# Oranges and lemons – fairness intuitions and “best execution”

by on November 13, 2014

I’m just in the middle of writing an article on the technicalities of the foreign exchange market, and what went wrong, and this example came up. I think the fair solution is pretty intuitive, but maybe others will differ. Presume below that this is a one-time interaction, so nothing to do with reputations, repeat business etc.

“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 I’ll pay you ten pence for doing it”. You think what the hell, and say yes. You ask what’s the maximum he’s prepared to pay for them and he says “Don’t care – whatever the market price is”.

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 five oranges from each stall 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 (I’d be interested to know if anyone could justify any other price).

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

In case a) your good turn has cost you a pretty penny – you paid Â£2.75 for your oranges when you could have got them for Â£2.50, and your 10p wages doesn’t cover the difference. Even in case c) you are down on the deal – paying Â£2.625 for your oranges, less 10p for an “all in” cost of oranges of Â£2.525 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. It’s also the point at which your profit from the overall transaction (10p) equals the wage that he said he would pay you.

Why should you subsidise him? But on the other hand, isn’t there something a bit hinky about deciding that all the best-priced oranges were for you, and all the worst deals were for your client?

Of course, I think people’s intuitions about fairness might change if your customer was paying you Â£10 to go to market for him, or if you had explicitly promised him that you would get him the best price possible. But in the simplest case (and this does match up pretty well to the actual structure and pricing of the FX market), I think it’s not obvious at all that the most intuitive concept of fair dealing corresponds at all to the regulatory concept of “duty of best execution”. Anyway, what do you think?

Update the longer post is now up.

1

maidhc 11.13.14 at 6:52 am

There’s a similar question that was much discussed in the days of the British Raj. Food vendors in the marketplace would charge more to British buyers than to Indian buyers. So the British would send their Indian servants down to the marketplace to purchase food at a lower price. It was customary for the servants to add a surcharge to these purchases so that the British ended up paying more than the Indian price but less than the British price. Some of the British would get quite incensed about this even though they were still paying less than if they had bought it themselves.

2

john c. halasz 11.13.14 at 7:14 am

There’s a notional quadrillion dollars being swapped on the FX market per annum. Total global GDP is maybe \$70 trn. The actually trade in “goods and services” might be 30% of that. Who’s to say what’s fair? But I’d tend to say that this is a case of “coin clipping”.

3

Daniel 11.13.14 at 7:26 am

No, that’s just an artifact of how the statistics are calculated. GDP (correctly because it is a value added concept) cancels out intermediate transactions. FX turnover doesn’t. Since clients often place orders which are larger than a single dealer’s inventory capacity, orders tend to get bounced around and split up in interdealer trades on their way to finding end-users with the opposite desire for currency.

I’ve often noted that if tomatoes were accounted for in the same way as FX turnover, then you would find that as a crop went from farmer to wholesaler to processor to wholesaler to retailer to customer, it would turn out that five times as many tomatoes were sold as were grown.

4

ZM 11.13.14 at 7:28 am

I can only presume the character getting 10 pence is a child and the one sending them on the errand is an eccentric benevolent adult who thinks the kid would like 10 pence for running an errand.

If adult1 accosted another adult2 and asked them to go to the farmer’s market or Saturday market to pick them up oranges for 10 pence it is most likely adult1 would take offence.

The only exceptions for this would be something like maybe adult2 was elderly and had a walking stick and was breathless trying to walk to the market, so adult1 was happy to do them a favour; or perhaps they were friendly neighbours and adult2 was busy looking after small children or baking a cake and so adult1 would be happy to do the favour in this case too. Or perhaps this is adult2’s way of striking up a friendship?

Otherwise in present day Australia it is not at all customary or polite for an adult to accost another adult who is a stranger and ask them to pick up some oranges at the market for you for 10 pence (cents).

It is quiet a Dickens sort of situation.

So perhaps the character should choose the benevolent option a. and then the stranger will leave them a great inheritance or some such Dickensian thing.

