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NY Fed Executive Urges Universal Adoption of FX Global Code

jlrobins@debevoise.com's picture
Commentary by Jeff Robins

Federal Reserve Bank of New York ("NY Fed") Executive Vice President Simon Potter urged all foreign exchange market participants to adopt the FX Global Code (the "Code"), a set of best-practice principles for operating within foreign exchange markets (see previous coverage). Mr. Potter remarked that while his views were not necessarily those of the NY Fed, his "remarks on the expectations for FX counterparties reflect the policies of the [NY Fed]."

At the 2017 FX Week Conference in New York City, Mr. Potter outlined the Code's focus on six key areas: Ethics, Governance, Execution, Information Sharing, Risk Management and Compliance, and Confirmation and Settlement.

Mr. Potter stated that while the Code is not a binding set of rules, there is an expectation that regulatory authorities and industry participants will promote widespread adoption, not just by FX dealers, but also by "regional banks, asset managers, and corporations, to hedge funds, high frequency trading firms and others." An institution can choose to pledge adherence to the Code's principles through a voluntary Statement of Commitment.

Mr. Potter also emphasized treatment of the so-called "last look" practices and its application to electronic trading platforms. He reported that principle 17 of the Code "likely consumed the most time and energy of any of the principles of the Code," and noted that discussions evidenced that different participants took different views as to what constitutes "last look." Given the range of views, Mr. Potter said that the relevant principle highlights broadly that last look should not be used for information gathering "without an intention to accept the trade request." Mr. Potter also announced a further consultation on last look and asked market participants to submit further comments to the Global Foreign Exchange Committee as to whether "last look" was appropriately described in the Code and whether the provisions on trading in the "last look" window are appropriate.

Commentary

jlrobins@debevoise.com's picture
Jeff Robins

Mr. Potter's speech indicates that while the Code is "voluntary" by its terms, regulatory authorities throughout the world will be working to encourage market participants to adopt it. As with other non-binding statements, such as the Treasury Market Practice "recommendations" for agency MBS trading, regulators in the United States have the ability to impose significant pressure for adoption, even without formal rulemaking processes.  Though less regulated than the swaps and securities markets, the FX market has been under a lot of recent scrutiny and regulators are clearly telling market participants to close the gaps.  

Market participants considering adopting the Code should carefully consider both the substance of the Code and what submitting a "Statement of Commitment" actually means. The statement itself is brief and asks a participant to confirm that it is "committed to conducting its FX Market activities ... in a manner consistent with the principles of the Code" and has taken steps to "align its activities with the principles of the Code." In FAQs on the statement, the GFXC seems to suggest that the commitment apparatus provides flexibility and recognizes that participants in the market are diverse, and so the Code and the statement should be interpreted with this diversity in mind. Practically speaking, the FAQs say that this means that adherence will reflect the "size and complexity" of a firm's FX market activities and "the nature of its engagement in the FX Market," as well as "applicable law."

While this flexibility in implementation is helpful to market participants, it also raises a number of questions given the often prescriptive nature of the requirements of the Code. If a market participant commits to acting in a manner "consistent" with the principles, and its engagement with the FX market is limited, should it be expected to comply with all aspects, or can it deem some aspects immaterial to its situation? The latter approach may not be easy to follow, particularly when enforcement actions and/or private litigation could cite failure to comply with the Code as evidence of misconduct.

Whatever the commitment means, firms have a good deal to consider in terms of the substantive requirements. A few of these issues are highlighted below.

  • Product Scope. The Code covers a wide range of wholesale FX transactions, including spot trades. This is in contrast to the CFTC regulations, where physically settled FX transactions are subject to a more limited set of requirements and spot transactions are entirely excluded from CFTC jurisdiction.
  • Pre-Hedging. The Code requires fair treatment and transparency when engaging in "pre-hedging" and use of pre-hedging only where it will not disadvantage clients. U.S. market participants may note that existing documentation, such as that found in Section 2.15(b) of the ISDA August 2012 DF Protocol Supplement includes agreements potentially allowing for a dealer to engage in anticipatory hedging. However, this consent may be found to be too limited for Code purposes, given the broader product scope of the Code, and it may not be in the documentation of some market participants.
  • Disclosures.  In a number of places, the Code encourages or requires disclosures of specific practices around execution and hedging that are unlikely to be supplied in industry disclosure documents.  In this regard the Code is arguably more stringent than swap regulation.  Dealers and electronic platform providers in particular are likely going to need to review their disclosure practices carefully as well as their processes for keeping those disclosures updated.  
  • "Last Look". The Code specifies controversially that trading during a last look window is likely inconsistent with its principles and suggests that it should only be used as a risk control and not to make use of the customer order information. As Mr. Potter noted in his speech, regulators are continuing to consider how best to address the practice.
  • Markups. The Code expects that mark-ups charged on FX transactions will be "fair and reasonable" and fairly fulsome disclosure of mark-up practices. This goes beyond what is required by CFTC regulations. 
  • Risk Management and Recordkeeping. The Code includes broad requirements that market participants establish robust compliance processes, through detailed governance and risk management practices. Firms are also required to establish recordkeeping practices and maintain transaction data that, in many ways, goes beyond existing requirements under U.S. law.

As expected by the GFXC FAQ, commitment will involve a significant amount of work. (The Code anticipates 6-12 months for "most" market participants.) This will include:

  • Compliance & Risk Management Processes. Adherence to the Code will require a firm to undertake a broad, global review of its compliance policies and procedures, from supervisory review of orders and businesses to risk management controls.
  • Disclosure Updates. Disclosures to counterparties will need to be fully reviewed and, in many cases, updates will be required to enhance existing disclosures to ensure that they are consistent with the Code. In some cases, this may be as simple as applying existing disclosures to the full set of products to which the Code applies, but in other cases, this will require supplementing or amending existing disclosures.
  • Counterparty Documentation Updates. The Code does not contain explicit documentation requirements, but generally provides that firms should use appropriate documentation to manage credit risks, such as collateral arrangements and enforceable netting arrangements. While much of the market has begun documenting non-spot FX transactions pursuant to CFTC and EMIR requirements, other aspects of the Code implicitly require additional documentation, such as the obtaining of consents from counterparties on practices such as anticipatory hedging and "last look" reviews.

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