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A crying need for Benchmarked Execution

Jun 18, 2019

A popular misconception of the FX market is that FX is highly competitive and transparent. An excellent article in the FT dispels[1]this myth with some eye-watering numbers. Quoting an upcoming research report to be published by the ECB on discriminatory pricing of OTC derivatives, a comprehensive study of trade reporting data demonstrates that the majority of FX participants pay up to 25 times more to hedge their FX exposure than the most active, sophisticated buyside firms. In essence, the banks treat a small favoured group of select clients very well, while engaging in systematic price gouging on those firms that are least able to afford to set up a dealing desk infrastructure.

The study focuses on EURUSD only, and shows that trading via a multi- dealer platform through a Request For Quote process eliminates price discrimination. Putting dealers into competition produces dramatically enhanced outcomes. One thing it does not do however is address the issue of market impact- in RFQ pricing, market impact is impounded in the price. FX Prices change (via RFQ) in anticipation of orders.

When markets are opaque it is easy for better informed participants (dealers with access to better price information) to extract information rents. The authors of the study argue that the high costs of trading (more than 50 basis points as opposed to 2 basis points) dissuades many potential participants from hedging their FX exposures. This is the socially destructive nature of rent seeking ; it leads to sub optimal decisions and a misallocation of resources.

Most companies and managers cannot afford to set up a multi-dealer trading function.

Fortunately there is an easy solution. As Duffie et al (2015)[2]note, benchmarks reduce price information asymmetry and can encourage greater participation, leading to higher volumes and more efficient markets. Benchmarking execution on an agency basis, charging a transparent spread over the NewChange FX mid-rate would enable many more participants to enter the FX market, and in aggregate would probably generate greater revenues for the FX industry, without leaving consumers with the impression they had been hard done by.

[1]Banks accused of ‘systematic’ gouging of small customers on FX- FT article 17th June 2019

[2]Benchmarks in Search Markets –Duffie, Dworzak, Haoxiang Zhu, 2015