix are filled at the mid-rate, and thus do not pay any fee or bid offer spread to their bank for filling their order.

Why does this occur?  Banks allow it as the cost of doing business with large customers.  If others are doing it, you need to do it as well - it became a market practice in effect.

Bank customers, of course, would like all trades executed for free, so how did fix trades become the only trade type executed routinely without spread or fee? This occurred as many funds use the WM Reuters FX rates to translate their local currency asset values into base currency values each day.  The investment managers then wanted to execute any trades for that day at the same rate to avoid FX tracking error for their funds.  Many managers also saw these rates as a means to achieve market rates without going through the work of negotiating rates with their banks. Others such as corporates began using the mid rate for execution purposes while hedge funds and others did so for speculative purposes.

While this seemed to be a win for the customers, it was not for the banks.  When the fix began in the early 1990s FX spreads were quite wide compared to today and perhaps the banks could more easily tolerate these "free trades".  Apparently as pressure increased on traders to perform in an environment of reducing spreads, some misconduct occurred, including collusion, as a means to generate profits on these trades.

The FSB's suggestion seems quite sensible to us.  Expecting free services does not. In effect, the actions that traders took in recent years reinforces the adage regarding no free lunches.  Using bid offer spreads or a small commission should reduce this tension between bank and customer.

While not the only change required to benchmark trading, this change is reasonable and should go along way in making this a more rational part of the FX business.

Asset managers and other fix users may not like the concept initially, but its inherent reasonableness and the need to increase market participants' faith in benchmark rates should see customers agreeing.  The devil being in the details, however, the size of any commission or spread (tracking error to many) may be much more controversial.

FSB Proposes FX Benchmark Changes; UK Opens Criminal FX Benchmark Investigation

The Financial Stability Board (coordinates national regulators and international standard setting bodies)  published suggested changes to FX benchmark calculations in the following areas:

• The calculation methodology of the WM/Reuters (WMR) benchmark rates;
• The publication of reference rates by central banks;
• Market infrastructure in relation to the execution of fix trades;
• The behaviour of market participants around the time of the major FX benchmarks (primarily the WMR 4pm London fix);
• Recommendations from a forthcoming IOSCO review of the WMR fixes.

These are open to comments and should entail great diversity as there is much disagreement on how to reduce the possibility of rate rigging in FX markets.

In the UK, the Serious Fraud Office (SFO) has opened a criminal investigation into possible fraud occurring in benchmark rate setting.  The US DOJ has been looking into criminal angles for quite some time,and last week we reported their offer of immunity to junior FX traders in exchange for information. The SFO has an ongoing investigation into LIBOR rigging as well.