The global FX code: transcending myopia

Notwithstanding its flaws, the new code of conduct for currency trading is the most significant reform initiative yet in changing the culture of wholesale markets.

It gives stakeholders the opportunity to promote market integrity and commit to societal progress on a scale not seen since the New Deal was first developed in the US, according to Justin O’Brien, finance professor at Monash Business School.

“Moreover, the (forced) recruitment of financial firms embeds common conceptions of practice within and across institutional actors by leveraging a shaming mechanism.”

In a report for the Australian Centre for Financial Studies, O’Brien highlighted this “creative ambiguity” surrounding the code’s apparent voluntary nature. As will be shown, he wrote, the code and adherence to it is nothing of the sort.

“The Bank of International Settlements, in recognising the benefits of clothing power with a velvet glove, is, as a consequence, leaving little to chance. Central banks – essential counter-parties in the FX markets – will not transact with institutions that do not sign up to the code.”

Yet surprisingly, he argued, this ‘imaginative component’ is matched by an almost complete lack of media and academic attention.

'Mere tinkering'

Outside single articles in the Financial Times, and The Economist, O'Brien lamented, the broadsheet press ignored a two-year negotiation to protect the fragile but critical foreign exchange ecosystem.

“The international news wires were equally underwhelmed at what may be perceived as mere tinkering at the margins of a discrete mode capitalism that subverts the stated purpose of finance to enrich society.”

Notwithstanding the importance of the City of London to the British economy, he went on to say, neither government nor opposition saw advantage in highlighting an unproven model in the run-up to a closely watched, bitterly contested general election.

Odd as this may seem, Australia did no better.

“Even national pride, recent settlement of FX market manipulation charges and interlinked questions about why ongoing litigation involving three of the most influential domestic banks in alleged manipulation of the domestic bank bill swap rate remained on the federal docket, could not raise the Australian media from its torpor," O'Brien said.

"This myopia, it is argued, is a mistake.”

Designed to restore trust within the currency market and, more significantly, between it and society, the code came about after a succession of scandals, involving a small number of critical players across developed jurisdictions. It was clear something had to change.

Bailouts in critical markets

Significantly, O’Brien argued, the main FX and financial benchmark scandals – including the manipulation of LIBOR and its facsimiles in Europe, Hong Kong, Singapore and Tokyo – occurred after sovereign bailouts in critical markets.

More alarming, he claimed, is the fact that the FX scandals post-dated the initial financial benchmark investigations provided further evidence of sub-optimal control. 

“Misconduct in the FX space continued notwithstanding formal investigation in functionally equivalent trading areas," he said, blaming the failure of senior management to take responsibility for anything more than regret.

“It is of equal significance that throughout, prudential regulators had miscalculated the political risk, or deemed it not material in terms of immediate risk of banking failure. While the risk of a run was and remains low, the failure to manage the politics has had a profound impact on regulatory standing.”

Strengthening the legal protections was always unlikely to soothe concerns. The conundrum for regulators, O’Brien wrote, is that it was never realistic to assume that major banks would be prosecuted to a judicial conclusion given the potential externalities involved in cases of licence revocation.

“This did not mean, however, that regulatory and prosecutorial authorities were powerless to effect change. In large measure, they declined to use latent power. This was a mistake.”

'Subtle game'

In the report, O’Brien argued that doubling down on the benefits of the ‘associational governance’ model, the code can be viewed using two very different heuristic lenses.

“The first, works on the assumption that a strengthened code of conduct could and should provide warranted public confidence," he said.

“The second questions the wisdom of continuing a failed approach to regulatory design. It views the reform agenda as a last gasp attempt by a self-serving elite to keep open the proverbial last-chance saloon, the (inevitable) failure of which will inevitably further erode public trust.

“Neither heuristic appreciates the dynamics of a subtle game being played for the highest stakes possible, and for which the rules of engagement have definitively changed.”

Critically though, the code addressed the currency market as a complex ecosystem. It was chaired by the RBA with the Federal Reserve Bank of New York responsible for code design and the Bank of England leading the stream on adherence.

A Market Participants Group brought together leading practitioners from across industry. This was a critical design decision, according to O’Brien.

“No successful campaign can be prosecuted without recruitment of potential allies; no war can be won with troops, voluntarily committed or dragooned. Change could only occur if approached holistically. The initial framing extended the range of stakeholders, each with a direct (if divergent) interest in changing the structure of the industry," he said.

Crucially, he wrote, the calibration placed the sell-side major financial institutions at a strategic disadvantage. If the rules of the game were changing, the balance of power had to also. The major banks become one set of players among many. While their power in the marketplace was not reduced, power to direct the trajectory of debate was.

Within the law

Finally, he argued, for the principles to have value in strengthening deliberative governance, they must be believed in.

“Otherwise they privilege symbolism over substance. It is to the credit of the code that it goes beyond symbolism," he said, but O’Brien is not saying that there aren’t some shortcomings.

One drawback, for instance, is it is no longer sufficient, for example, to suggest commitment to ‘fairness’ or ‘integrity’ - the definition of which depends on the degree of expansiveness involved and purposive reading by regulators. 

“Acting within the law may well constitute acting with integrity. It may not,” he argued. “What constitutes professional conduct is disputatious, within recognised professions, never mind those who aspire to such an exulted status.”

Likewise, the code calls for sufficient knowledge of applicable law, sufficient relevant experience, technical knowledge and qualification and evidence of applying with competence and skill without defining what constitutes relevant knowledge, experience or evidence.

Also, O’Brien argued, while the code tackles remuneration it falls short of calling for positive incentive structures to not engage in particular transactions.

What’s understandably even more maddening to the finance professor is suggesting that conflicts of interest, if not capable of being eradicated, must be managed (and only if not managed effectively disclosed to a counter-party) is part and parcel of a failed and failing regulatory paradigm.

While it is anticipated that the code’s efficacy will be reviewed on an ongoing basis, it remains unclear to him what criteria is going to be used or whether performance of institutions or jurisdictions will be ranked.

To read the full report, click here.


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