Caveat venditor - the end of caveat emptor (part 2)

This is the second of 4 articles about how principles-based regulation could be augmented to improve outcomes in payment services and electronic money sectors, particularly in the FX execution arena. Specifically, FX banks and Liquidity Providers to the payments industry could consider doing more in their role as product manufacturer. Conduct regulators might also decide to provide more prescriptive direction on this matter.

In the first article I set the scene and talked about basic poor execution discipline. This second article is focused on a specific conduct example which is the close-out of in-the-money forwards, retaining the profit. In this example, the client has already done a FX deal (trade) which has yet to settle. At the outset, the client has an almost 50:50 chance of the transaction ending up in-the-money (it’s not quite 50:50 due to the execution spread). Where the transaction is still live and then moves heavily in-the-money (where closing the trade would generate a breakage gain to the client) there are at least 2 opportunities for misconduct.

1 - The client calls the firm to terminate the trade prior to it's settlement date because their underlying transaction (e.g. an overseas house purchase) has fallen-through; or

2 - There is no client-initiated contact. The dealer at the firm makes some cursory, half-hearted attempt to contact the client. They might use old or non-preferred contact details on a pretext (but hoping / expecting to fail).

In both cases, the dealer will terminate the client’s trade and record the resulting gain as sales income. This can be a significant amount – a £1m forward where the spot market has moved 5% in-the-money (not uncommon in volatile times over a 3-month horizon) nets a £50k profit. The dealer personally benefits in the form of commissions, and the firm doesn’t ask too many questions about where the P&L came from. Let’s have a look in more detail at both scenarios.

In the former case, the client calls to terminate the transaction that they no longer need. The dealer tells them that they cannot be paid the breakage gain. They tell clients they can’t benefit from terminating transactions as this would mean they are no longer using the transaction as a “Means of Payment” (MoP).

The MoP representation from the client to the firm is mandatory at inception of a transaction. It means the FX forward transaction does not have to be treated as an investment (for which the firm would need quite different regulatory permissions). It simply means that the FX deal will ultimately be used to pay for something.

As a result of their convenient interpretation of the MoP representation, the dealer tells the client that they either need to (i) settle the transaction in full and then reverse it to realise the gain; or (ii) find another transaction that they can use the deal for.

Whilst subjective, my own view is that qualification for MoP is tested at the time of the trade. If there was a reasonable expectation MoP would apply but then the client legitimately has no need for the transaction (e.g. an overseas holiday home purchase fails) this material change of circumstance doesn’t retrospectively alter the original rationale for the MoP representation. The original intent to purchase can still be evidenced, as can the change of circumstance leading to the purchase failure. In the face of such evidence, it could hardly be claimed that the transaction became an investment rather than a MoP.

In this example, the house purchase might even have fallen-through because of the general economic conditions so the consumer could even be being punished twice.

Be in no doubt; if the client’s circumstances changed and the trade was ‘out of the money’ i.e. would generate a breakage loss, the client would be charged for that loss. In closing out the transaction, there is thus either a loss, or zero gain. Contractually, the client could not say “I don’t need the trade. It’s now an open investment position which is ultra-vires i.e. with hindsight it shouldn’t have been entered so I’m walking away without having to pay you the breakage”.

If a client has to pay to break but does not get paid if a trade that was once legitimately MoP becomes no longer needed, that is an asymmetric outcome. Asymmetric outcomes are rightly considered unfair.

Even if my view is wrong and the consensus amongst lawyers was that the Means of Payment exclusion prevents the client benefitting from a mark-to-market gain, clients should be provided with an explicit disclosure that describes any potential asymmetric outcome scenario before they do the deal. If that disclosure were prominently made, it seems reasonable to assume that far fewer forwards would be sold to consumers and small businesses. This would be a shame because clients enter these trades to protect themselves i.e. there is generally a strong rationale for doing the transaction in the first place.

Clearly, if both parties can walk away if the underlying rationale no longer applies then that is fine, but this is no longer an FX Forward; it is a deal-contingent hedge (which is a very complex derivative trade).

The second, latter scenario (‘loss of contact’), is simple theft and little different to a stockbroker wilfully misappropriating the gains of a client’s shares that have risen in value. The client will originally have entered the deal to lock-in a rate for the eventual execution of a payment i.e. for hedging purposes. The dealer is effectively stealing the benefit of the trade.

Clients who later call to, for example, modify the delivery date of their trade or provide settlement instructions (as the settlement date approaches) might receive some benefit indirectly through improved execution. But not before the dealer tries to claim loss of contact, points to the T&Cs and (see above) attempts to claim they cannot pay the gains that were realised at termination.

The behaviour described may not be contractually illegal as there will likely be wording in T&Cs that allows it. However, it is morally suspect at the very least, probably breaches Unfair Contract Terms laws (see asymmetric outcomes already described) and various good outcome and fairness regulatory principles.

What can be done? Well, the underlying banks / LPs can (and must) step in here and provide some monitoring. Where heavily in-the-money FX forward trades are being closed out by payments industry firms, their banks can easily spot these and ask for rationale. They can check what the T&Cs from the payments firm to their clients say in relation to FX deals. Or at periodic review look at the list of deals and simply ask “who ultimately realised the breakage gains?”.

Banks may only be the market maker, but if they are the product manufacturer then their products must be fit for purpose, capable of being applied fairly and comply with a Consumer Duty principle (and equivalent in other jurisdictions). As illustrated, these activities are relatively easy to spot by the FX bank and a regulator could easily direct them to look out for it.

So I’m afraid to tell you, Mr Banker, that the excuses of “we do tens of thousands of tickets per day, we can’t interpret what’s going on” and “we don’t face the end client”, simply don’t cut the mustard. Neither does “we’re not the regulator”. If this were truly institutional flow those excuses might stand up. But (i) you earn mark-up income on every ticket facing your payments firm clients, which distinguishes you as a product manufacturer; and (ii) you monitor and audit payment firms’ payments activities – you are either at risk from your clients’ behaviours, or you are not (which is it?).

In the next article I describe some of the ‘interesting’ behaviours in the sale and settlement of window forwards (“Time Option Forwards” or “Option-Dated Forwards”). Again, these behaviours are easy for a product manufacturer (FX bank) to spot in trade data. Have a guess what conclusions I reach…