Caveat venditor - the end of caveat emptor (part 1)

Principles-based regulation is an exceptionally powerful feature of the UK financial services regulatory ecosystem and has helped the UK to become one of the global drivers of fintech innovation. However, the principles for good outcomes (including the new Consumer Duty principle) are far from foolproof on their own. In my view, they often need augmenting to protect the innocent. The UK conduct regulator (the FCA) tacitly agrees; they already target sectors and prescribe specific actions to create jeopardy to any (miss) seller and an environment for better outcomes. But better does not always equal good.

This series of four articles identifies potential for poor conduct in situations which (again, in my view) have yet to be tackled. They describe how some of these actions can be spotted and prevented so that outcomes can be improved. Potential controls suggested are specific to FX deal execution, and I have tried to suggest actions that could be taken and support (do not cut-across) the existing principles-based approach.

Historically, banks either (i) embraced the payments industry, or (ii) avoided it due to supportability or competitive concerns. Collaboration with payment firms is mandated by Payment Services Regulations 2017 (article 105) and banks are forced to undertake a less voluntary role (POND, for those that know it). This regulation already prescribes what the banks need to do to support the industry from a payments perspective but, since the regulation is payments-specific, it doesn’t consider behaviours relating to FX.

Somewhat ironically, had banks voluntarily taken control of FX behaviours whilst they were being forced to engage in the payments sphere, there may have been less revenue available to the payments industry and less opportunity for new non-banks to insert themselves as intermediaries. This might have resulted in a reduced pace of ‘leakage’ of FX revenues to their non-bank competitors. Whether this would have given the banks enough time to upgrade their payments proposition is debatable; many of them might have done what they did anyway. Which is to say they might anyway have largely ignored it and just focused on tweaking their retail mortgage book.

Some of the FX conduct surveillance I am suggesting would have to be done by FX Liquidity Providers (“LPs”). LPs are typically, although not always, wholesale banks. For the purposes of these articles, from this point onwards, the reader is left to infer whether I am talking about LPs or banks. Even where LPs are not actually wholesale banks, there is usually a bank behind them who is providing them with live 2-way executable prices. I acknowledge the ambiguity but the actions I am suggesting could fall to either or both. The proposed actions each might have to take are relatively clear and regulators need not even impose a specific split of responsibilities.

The first and simplest example is one that banks cannot control directly i.e. price-gouging through information asymmetry. In this scenario, an egregious margin is charged on the FX transaction.

One pathway that could lead to this outcome is (i) a pre-sale conversation takes place to assess client sophistication and vulnerability, but that same discussion is used to spot opportunities to widen the FX profit margin; (ii) price is misquoted. This could be done through many mechanisms including just to test the water with a poor quote and await challenge, lag the FX quote vs. during favourable market moves or quote a spot rate instead when a forward rate should be quoted (or vice versa).

Misquoting has historically been difficult to identify. For example, it is not something banks could spot at the time of any given transaction. However, most payment companies’ systems now set prices according to specific fixed deal parameters so any misquoting would have to be done as an over-ride to a system-generated price. This over-ride would usually require authorisation and even if not it would be difficult to hide. The margin would be hard-coded into the platform and/or there should be internal notes between sales and dealing functions specifying the commercial terms.

Secondly, periodically a list of transactions could be generated with basic static information and deal parameters. With some very basic maths the outcomes could easily be measured vs. a target margin that would be recordable in the client record.

What can banks do here? As part of their review of payment industry clients they should be looking at firms’ separation of sales / dealer roles; formal communication and record-keeping of target and achieved profits; the channel mix of online vs. telephone dealing; and also consider the extent to which their technology platform controls for conduct. They should be able to ask firms monthly or quarterly for the list of deals done (as described above), with target vs. achieved margins.

There are exceptions where the margin might be larger than expected. For example, where executing transactions that are large, the outcome might not match the agreed spreads. This is legitimate execution slippage – larger transactions (even in major currencies) can themselves move the market rate. The size threshold or reason for price slippage can vary. There may be more movement when buying or selling non-major currencies (which, by definition, are less liquid). Slippage might also occur due to the time or date of the FX transaction. For example the it could be more difficult close transactions at agreed spreads when the market is about to close for the day or just before public holidays. It has also sometimes been difficult to source liquidity for very small deals when executing larger deals was a bit easier. Liquidity has historically been difficult to source in smaller transactions for minor East Asian currencies, for example. Such differentials will show up in the data as a mismatch, but the transaction size and/or timing will explain the outcome; legitimate exceptions can be discounted with simple rationale.

Misquoting is much less of a problem than it was even a few years ago, there are still advantages to looking out for these outcomes. In the second article we discuss firms deliberately withholding deal profits. Stay tuned..!