Unless it is a sad Dickens story, then the character will choose a. and this lost 25 pence will have ripple on effects and lead to the character’s most sorrowful death.

5

Marcos 11.13.14 at 7:32 am

If after buying the 10 oranges there are no longer any 55p oranges left, and the next stall is selling at 57p.
More than a few people would argue they can come back to the the customer and say: The price is 57p.
Which I guess would mean that I bought mine, I bought his, and I charged what he would need to pay if he refused to honor the deal and had to come to the market himself. This includes him thinking I’m a profiteering thief and deciding that he’d rather pay more at the market. That is if he had perfect information.

6

david 11.13.14 at 7:38 am

In this case it seems that fairness is suitably achieved by informing the client of the full process as chronologically occurred, i.e., that you bought ten oranges starting with the cheapest, and then filled the orders as you received them, including orders from yourself.

A more difficult question is if, upon receiving the order from the client to buy, you were inspired to acquire oranges yourself.

7

Tony 11.13.14 at 7:41 am

The problem here is that by being in the same market you are potentially in competition with the client. If you disclose this you can then agree on responses to certain market factors. For example there might have only been five oranges left at the market…

8

Daniel 11.13.14 at 7:43 am

On the technicalities, I commented here and here when the scandal first blew up.

9

Chris 11.13.14 at 7:45 am

Your order was already in place, so gets executed first. Had you decided to get oranges as a result of your client’s order, it would go second.

10

john c. halasz 11.13.14 at 7:53 am

@3:

Potatoes/tomatoes. But what is the “value-added” from all those FX swaps?

11

david 11.13.14 at 7:54 am

The ability to buy/sell things in a foreign economy that uses said FX…?

12

ZM 11.13.14 at 7:59 am

“@3:

Potatoes/tomatoes. But what is the â€œvalue-addedâ€ from all those FX swaps?”

My understanding is this is how trading cities like the city of London or Hong Kong make their money.

13

Zamfir 11.13.14 at 8:16 am

One vote for Chris @8

14

dsquared 11.13.14 at 8:51 am

“what is the â€œvalue-addedâ€ from all those FX swaps?”

They make it possible to carry out an international transaction without having to wait for someone with exactly the opposite foreign exchange order. Same as any other middleman or clearing house really.

15

dsquared 11.13.14 at 8:58 am

Chris’ number 8 is a good point but wouldn’t pass muster with any regulator. I don’t have any orders (in the sense which matters for order priority) until I get to the market; if I saw oranges quoted at Â£2.50 I would probably change my mind as far as my own account was concerned. But it is a good point.

16

gianni 11.13.14 at 9:21 am

Choice b seems obvious as it preserves the spirit of the initial agreement – you end the transaction up 10 pence while they have their fruit, and they are indiscriminate regarding price so should have no complaint.

This approach breaks down, however, if you are buying a large amount of oranges, such that the price really starts to spike as a result of your action. In this case, where you plan on buying in high volume and thus can count on causing a price rise before you even reach the market, I would say the fair approach is to give this person the before price, not the after price. The problem of course is that I can’t specify a threshold where the first course of action changes to the second.

17

J Thomas 11.13.14 at 9:50 am

#3 Daniel

Iâ€™ve often noted that if tomatoes were accounted for in the same way as FX turnover, then you would find that as a crop went from farmer to wholesaler to processor to wholesaler to retailer to customer, it would turn out that five times as many tomatoes were sold as were grown.

Or how about a gold coin? It might be bought and sold thousands of times before somebody finally consumes it.

Or a Google share. Nobody will ever consume it, it will just get traded around until Google goes out of business. It could get traded a thousand times a year. There’s no value-added, but presumably each time it gets traded both sides feel they are better off or they wouldn’t do it.

It’s early morning for me and I’m not sure I’m making sense, but I just thought of a metaphor which is bound to be useful to somebody even if it doesn’t fit here.

