DRS Italia SRL
Via Vincenzo Monti 8
Tel. +39 0287 38 46 00
Global trading in forex markets amounts to USD 6.6 trillion per day, with turnover in the spot forex market making up almost 30% at USD 2 trillion per day (Bank for International Settlements, April 2019). Given the significant size of the market, as well as recent high profile decisions by European regulators, the European Commission (“EC”) with the input of the European Securities and Markets Authority (“ESMA”) is currently considering a possible expansion of the Market Abuse Regulation (“MAR”) to include spot forex as a regulated financial instrument for the first time.
The MAR came into effect on 3 July 2016 with the goal of increasing market fairness and protecting investors. It prohibits market abuse, which includes insider dealing, unlawful disclosure of inside information and market manipulation. It obliges firms to put in place monitoring and surveillance requirements to track behaviour, with more stringent requirements for larger firms in order to effectively enforce the regulation.
Foreign exchange spot transactions are agreements between two parties to exchange currencies at an agreed price on the spot date. The market is geographically dispersed and decentralised, with exchanges between private parties occurring as ‘over the counter’ (“OTC”) transactions rather than over a central exchange. Parties transact with banks on the retail level, while banks transact with other banks on the wholesale level. Central banks play a critical role in ensuring the proper functioning of the market.
National regulators around the world have found misconduct in the spot forex market and have expressed the need for greater regulation of the market. In 2014, the UK Financial Conduct Authority (“FCA”) announced fines of GBP 1.1 billion (the largest fines to date) on five banks for “failing to control business practices” related to their forex operations. Notably, these fines were essentially related to their internal practices, and the actions of individual traders. Following these findings, the FCA, together with the Bank of England and HM Treasury in their 2015 Fair and Effective Markets Review stated that a new regulatory system was needed, including some of the key features of the MAR regime. This includes sanctions for abusive behaviour, record-keeping obligations for firms and obligations to report suspicious behaviour.
One of the major reasons cited in the past for not subjecting spot forex to regulatory authority, is that the market is already subject to internal banking regulations, and banks are sophisticated institutions. Additionally, unlike in the derivatives field, which entails some speculation and risk, spot transactions are a simple sale transaction at a negotiated price. In fact, according to some sources, extensive regulation in the spot forex market would prevent efficient functioning and market liquidity.
Given the findings of misconduct, however, it is clear that many banks had failed to integrate the provisions of the codes into their internal control systems.
On the other hand, in 2017, the ‘FX Working Group’, a voluntary initiative between several central banks and private sector market participants, developed the ‘FX Global Code’ to tackle many of the issues associated with a lack of regulation. This is a set of principles of good practice which market participants can voluntarily adhere to, and which aims to “promote the integrity and effective functioning of the wholesale foreign exchange market”.
According to ESMA, a significant portion of the market has signed on to these principles. The Global Index of Public Registers, which was introduced for members to publicly declare their adoption of the code, and which functions as a public accountability mechanism, currently lists 985 entries. The terms of reference for the code are reviewed on a yearly basis and are, where necessary, amended.
The code has been enthusiastically embraced by some market participants, including the European Central Bank, which has in fact made it a prerequisite for membership in its Foreign Exchange Contact Group, and stated that members that have signed on to the code will be required to demonstrate their commitment to the code in line with the terms of reference.
However, independent of the market players themselves, there is no official supervision of compliance with the code and no threat of, or imposition of sanctions for failure to adhere to the code. Additionally, findings by national regulators have shown that, conduct by just a few individuals at a small number of banks can have major consequences on the market, so it is important that rules are put in place that apply to all market players. The FX Working Group further notes that the code “does not impose legal or regulatory obligations on Market Participants, nor does it substitute for regulation, but rather it is intended to serve as a supplement to any and all local laws, rules and regulations by identifying global good practices and processes.”
In addition to the financial market abuse ramifications, spot forex is vulnerable to, and has been the subject of antitrust abuses in the past. In May 2019, the EC in two settlement decisions fined five banks EUR 1.07 billion for participating in two cartels in the spot foreign exchange market for eleven currencies, indicating an important link between market abuse and antitrust rules.
An inclusion of spot forex contracts in the MAR would regulate the types of activities, including the exchange of sensitive information and trading plans, and the coordination of trading plans which the EC declared an infringement of competition law in its decision.
The findings of misconduct in multiple jurisdictions around the world show that greater regulation is needed for the protection of investors. The MAR is a robust system that already regulates a significant number of related financial instruments, so on a European level, the inclusion of spot forex contracts is a feasible option. However, the nature of spot forex also creates some issues. The size and informal nature of the market poses major costs to market participants and national regulators in terms of monitoring.
Further, the global nature of the market, with forex trading occurring between different currencies and jurisdictions, also raises questions about where regulatory authority would lie. The most effective approach would likely be a global system. Without this, there is a risk of fragmentation, with market participants moving to more favourable jurisdictions, resulting perhaps in a regulatory race to the bottom and as a result worse conditions for investors.