We are saddened to see another negative example of the OTC FX market splashed across the world’s leading newspapers. These two headlines below aptly demonstrate the strain the institutional currency market is under.
The banks likely believe they have the right to cover the open position risk as they see fit, in order to protect the bank and its shareholders. Buy-side clients and the regulators expect that bank’s risk management process should not negatively impact clients. In short, the traditional OTC FX market principal risk transfer model, with undisclosed mark-ups, is under attack.
Legal and regulatory challenges on the market making banks are leaving a less liquid and more volatile market for the key buy-side participants. News of alleged malfeasance surrounding the following areas have existed in the last seven years: extreme custodian mark-ups, WMR fixing manipulations, last-look electronic dealing practices, and the latest news: front running client flow. The current headlines will only further damage the trust necessary for properly functioning dealing practices.
At FXT, we feel the OTC market structure has worked for decades, as it has provided required currency liquidity, credit, and settlement services for institutional buy-side firms. More government sponsored regulation is not necessary. The cost of this governance gets passed on to the very investors that they regulators are trying to protect. Rather than this massive tax on all FX trading, regulators should consider mandating cost-efficient, independent oversight via FX Transaction Cost Analysis (FX TCA).
A proper monitoring program allows the actual participants, the asset owners, corporates and investment managers, to know how much FX practices are impacting their returns and bottom line. The credit, liquidity and settlement services from liquidity providers must come at a fee to ensure an environment where market-making can occur. Understanding and measuring FX costs are essential to reward the best liquidity providers for their services. These partnerships are crucial to make certain that foreign exchange markets continue to function, even in times of increased volatility such as the SNB peg removal, Brexit, a Turkish coup attempt, and the upcoming US elections.
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