Last week we looked at the recent GFXC note on Disclosures and today we take a deep dive into the accompanying report. As will be seen, it continues the theme of the importance of disclosures.
The Cover & Deal report “discusses a trading practice used in the wholesale FX market that is often referred to as ‘cover and deal.’ In general terms, it is a type of arrangement whereby a Market Participant looks to facilitate their Client’s trade request without taking on any market risk. This arrangement typically involves use of an electronic trading practice referred to as ‘last look’.” The report notes that this execution method is used by hundreds of banks within the marketplace and across a range of jurisdictions.
The main problem with this commonly used method of execution is that the Intermediate Provider covers a deal with a Liquidity Provider before accepting the initial customer trade. This results in the Intermediary Provider trading in the last look window, which does not sit comfortably with Principle 17 that states, “Market Participants should not conduct trading activity that utilises the information from the Client’s trade request during the last look window”. However, a caveat was included in the FXGC of August 2018 that states “This guidance does not apply to an arrangement that features all of the following characteristics:
- An explicit understanding that the Market Participant will fill the Client’s trade request without taking on market risk in connection with the trade request by first entering into offsetting transactions in the market; and
- The volume traded in the last look window will be passed on to the Client in its entirety; and
- This understanding is appropriately documented and disclosed to the Client.
Thus, it all comes down to appropriate and transparent disclosure to the client, which is central to the FXGC principles. However, what can cause a problem is that the Intermediate Provider is acting as Principal to the trade and may be giving the client the impression they are a Principal Liquidity Provider. In old parlance, pre MiFID II, the capacity in which they are actually acting is that of riskless principle as they do not take market risk but do take credit and settlement risks. In this is the nub of the problem.
In the original incarnation of cover and deal, the workflow was very simple. The client would request a price; the Intermediate Provider would request a price from a Liquidity Provider, add a mark-up, and show the marked up price to the client using last look. If the client traded, you covered the deal with the Liquidity Provider and once this was accepted you accepted the client deal. Thus, the Intermediate Provider incurred no market risk and earned the mark-up as a profit on the trade compensating for the credit and settlement risk and enabling a profit to be earned. This was automated either by, say, a multi-bank platform or within the Intermediate Providers platforms.
As the practice became more widespread and technology evolved, another scenario came into play. If the liquidity provision was streaming and prices changed while the Intermediate Provider was covering in the last look window you could earn additional pips if the market moved. If the market moved against the Intermediate Liquidity Provider, the client trade would normally be rejected but if it moved in the favour of the Intermediate Provider, the additional pips would be earned and it was a common practice not to pass this improvement to the client but to earn the additional pips. So, this is a heads I win and tails you lose scenario which was a big issue with asymmetric last look practices.
In a pure agency model this would not sit with the best execution requirements and the improvement would have to be passed onto the client given no market risk is assumed. A further complication exists where a trade request is made on a cross currency pair for which the Intermediate Provider is willing to carry risk on only one leg, such that they will look to ‘cover’ the risk on the other leg before agreeing to the trade request but we will leave that complication for now.
The paper does address the commercial aspect of pricing - “The Code’s guidance on ‘cover and deal’ is that volumes traded in the last look window should be passed through to the Client. The Code does not provide explicit guidance on how any price improvements or slippage that are realised by the Intermediate Provider should be apportioned between the two parties. Pricing is a commercial matter between the parties and engagement with Market Participants has confirmed that practices around passing on price improvements/slippage are not uniform within the industry and, in certain cases, will be constrained by the technology used.”
The report further notes that – “Principle 17 of the Code stresses the importance of Clients having sufficient transparency around the Market Participant’s execution practices that would allow them to evaluate the handling of its trade requests. Information regarding the treatment of price changes during the last look window should form part of that discussion.”
So, it comes down to disclosure and you need to be transparent to the client as to how exactly this practice is dealt with alongside clear explanations of the use of cover and deal. It is worth remembering Principle 8 in the FXGC in this regard – “Market Participants should understand and clearly communicate their roles and capacities in managing orders or executing transactions. Market Participants may have a standing agreement or other terms of business as to their roles that govern all trades, or they may manage their relationship by determining their roles on a trade-by-trade basis. If a Market Participant wishes to vary the capacity in which it or its counterpart acts, any such alternative arrangement should be agreed by both parties.”
Therefore, the message is more that careful attention needs to be paid to how you frame the firm’s execution policy in terms of client disclosures. As the report concludes, “Those operating ‘cover and deal’ models are encouraged to review the nature of their current disclosures and maintain an ongoing dialogue with their Clients that provides sufficient transparency around their practices.”