Trade reject codes lack clarity – BoE official

Foreign exchange dealers might not be explaining themselves properly when declining to accept a client order, according to a Bank of England official.

Minutes from the central bank’s Foreign Exchange Joint Standing Committee meeting on May 9 – first published this week – show James O’Connor, head of the BoE’s FX and money market desk, observing that the current mish-mash of so-called reject codes might not be useful to clients.

“The information provided may not, in some cases, be particularly informative,” the minutes record him saying.

A reject code is sent to a client following a rejection, but each bank has its own set. The Investment Association is pressing for the adoption of a standard set of codes, arguing it will help asset managers compare the behaviour of dealers during the controversial, milliseconds-long ‘last look’ window, which opens once a client order has been received. Dealers can refuse the trade at this point.  

Robbie Boukhoufane, global head of fixed income and FX trading at fund manager Schroders, told the meeting that a clear understanding of the reasons for the rejection is an important part of the industry’s efforts to ensure it is executing in the best possible way for end-investors.

The information “would enable market participants to make more informed decisions with regard to trade and counterparty evaluation”, the minutes show him arguing.

Other attendees agreed that, in practice, there are a relatively limited set of reasons for trade rejections; for example, because the market has moved and the dealer wants a chance to change its price, or because the client has breached its credit limits. Dealers at the meeting included Barclays, Citi, Deutsche, Goldman Sachs, HSBC and XTX Markets.

The information provided may not, in some cases, be particularly informative

James O’Connor, Bank of England

Despite this, industry sources say each dealer may currently use dozens of proprietary reject codes, making comparisons tricky for clients.

Speaking to FX Week in December 2018, Nick Wood, head of execution at hedge fund Millennium Global Investments, said the lack of clarity in reject codes was “a bit of a minefield”.

Addressing mistrust

Trust between the buy- and sell-side in foreign exchange deteriorated after several large dealer banks in the spot FX market were involved in frontrunning scandals. Controversy also erupted over dealer behaviour during the last look window, with some banks using it to pre-hedge incoming client trades – indistinguishable from frontrunning in some cases – or to selectively reject trades when the market had moved in a client’s favour prior to execution.

The Investment Association (IA), a trade body for fund managers, is set to publish a position paper that will outline 10 to 12 high-level reject code categories in a hierarchical fashion, which it proposes should be adopted consistently by execution providers.

The categories will cover rejections taking place at both the quote and the trade stage, to account for dealers who run credit checks before or after they offer a quote. Dealers will be able to supply clients with additional information on top of the high-level rejection codes if they feel it is necessary.

In a previous position paper on last look, the IA said buy-side firms are often unclear as to when individual trades have been rejected as a result of last look, and why last look was applied.

To address issues of mistrust between clients and liquidity providers in the FX market, the FX Global Code of Conduct was published in May 2017.

Principle 17 of the Code urges transparency in last-look practices as they apply to trade rejections and expects dealers to share this information with clients.

It states: “The market participant should disclose, at a minimum, explanations regarding whether, and if so how, changes to price in either direction may impact the decision to accept or reject the trade, the expected or typical period of time for making that decision and, more broadly, the purpose for using last look.”

The Code goes on to say that market participants have sole discretion over whether the client trade requests are booked and last look should not be used for purposes of information-gathering with no intention to execute.

In research published by FX Week sister site Risk.net in August, only 26% of liquidity providers were found to state explicitly in their disclosures that they do not use information from rejected trade-order requests to adjust their trading or risk management strategy. However, after further investigation, 70% of liquidity providers confirmed they do not use such information, with the rest either declining to comment or failing to respond.

End-users could start to compare the reasons for rejections across market-makers… They could do much richer analysis of whether last look rejections impact their overall trading profitability

Neill Penney, Refinitiv

But, to gain traction, a concerted industry effort will be required to drive consensual adoption of the standardised reject codes.

Stephan von Massenbach, director of FX consultant Modular FX Services, notes asset managers may not be facing dealers directly and instead go through aggregators or trading venues. As such, he believes venues should take the lead in adopting the standardised codes: “It might be an easier way to ensure common understanding of error messages.”

One such venue says action would also be required of dealers to provide “clean and consistent” reject codes, enabling venues to provide end-users with analysis around last-look rejects.

Neill Penney, managing director and co-head of trading at Refinitiv, owner of the FXall venue, argues standard codes would ultimately help buy- and sell-side traders: “End-users could start to compare the reasons for rejections across market-makers. They could look at the impact a rejection made on their slippage. They could start tying different types of rejection to movements in the market. They could do much richer analysis of whether last look rejections impact their overall trading profitability.”

He adds: “They would then be able to have more informed discussions with their counterparties about last look. Given that we should expect a balance between tightness of spread and probability of a last-look reject, counterparties might tweak the way they provide liquidity based on these discussions, aiming to better align with the end-user’s execution preferences. For example, tighter spreads with more rejects or wider spreads with fewer rejects.”

Foreign exchange analytics start-up Tradefeedr also argues richer information is needed if buy-side firms want to understand this trade-off. Instead of basic reject reports, the firm’s co-founder, Alexei Jiltsov, says buy-side firms should embrace the idea of “effective spread” – spread paid on filled orders, adjusted for both the cost of rejects and any price improvements.

“The rejection may or may not be a problem. It depends on the combination of client short-term alpha and dealer rejection strategy. The problem is a buy-side client not measuring the costs of trading at a millisecond precision against a sensible set of benchmarks. Banks and trading platforms can help by making their data available for independent analysis,” he says.

Tradefeedr’s business model envisages the firm as the provider of this analysis.