For many years it has been the mantra in the FX markets that ‘spot is unregulated’. Issues such as the WMR fixing scandal have brought this into focus as has the roll out of the FX Global Code. In this article I will explain my view that in many of the areas that matter, and particularly in the UK, the FX spot market is de facto regulated even if it is not de jure. It is also a live issue in the EU with ESMA looking at this as part of their review of MAR and awaiting the next updates to the FX Global Code before deciding on next steps.
So, is it regulated or not?
The concept of FX spot being unregulated in the UK comes I think from it not being a MiFID instrument and whilst this removes it from the scope of the many conduct and market requirements in MiFID and MiFIR it also removes FX spot from the scope of MAR and EMIR. Equally the regulatory regimes overseen by the CFTC and the SEC in the US do not cover pure spot FX, though there has been talk of reviewing this considering the Johnson case.
So far this all looks clear but leaves a massive question as to how the industry was so roiled from 2014 onwards by activity that largely took place in the FX spot market? The main answer is that regulators in the UK and US (and beyond) had other tools in their armoury for dealing with regulated firms even in areas that might technically be outside the regulatory perimeter. For example, the FCA will often focus on the principles for business that apply to all regulated firms across all their business.
Notably FCA leant on Principle 3 - that a firm must take reasonable care to organise and control its affairs responsibly and effectively, with adequate risk management systems - for the major enforcement cases in 2014. FCA could have looked at principle 5 - A firm must observe proper standards of market conduct -if they had felt they needed to. Similarly, the US and other regulators were able to find means to take action and firms under their jurisdiction.
This raises a key point that where action was taken it was against firms who were already regulated for their activity in financial markets whether that be securities or derivatives including all the non-spot FX products that fall into this latter bucket (fx options, leveraged fx products, rolling spot contracts, CFDs, spread betting and most fx swaps and forwards).
For many European (and other) markets it can also be a mistake to assume that being outside MiFID or equivalent securities legislation make spot fx completely unregulated, instead basic banking regulation can also capture this product. ESMA called out the example of Australia where the Corporations Act 2001 includes spot fx as a financial product.
Therefore, I argue that fx spot is de facto regulated because activity deemed egregious by regulators and society can be readily be enforced against whilst some important technical elements that we will come on to clearly do not apply.
Is this just an academic debate or does it matter in the real world?
This does of course matter, due to the law of unintended consequences. Whilst at face value one could look at what has happened in the fx spot market in the last 10 years and say it calls out for regulation, it is necessary to think about what that would mean in practice, who it would impact and what actual problem it would be solving for.
In Europe, the obvious way to regulate spot fx would be to make it a MiFID instrument, though ESMA are considering trying to have a MAR only application as they have done with some spot commodity contracts but they acknowledge it might impact MiFID and MiFIR. Taking the MiFID route could have some serious unintended consequences, for example would firms offering bureau de change (physically or online) services could be required to be regulated.
Equally some of the regulations that apply to securities and derivatives such as transaction reporting, transparency and margin reform could be massively onerous and expensive for banks and investment firms dealing in fx spot to implement with no obvious commensurate reduction in risk to consumers and the financial system.
Anyone who has the dubious pleasure of implementing transaction reporting regimes will know the technical difficulty as well as amount of resource taken up delivering these projects, whilst that should not be a defining argument against a new regulation it is hard to see what supervisory insights regulators would gain from these mountains of transactions.
I will come onto the ‘what problem are we solving’ this in the next section but here I would argue that more regulation is not needed here as the industry and central banks are leading the way here, most notably through the FX Global Code and FMSB work.
How does the FX Code fit into all of this?
The FX Global Code should be our best hope in striking the balance between raising standards in the fx spot market and not placing unnecessary burdens on firms through formal regulation.
I was fortunate enough to be involved in some of the drafting process and was always struck by the spirit of cooperation between the many industry participants and central banks that took part and have continued working away behind the scenes.
This has continued under the auspices of the Global Foreign Exchange Committee (GFXC) as the code goes through regular refreshes and working groups develop areas of need. Work continues on pre-hedging, last look, disclosures, anonymous trading, algos, settlement risk and buy side outreach.
The example of settlement risk highlights one of the strengths of the code overseen by regular GFXC meetings in that they can react more quickly events, in this example some of the issues seen this year in the Argentine Peso and Turkish Lira markets.
The code is also truly global with GFXC membership and signatories from all over the world, this is important for what is the most global of all the financial markets, with G10 trading non-stop from the Monday morning open in New Zealand to the Friday evening close in the US. It also highlights the difficulty of trying to regulate a market that consists of currency pairs, for example if you are a European regulator worried about trading involving the Euro and Japanese Yen any investigation and action requires cooperation with the authorities in Japan. A common set of principles such as the FX Global Code makes that much easier.
To help win this argument the industry can, and should, help by continuing to drive adherence to the code and hence the GFXC focus on buy side outreach. Firms could also challenge their counterparties and counterparties who have dragged their feet on this. Finally, EU and other regulators could also look at the FCA approach of formally recognising the FX Global Code as a middle way between black letter regulation and something purely voluntary.
What are we likely to see next from regulators and industry bodies?
The GFXC met on 10th December and should hopefully publish their minutes soon however we do know that they expect the rewrite of the code to be finalised in mid-2021. We also know that their agenda covered updates from their working groups on; Disclosures, Anonymous Trading, Algorithmic Trading/TCA and Execution Principles (Last Look, Pre-Hedging, Riskless Principal).
From a European perspective the statement from ESMA is September on the review of MAR suggests that they will await the 2021 review of the FX Global Code before taking action, Guy Debelle from RBA (and a key player on the GFXC) has been proactive in raising this with ESMA and highlighting options other black letter regulation.
From a UK perspective (deal or no deal) it seems unlikely that the default will be for UK regulators to follow ESMA, especially in an area where there is a principles-based industry solution so I would not expect the FCA to change the perimeter to bring in fx spot.
Where can I learn more about this marvellous subject?
I would recommend David Woolcock’s blog on this subject: A Ghost of Christmas Past Makes an Early Appearance – ESMA and MAR Haunt the Spot FX Market (eurobase.com)
David and I also joined an ACI discussion on this and other FX topics a few months ago (along with Colin Lambert and Jack Drohan) which can be viewed here: https://www.linkedin.com/posts/aci-uk_one-code-to-guide-us-all-aci-uk-panel-discussion-activity-6729790340691173376-OBn_
Leaman Crellin Limited role specific training on the code: Market Conduct Training from Leaman Crellin Limited
GFXC website: Global Foreign Exchange Committee (globalfxc.org)
ACI UK (in particular look at the ACI Global Code Certificate): ACI The Financial Markets Association (aci-uk.com)
ESMA update: ESMA publishes outcomes of MAR Review (europa.eu)