A decade ago, trading foreign exchange benchmarks was in many ways a human affair. A buy-side client would call up a dealer bank with an order, a trader would assume the risk and try to transact as carefully as possible without tipping their hand to the rest of the market.

Since then the role humans play in trading benchmark fixes has rapidly diminished. In their place are sophisticated computer programs that are more patient and stealthier when working these orders into the market. This has resulted in lower trading costs for buy-side market participants.

Algorithms may be bringing change to the trading of benchmark fixes, but some of the old human habits are refusing to die. Despite already seeing lower fees for trading the fix, some buy-side clients are still trying to nudge costs even lower, and there are banks only too happy to oblige, dealers say.

The willingness by a few of their peers to depress fees to accommodate such requests is causing concern among dealers that another race to zero may be slowly taking shape. Some fear a revival of undercutting, the kind of market practice that led to manipulation of the popular WM/Reuters 4pm reference rate 10 or more years ago. Regulators have urged dealers to properly charge for this kind of risk, but a failure to do so threatens to undermine years of work to try to bring some transparency to the fix.

“We are a decade past the scandal and there are clients out there asking what can you do for me again? And that is where the race to zero comes in. Because then you get to a situation where the client says, ‘Well, this bank is doing X, can you beat X?’” says an FX executive at a global bank. “That doesn’t mean they’re colluding. The surveillance is there. But it goes against the spirit of the Code of Conduct.”

The FX fixing business at a number of global banks underwent wholesale change following allegations of collusion to manipulate the WM/R 4pm fix in 2013. A co-ordinated regulatory probe led to the sacking of dozens of currency traders and fines or settlements of more than $11 billion by global banks. US criminal probes are ongoing.

The scandal prompted authorities to overhaul the WM/R benchmark’s methodology in 2015. The industry also created a formal code of practice for participants, the FX Global Code of Conduct, which was finalised in 2017.

We are a decade past the scandal and there are clients out there asking what can you do for me again? And that is where the race to zero comes in

FX executive at a global bank

It is estimated, at least anecdotally, that some 80% to 90% of fixing flows reference the WM/R 4pm benchmark rate. Much of this liquidity is pooled at a handful of dealer banks that have chosen to separate their benchmark fixing business from proprietary trading activities.

But the competition for client business among these dealers is heating up again. That, combined with the more widespread use of algorithmic trading, is tightening fees for trading at the fix.

“We have observed reduced fees for trading at the WM/R 4pm fix. While some decline may be due to technological improvements, we also attribute lower costs to competition among dealers for buy-side order flow,” says Michael DuCharme, head of trading operations in Mesirow Financial’s currency management group.

The fee squeeze has caused a creeping sense of disquiet within the industry. Logic holds that when traders are making less money from a business, there is more of an incentive for them to distort the market until it becomes more profitable. Regulators are convinced that a healthy market is one where all parties are amply paid for the risk they are taking.

“Obviously going towards zero is not a good idea. The regulators want the banks to make money to make sure that everything can function normally. There is no market where people make zero. It doesn’t exist – or not for long anyway,” says a senior currencies trader at a large dealer.

Short-term memory

Dealers say in the immediate aftermath of the benchmark-rigging scandal and the subsequent release of the Code of Conduct, banks were adamant about what they charged for fixing orders – typically the midpoint between the bid and offer, plus a fee – and were rigorous about not deviating from it. However, that rigour appears to have begun to dissipate a year ago when some clients started calling dealers and asking for price revisions because other counterparties were reducing their fees.

Ducharme says fees are now as low as mid rate plus $10 per million traded, or 0.1 basis points, for non-algorithmic trading on G10 currency pairs at some dealers. Algo costs can range up to $50 per million traded.

A global head of trading at a third bank says: “You can argue some banks have short-term memory. They seem to forget how much they lost because the risk they took was greater than it should have been versus what they were charging clients. This emphasises the importance of high-quality risk management.”

Insiders say dealers that agree to reduce their fees are removing transparency from the market and increasing the risk that the fixing business will once again become unprofitable, which could lead more dealers to develop a distaste for handling such transactions. Fewer market-makers could stunt liquidity and increase concentration risk.

“The WM/R is not supposed to be done at mid. The idea behind charging a fee is to keep the fix honest. It offsets the risks the banks are taking,” the FX executive says. “I worry that there is a race to zero happening again.”

Regulators are aware that prices for fixing transactions are coming down. Minutes of a February 5 meeting of the FX committee at the Federal Reserve Bank of New York show that members discussed whether the fees institutions were charging for such services “appropriately reflected their incurred costs, given the reported trend of price compression”.

