Once upon a time, the fixed income, currencies, and commodities (FICC) business model was considered rather innocuous from a compliance risk management perspective. Many arguments and defenses were made by the industry, its regulators, and other governmental bodies (e.g., the Federal Reserve Board), that the FICC markets were too deep, too big, and too dominated by sophisticated sell-side and buy-side gorillas to be abused or manipulated.
Then, one by one, the dominoes started to fall in the cash markets for rates and credit, in OTC derivatives (swaps), in benchmarking across all markets (including commodities), and now -- I'm shocked (think Casablanca casino scene) -- in the FX market.
The ramifications of the alleged improprieties in the FX spot market, by far the largest financial market, with an estimated daily volume of $5.3 trillion, might lead to cataclysmic events. Through the looking glass of the likely outcome -- the damages that could be awarded in class action and individual litigations involving direct and indirect market participants, as well as the financial fines and damages that will be doled out by regulators and enforcement agencies globally -- things could get brutal.
So, exactly where were the failures that led to this debacle? Well, if you don't have any speed traps, you would be delusional at best in believing that the market will take care of itself. The past arguments may have taken the point of view: "Aren't FX regulatory radars unnecessary and/or redundant when the regulated themselves have implemented robust and effective self-regulatory checks and balances?" Does this sound familiar? It should. Wasn't this the same argument for OTC derivatives and, in particular, swaps?
One very obvious and huge control gap that emerged: Where were the dealers' bells and whistles that would have alerted them to the tacit collusion trail of bread crumbs discovered by regulators? At least anecdotally, this complacency and false sense of security also may have led to minimal capital spend and compliance/systems infrastructure development for FX compliance risk controls across the industry. Well, that was then, and this is now.
Fortunately, there is now very discernible momentum among dealers to conduct risk assessments of their FX business models and to respond quickly to weaknesses and gaps within their control infrastructure. This movement was galvanized, as expected, by recent FX market headlines like "Forex probes set to dwarf Libor cases" (registration required).
The industry will confront many challenges as it responds to this paradigm shift. One thing that sets the FX market apart from other markets is that it is a 24x6 market with global trading desks at the enterprise level. That is a very compelling reason to have the right-sized controls at the holistic level across the enterprise. If you try to manage a global business model at the decentralized local level, you are doomed to failure.
The holistic model requires two levels of compliance controls. One goes to trade analytics, and the other goes to communications surveillance. These levels must be integrated and not siloed. This integration results in a more efficient and effective control framework for a few reasons, most notably in connecting the dots as part of identifying and analyzing risk. That being said, don't underestimate the difficulty of creating or finding the right size commercial technology for capturing and monitoring all communication channels (voice, interactive media, chat, etc.) and of integrating the results with the enterprise's trade analytics.
Evidence of the dangers of siloed risk management is in great abundance. Look no further than the various multibillon-dollar rogue trader losses of recent years. Compliance trade analytics should incorporate risk data from areas outside of compliance (market risk, operational risk, credit risk, etc.) where it would add value. Since compliance is morphing into a risk management function, I would not think it unreasonable if compliance risk controls were pushed down to the business units themselves as the owners of that risk. And over time, real-time (as opposed to batch) controls may prove to be the rule, rather than the exception.
The allegations regarding FX benchmark manipulation may lead to the identification of other improprieties in the FX markets. The issues identified thus far were discovered largely via the review of communications, as opposed to trade/market reconstruction and analysis. There may very well be other market abuses/manipulations and fraudulent (e.g., macro event insider trading) activities in the FX market. In other words, the benchmark manipulation may by just the tip of this iceberg.
Avoid unintended consequences
Lastly, FX is a complex and complicated market. The alleged untoward dealer activities were in the spot market segment. The spot market is indeed significant in size but makes up only approximately 38% of the FX market. What other types of compliance issues and risk have not surfaced relating to the other 62% of the pie? Are an organization's risk assessments contemplating the other slices rolling up to the 62%? Will the risk controls connect the dots across products and markets for the stakeholder? There are obviously a lot of questions to be asked and answered.
Over time, I fully anticipate that global regulators -- if not in harmony, than at least individually -- will introduce rules and regulations. That scenario will have a very significant impact on the full FX market structure. Though it may indeed pale in comparison to what evolved after the recent financial crisis (e.g., Dodd-Frank), it will in all likelihood have a very profound impact on the market and compliance risk management accountability and responsibility.
There are no doubt certain idiosyncrasies between the FX markets and all other financial markets. One would only hope that the regulators will be thoughtful in their rule adoption and related undertakings and take a methodical, unintended consequence approach in their analysis. The dealers, in turn, will need to have a compliance system/platform that is responsive to any structural and regulatory changes from the perspective of flexibility and adaptability, and which can be recalibrated with ease as the compliance risk stakeholders move up the learning curve.Stephen Anikewich is Head of US Compliance for NICE Actimize and responsible for business development of the institutional risk platform. He provides consulting support to help Actimize clients meet their compliance and business needs. He is an expert in the Capital Markets ... View Full Bio