Fixing the 4pm fix

There has been a considerable amount of controversy around the 4pm FX fix. It has been a big media story. We can see in the chart above, the number of articles on Bloomberg News referring to WMR. From the chart, last summer was the starting point for much of this media coverage. Earlier this year, I published a Thalesians paper discussing the 4pm fix (link: Thalesians: Taking on risk at 4pm - Estimating cost of 4pm fix for market makers 11 Mar 2014), which was featured in the WSJ (link: WSJ: Why FX Traders Trade: A Reminder 11 Mar 2014). In particular, I attempted to quantify the risk which market makers face around the 4pm FX fix, by modelling intraday option prices and also understanding intraday volatility around 4pm.

Today, the Financial Stability Board (FSB) published their comprehensive report on foreign exchange benchmarks after a long investigation. Katie Martin's WSJ recent article (link WSJ: Basel’s Super-Regulator On FX Benchmarks (And Traders) 15 Jul 2014), offers a concise summary of the FSB's findings, which I recommend reading. Martin notes several points from the report, which I have listed below.

• The benchmark does not need to be changed significantly, which somewhat differs from the situation we had with LIBOR. 
• Banks should ensure that guidelines are followed around the fix (eg "address potential conflicts of interest arising from managing customer flow")

If we delve into the FSB's report there were several other interesting points, which tally with a lot of the findings from my paper. The FSB notes that the FX market maker faces a risk when offering to guarantee an unknown price (ie. 4pm fix) to a client. In my paper, as mentioned I attempted to quantify this risk, by modelling intraday options.

"FSB: It also creates a market where the dealer is agreeing ahead of the fixing time to execute 
at an unknown price, which is established subsequently during the fixing window as the 
clearing price which reflects the balance of those fixing transactions and other transactions 
undertaken in the calculation window. In many cases, the dealer agrees to give the client the 
mid-rate of this (as yet unknown) fix price, rather than applying a spread, whether they are 
buying or selling. Given the market structure, the dealers can be placed under strong pressure 
to try and offset the risks they face given the price commitment."

The FSB's report also presents some interesting quant results. The FSB notes that whilst FX volume is higher around the fix, as we might expect, the pick up in EUR/USD volatility is less than it is at other times of day (such as US data releases), which tallies with my earlier report (chart below). In my report I also analysed intraday volatility for other currency pairs too.

As well as making recommendations for the sell side, the FSB also make several key suggestions for asset managers. In effect, they suggest that asset managers should address their own FX execution and do their own research around the topic. This, I think, is crucial. Whenever, I have worked on FX systematic trading strategies, understanding transaction costs has been crucial and a considerable amount of my time has been spent understanding how they impact overall returns. Transaction costs are not just incorporated in the bid/ask spread, but also include slippage in execution. Obviously, I am talking my own book here, as we say in the industry, given I offer quant analysis services to clients (including transaction cost analysis). However, it does seem reasonable to expect that if investors choose not to research their own FX execution, then it is likely they will end up paying a lot more later through suboptimal execution later.

"FSB: The group recommends that asset managers, including those passively tracking an index, should conduct appropriate due diligence around their foreign exchange execution and be able to demonstrate that to their own clients if requested. Asset managers should also reflect the importance of selecting a reference rate that is consistent with the relevant use of that rate as they conduct such due diligence."

Whilst I still haven't read the FSB report yet in its entirety, what I have read so far is well worth a read. It also seems to be well balanced, acknowledging the risks which market makers face when offering the fix, which seems to have been lost in a lot of the media coverage. At the same time, it makes suggestions on how banks could better manage the execution of the fix.

Please also take the time to read my paper on 4pm FX from earlier this year.