The recent news that IEX was approved as a ‘fair’ exchange by the SEC is great news indeed. Although it seems to be the beginning of a long battle, as lawyers already threatening the SEC with lawsuits. But anyway – it’s a great step in the right direction for fair markets onshore in the US.
The next market to be normalized is Forex. Forex still trades without an exchange or globally recognized model. Liquidity is fragmented and although regulations have somewhat stopped retail fraud, the talks to make a fair, FX market as IEX is doing for stocks, it’s not even a discussion. We’ve tried to start that discussion with the book Splitting Pennies – Understanding Forex.
A detailed white paper by major FX exchange LMAX “Restoring trust in global FX markets” outlines examples of how FX markets have shifted in the past few years, and how technology is pushing existing banks & non-bank LPs (Liquidity Providers) to change the way they do business. Although the paper is biased towards their commercial publisher – it’s well done and a must read for any student of FX. Click here to download / view the report in its entirety. Some interesting key quotes:
“Non-bank market participants have grown by 48% and has become
the largest, most active segment in the market”
BIS Triennial Central Bank Survey, 2013
“Amazon started out selling just books online and over time they
incorporated third-party sellers. We work with the banks like that,
and as a result we are seeing a very healthy ecosystem developing”
Jamil Nazarali, Head of Citadel Execution Services, Citadel Securities
“On an exchange model you get firm prices, and that’s something
the regulators like and understand. I think as the regulators turn over
more stones in the FX industry they will say ‘wow, I didn’t know it
worked like that’ ”
David Holcombe, Head of FX Product, Nasdaq
One of the most alarming statements though, not for LMAX but for FX in general, is in the intro written by the CEO:
In recent years, the evolution of the market has put greater pressure on LPs to take more risk
to benefit from their liquidity service provision and perhaps the line between market making and
proprietary trading became too blurred as a result.
There should be such a distinct line between these 2 activities, they should be separate entities – they shouldn’t be in the same building even. Imagine this was the case in stocks – not only HFT firms sucking up liquidity and front-running orders, market makers are also trading for their own book – not as a market making activity but based on algorithms run as a prop shop does, like jump trading. Anyway that’s what we have in FX, banks have become a blurry mix of prop shops and market makers – and they’re making a fortune. Fortunately, they aren’t completely fleecing customers, because of the recent WM/Reuters settlements; their game to profit from their market position as a virtual monopoly has just shifted, to one of a more technological nature. And they can take notes from the IEX debacle because unlike with stocks, with FX, they don’t need to worry about the SEC – Forex is totally unregulated. That means – for those who do not understand clearly – the Forex market itself is an interbank market where banks trade with other banks, and some non-bank participants such as Hotspot (now owned by BATS). That means, they don’t have to worry about Reg NMS or other SEC rules, interpretations, comment letters, or policies. They need only worry about a big lawsuit – and when we say ‘big’ we mean “FX Big” – just one case so far the fines are up to over $5 Billion. One doesn’t need a PhD degree from MIT in mathematics to calculate that if the banks have agreed to pay $5+ Billion in fines, the amount of money they are making in FX fleecing customers is 50x or 100x or 200x that. If you don’t understand this logic, ask a class action law firm about settlement math, companies always agree to pay out settlements that are pennies on the dollar what their underlying business generates, otherwise it wouldn’t make sense for them to do so. In the case of FX though, being that it’s a completely artificial market, the only real ‘injury’ to clients is huge losses – it’s a little different than if someone buys a hair product and all their hair falls out. And we know that from other FX venues that are a little more transparent about their operations, that a small group of “Elite” companies are making billions upon billions in FX, without taking any risk. If you don’t understand that there’s free money in FX – read this WSJ article or you can start by checking out our book Splitting Pennies – Understanding Forex.
Being that FX trading itself is unregulated, the market relies on natural evolution to change – maybe that’s a good thing. Domestic regulators have little to say about FX except how retail participants trade in it. In the case of the United States, they practically made retail FX illegal – making it so difficult and cumbersome with so many rules and regulations that it makes any strategy barely profitable. And since the regulators squeezed out decent FX brokers – the only ones left are semi-legit companies that even if there’s no default risk, the chances of having a fair shot trading at these firms is minimal. So once again, the US retail customer takes it on the chin, waiting for a sunny day when either he’ll win the lottery and thus become a QEP (Qualified Eligible Person) thus opening the door to a plethora of profitable strategies with limited risk, or US regulations will change regarding FX – possibly in the way in which enabled IEX to exist. Although there was FX fraud before the dodd-frank rules – there were also many legitimate Forex managers, strategies, brokers, and other participants, who just wanted to trade in this deeply liquid, important global market.
Lobbying Congress isn’t practical for even small businesses, let alone the average investor. The best start is an undertsanding of FX – how it impacts us daily, how central banks manipulate the value of the US Dollar (and all other currencies) – and what tools are available to protect our portfolios from these risks. The more people understand FX and the more investors try to protect themselves from FX risks – such as the pending Brexit situation – the more likely it is that we can have a practical, efficient FX markets regime, that works both in the US and outside of the US. It is, after all, a global market – there is no reason that – like with other things such as Kyoto protocol, the US should hold itself to a different standard. Especially considering the US is the world’s reserve FX currency. If the US FX policy is to continue – it should coincide with a policy of isolationism, whereby the US closes its borders to trade, as it was in the 19th century. If the US however, wants cheap products from Asia, and wants to be a net importer, and wants to do business with the world, there needs to be an efficient, practical, and profitable FX regime that can allow businesses to manage the US Dollar as a world reserve currency, and manage their trade with the rest of the world.
About IEX news – the FX market says congratulations. We try to make a fair exchange for FX for last years, in the United States.
First published here: http://j.mp/1UCTRab