The meeting picked up on similar discussions by the Global Foreign Exchange Committee, the industry body tasked to oversee currency markets, the previous December. The issue resurfaced once more in June, when the GFXC highlighted the declining costs charged to clients for executing orders at the fix, in part because of the increasing use of algorithms to manage those orders.

The GFXC has cautioned market participants that there would be a limit to how far those costs could decline, given that the charges for handling fixing orders should be transparent and consistent with the risk inherent in such transactions.

“Our main recommendation was you’ve got to charge for the risk transfer, and that price isn’t zero. It is undercharging – not overcharging – which is the concern,” says Guy Debelle, chair of the GFXC, speaking in early August. “If the price goes down to zero again, then that creates bad incentives, or not so good incentives, which can lead to the sort of behaviour we saw a few years back.”

Part of the problem that surrounded the benchmark rigging scandal, says Debelle, was that currency market participants were not charging for those types of orders. Instead, they would take on the risk for free and try to earn a commission by beating the fix. Traders ended up engaging in misconduct such as sharing client information, in order to increase their chances of earning a profit.

Debelle is keen for dealers to be aware that every time they are executing as a principal they are bearing risk. He says the risk is amplified at the WM/R 4pm benchmark because a particularly large volume of trades is being squeezed through a five-minute window.

“If you undercut to get more business, which was the problem seven or eight years ago, then that creates some bad incentives. Most of the time, the pricing is perfectly fine, but the prices come down, and that’s because the technology has improved and that’s fine,” says Debelle. “But just at some point you cannot charge zero, for instance, because you are bearing some risk. So there is a price which is too low in terms of the risk that you’re bearing.”

Not everyone has experienced a drop in fees. In fact, some are seeing greater inconsistency among dealers’ fees.

Sally Francis-Cole, global head of sales at Record Currency Management in the UK, says: “Ever since it became necessary to pay for the fix there has been quite a wide disparity between the fees that banks charge. Some banks still charge the full bid/offer whereas others are closer to $15 to $20 per million, which is in the ballpark of algo fees.”

She adds that Record only executes at the WM/R fix if the main reason for the trade is to minimise the deviation from the fix. This may stem from a particular client request or algo strategy.

“From the buy side point of view, the mechanism with which they deliver their required trades at the WM fix is more to do with operational efficiency,” says Francis-Cole.

An incentive to trade

Observers say banks engage in undercutting in the hope they may win further business from clients in other products such as swaps or forwards. The belief is that if they sacrifice profits in one area of the market, they can make up for that in another. A loss leader, if you will.

But that is precisely what is making some dealers and buy-side clients nervous.

“Dealer price cutting is an issue because it raises the concern that costs are being recouped in other trading situations or that the low costs are prompting undesirable practices at the fix such as front-running,” says DuCharme. “Investors could also be attracted to trading with specific banks at the fix as a result of low spot cost offerings. The reduction in the spot portion of the trade could be recouped in the forward spread resulting in similar overall costs paid compared to other dealers.”

DuCharme goes on to say that spread costs also incentivise the buy side to trade at the fix, which leads to more directional volume going through a single point in time and that could increase fix price volatility.

Others say market-makers might start to step away from offering the service should it become unsustainable and the rewards no longer justify the risks being taken.

“There is an equilibrium where the risk/reward works in the fixing business. And if you drop below that equilibrium of that price, does it really make sense to be there?” says the FX executive.

The exec says there was more of an alignment of interests between dealers and clients when banks were encouraged to start charging a fee for the fixing business following the misconduct allegations. This helped to provide more transparency in the market around costs and to remove anxieties about handling fixing orders. “By charging a fee there was no fear. As the price comes down and down, the question is: are the banks still aligned with the clients as much as they should be?”

You’re just looking at instantaneous spread and the liquidity in a five-minute window, and you’re forgetting that prices are moving in an unnatural way going into the fix

Fund manager in Europe

Any activity that threatens to undermine the authenticity of the WM/R 4pm fix would be a dangerous step for FX markets, participants say. The benchmark exists to provide a reference rate that market participants, specifically buy-side fund managers and pension funds, can rely on to value their portfolios and measure performance. That means theprice must be reliable and trustworthy. It must represent a fair reflection of market forces at that moment in time.

More than $12 trillion of assets at indexes such as MSCI are pegged to the rates. A lot is at stake if old habits should resurface.

Despite falling fees, confidence in the fix is already waning for some buy-side managers who are beginning to ponder whether it is still fit for purpose.

“You’re just looking at instantaneous spread and the liquidity in a five-minute window, and you’re forgetting that prices are moving in an unnatural way going into the fix,” says a fund manager in Europe. “You think you’ve done your job. But what is hidden in this whole thing is that the price has gone up 1% in the 30 minutes preceding the fix, and that is something which is predictable, and that is a concern.”

Editing by Alex Krohn