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FSB idea could help draw a line under forex scandal

A utility for foreign exchange trading (FT 17 July 2014)

Banks, asset managers, export companies and anyone else with a passing interest in a properly functioning foreign exchange market should not take off on their summer holidays just yet. A key consultation document on fixing the shortcomings of the forex market, published on Wednesday by global policy makers at the Financial Stability Board, gives respondents only until August 12 to take a view on a set of 15 important reform ideas. In tandem with a drive by conduct regulators to punish past misdemeanours by forex traders, the reforms are designed to help clean up the biggest scandal still hanging over the banking industry. At least 15 banks are being investigated over alleged market manipulation.

Many of the FSB’s ideas are commonsense behavioural recommendations. It urges market-makers, for example, not to pass on private information to clients that might give them a trading advantage. Others relate to the mechanics of the daily rate “fixes”, which are determined by averaging different market-makers’ order prices. Would a longer “window” than the current average of one minute of trades make the fix price less manipulable, for example? But one of the proposals is revolutionary. The FSB believes that market participants should set up a central global utility to match buy and sell orders from around the globe.

This would help drag the foreign exchange market into the modern world. It would reduce the scope for banks to anticipate and front-run client orders, since only unmatchable trades would be left for market-makers to broker. The “voice” traders who are at the heart of the allegations of forex price manipulation would be undermined by entrenching the trend towards electronic trading.

The FSB does not go into detail about how such a utility might operate. It could be run by banks on a collaborative basis, or by a third party. One model would be a not-for-profit agency akin to the US Depository Trust & Clearing Corporation. The idea is not risk-free. One obvious criticism is that the world would be sanctioning the creation of a giant “dark pool” for foreign exchange, along the lines of the controversial structures operated in the equities markets by big investment banks. Both Barclays and Goldman Sachs have come under fire recently over the treatment of investors in their dark pools. The untransparent design of dark pools makes them vulnerable to exploitation by aggressive high-frequency traders.

A more extreme alternative, not voiced by the FSB, would force forex trading on to a fully transparent exchange. But that would be unpopular with many investors. Despite the dangers inherent in a dark pool, the anonymity is appealing because it protects investors from rivals betting against them – a big risk in a market where large trades are the norm. But if the future of forex trading is to be conducted through a mechanism that lacks transparency, the argument in favour of regulating this market is all the more powerful.

In the UK, the global hub of the forex market, chancellor George Osborne recently ordered a “fair and efficient markets review”. The likely result is the extension of market abuse rules from securities markets to forex and commodities – a move that may well be followed by other jurisdictions. Suggestions that conduct regulators are pressing to bring the first case against a bank over historic forex abuses as quickly as possible will unnerve the City, following the succession of other market abuse and mis-selling scandals. But the combination of swift punishment and robust new rules is crucial to the process of drawing a line under the scandals.