Caveat venditor part 3 – window forwards

This is the third of four 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. In the first article I set the scene and talked about poor execution. In the second, I discussed the regulation and morality of payment firms retaining the benefit of their clients’ FX forward gains.

This third instalment relates to another ‘interesting’ behaviour, sometimes seen when payment firms sell window forwards (also known as “Time Option Forwards” or “Option-Dated Forwards”). It’s a good example to illustrate the why caveat emptor cannot apply where selling to non-market professionals, in this case largely due to information asymmetry.

A window forward is best defined by way of an example. A client could agree to buy USD (selling GBP) on a specific date in 3 months’ time. But rather than specify a particular settlement date, they agree with their payments / FX firm that delivery could take place at some date between (say) 2 and 5 months from the trade execution. Remember, this is just an example and the date range could be very different to this. The potential settlement dates in the example range of 2-5 months after execution are the ‘window’ of dates; the client must request take-up (or drawdown) of the transaction in whole or part. This type of deal is still considered to be a forward – there is no optionality as to whether the settlement takes place, only a decision from the client as to when. Clients can arrange to take delivery all at once or in a series of drawdowns during the window. Any portion of the trade not utilised by the last day is automatically settled.

Having executed a window forward, clients are persuaded / guided to take drawdowns early in the window. Why is this a conduct issue? The window forward will have been priced (and executed) as an outright forward against the most expensive rate in the window of dates, which is quite often the rate for the forward deal at the end of that window. Drawdown early in the window means the dealer earns more from the deal because they make an additional profit. This is realised from the difference in the Forward FX rate ("forward points") between the early drawdown date and the end of the window.

Early drawdown is not always bad. Indeed, it is a beneficial feature, and for very good reasons – if it did not have utility to the client then they would never be worthwhile doing. The distinction is where clients are encouraged (or soft-advised, see article #4) to drawdown early by the dealer. Allowing early drawdown at the client’s request is a good thing. Any persuasion towards early drawdown puts the dealer’s interest ahead of the client’s and is a conflict of interest. Neither the conflict nor the additional profit is disclosed. Astonishingly, some years back I heard the founders of one very large and well-known firm describe this practice, and the additional profits they make from it, with pride. I was speechless (which is pretty rare for me).

This behaviour generates the most additional profit when delivery windows are long and where there are large interest rate differentials between the 2 currencies. Dealers might also persuade clients to set up long delivery windows at inception to maximise their opportunity for this additional profit. Long windows are not exactly consistent with the Means of Payment exclusion from MiFIR, but I’ll leave that topic for another talk show host…

The legal position is roughly the same as the example I used in the second article. It also overlaps with whether advice was provided, which I’ll say more about in the final article. There is no explicit or specific regulation preventing this type of behaviour, but I would argue it is morally wrong and that it contravenes the same good outcomes principles (1, 6, 8, 9 and 12). Profits from this activity are not as large as they can be for keeping the in-the-moneyness of forwards. However, the opportunity arises more frequently because it does not depend on market moves.

As an aside, this product isn’t really used by market professionals precisely because they know that in using them they would be leaving money on the table. Professionals manage settlement timings by booking outright forwards (settling on a specific date) and then later, if they do need to move the timing, they can overlay an FX swap which changes the net effective settlement day. Why isn’t this approach offered more widely to non-market professionals? The combination of the forward overlaid with a FX swap can have cash flow implications that market professionals can easily absorb, but non-professionals hedging 'real' economic flows cannot. It might also have credit implications – professionals use more complicated documentation (such as ISDAs) that avoid credit issues. The documents are expensive to negotiate (requiring lawyers) which explains why non-professionals tend not to use them.

I am also aware bank salespeople get no benefit from encouraging early settlement in a window forward. They book the trade correctly with no potential for additional profits. Long may that continue. But the banks are facilitating the practice for the less scrupulous (read-on, dear reader), so you’ll understand that my congratulations in this matter are somewhat tempered.

What can be done? Again, the banks who facilitate this poor behaviour (unwittingly, but wilfully-so?) must share responsibility and be part of its resolution. They can easily spot this by some very basic monitoring of their PSP and EMI trades. A large number of FX swaps to move net effective settlement dates would be suggestive, for example. Why not dip-test those matching this criteria at periodic review? I would also check whether the firm is entering trades with very long delivery windows. As I said in my previous article, volume of trades is no excuse - it’s just a very basic data exercise. As the product manufacturer, banks will say Caveat Emptor applies to their immediate clients, but they will also know the same Latin principle isn’t applicable downstream. Good luck continuing to disclaim responsibility.

In the fourth and final article on the death of caveat emptor we will cover FX sales patter masquerading as advice, and also wrap-up the series. See you there.