What should be illegal on the foreign exchange markets?

(written by lawrence krubner, however indented passages are often quotes). You can contact lawrence at: lawrence@krubner.com


ON MONDAY: You are on your way to the fruit market, because you want to buy five oranges. Someone you’ve never met before accosts you on your way and says “Hey, you! Could you buy me five oranges please? I’ll give you the money when you come back and pay you ten pence for doing it”. You think what the hell, and say yes.
Down at the market, there is one stall which has five oranges for sale at 50p each, and another stall with five oranges for sale but charging 55p each. You buy ten oranges and head back home.
Your customer is waiting back at your gate. He gives you your ten pence, and asks “How much did my oranges cost?” What do you tell him?

You have three choices really.

a) Tell him “50p each” — ie, you filled his order first and then your own

b) Tell him “55p each” — ie, you bought yours first, and then his

c) Tell him “52 and a half pence” — ie, you give him the weighted average of what you managed to pick up

I’m not sure what the intution about fairness here is. In case a) you have done him a favour and are down on the deal — you paid £2.75 for your oranges when you could have got them for £2.50, and your 10p wages doesn’t cover the difference. Even in case c) you are losing money — paying £2.625 for your oranges, less 10p for an “all in” cost of oranges which is 2.5p more expensive than if you’d never met the guy. A lot of people would say case b) is perfectly fair — this guy clearly doesn’t really care all that much about how much he pays for oranges, or he would have gone to market himself rather than grabbing a complete stranger to do so. Why should you subsidise him?

Of course, I think people’s intuitions about fairness might change if your customer was paying you £10 to go to market for him, or if you had explicitly promised him that you would get him the best price possible. What we’re dealing with here is the concept of “duty of best execution”. In some markets (cash equities, and in almost any case in which you’re dealing with retail clients), there is always a presumption that a broker promises best execution to his or her clients, and these days you often need to be able to prove that you went to considerable trouble to get it. But the wholesale FX market developed in a different way — people tended to assume that it was a professionals-only marketplace, that anyone dealing in it should be presumed to be big enough to look after themselves and that competition and transparency of quotes was all the protection that clients needed. Everyone was, for the longest time, happy to let the market develop this way, for the very simple reason that best execution, as we saw in the oranges example, costs money and nobody wanted to pay it.