When water flows in a long pipe to your bathroom sink, there’s a whole lot of momentum. Not just the water which comes out but all along the pipe. When you turn off the tap, the motion suddenly stops. That would cause “water hammer”, an unpleasant crashing sound, except that the plumbers put in a closed dead-end pipe that goes higher than the sink with the top part full of air. The momentum is used to compress that air, and then the water in that pipe falls to its previous level.

So that’s a structure which is designed to create extra unnecessary movement of water, which gets cancelled out, only to assist with sudden changes in velocity. If the sudden changes didn’t bother us, it would be a waste.

18

Brett Bellmore 11.13.14 at 10:34 am

” But on the other hand, isnâ€™t there something a bit hinky about deciding that all the best-priced oranges were for you, and all the worst deals were for your client?”

Nah. You didn’t go looking for a “client”, you’re doing them a favor even running their errand, and they already said they don’t care about the price.

Now, if it was somebody I already knew, I might average the price. Or if I had been carrying a sign saying I’d buy oranges for people. But not for a stranger who accosted me on the street.

19

J Thomas 11.13.14 at 11:48 am

I think in the case of the oranges, it’s OK to charge him 55 cents each and add the 10 cents he offered to pay you. He said he didn’t care about the price.

It’s even sort of OK to buy 60 cent oranges from a pretty woman you want to chat up, when that’s closer to the average price. You went for the cheapest oranges there, but he might very well prefer better quality than that.

But it’s a different thing if you go into business running errands for people. If you’re doing it regularly, and you won’t run the errand unless they tell you they don’t care how much it costs, that’s edging into something a little bit shady, isn’t it?

If you buy the cheapest oranges for yourself when you don’t even want oranges, because you intend to resell them at a higher price to your customers on top of the fee you charge?

I can imagine justifications. “I’ll buy these cheap oranges today and store them in my room, and then when somebody wants oranges they can get them quicker than if I had to go all the way to the market. I deserve a profit for the service I do them, and also for the risk I’m taking that nobody will want them.”

If you’re good at predicting when the price of oranges will go up, so you buy them cheap — driving the price up a little early — and then you sell your cheap oranges at the going price when they’re high…. Your customers don’t mind, they told you they didn’t care what price they paid. If you have the skill to do this why shouldn’t you get paid for it? They don’t pay any more than they’d pay if you went to the market that day and bought them fresh oranges.

But at some point it’s definitely shady. Somewhere this side of padding the bill to cover the risks you take to provide them a service they didn’t ask for.

20

Daniel 11.13.14 at 11:54 am

I think JT #19 is about right. There is a right and wrong here, and I am very much in favour of condign punishment for people who rip their clients off (as I used to say when I was in the market, if nothing else, it frees up market share for honest people like me). But the FX case, unlike the LIBOR or CDO cases, really does seem to me like an episode where basically defensible market practices kind of drifted, rather than one where people just took the system for what it was worth. If nothing else, the clients really didn’t give any sign that they disapproved of the trading practices going on – they just wanted cheaper and cheaper execution.

Anyway, the piece is up now https://medium.com/bull-market/oranges-and-lemons-the-fx-scandal-in-perspective-cd3456089ce4

21

Trader Joe 11.13.14 at 12:46 pm

A very good article that makes a complex situation digestible.

The real case, of course, is far more complex. Firms that execute FX transactions on behalf of the customers donâ€™t really think of most of those customers as anonymous people they meet on the street.

To follow the analogy through, if I know a guy thatâ€™s addicted to oranges and is gonna need 5 of them pretty much every day and even better a guy that might both buy and sell them sometimes â€“ the proprietary interest the dealer has is only partly tied up in todayâ€™s specific transaction, but also in the flow of business the guy represents. When you think about getting 10p on a transaction even at the 55p price itâ€™s a 3.6% commission for execution â€“ thatâ€™s high. At 1p, its 0.36% which is miniscule and most people wouldn’t do it unless they knew it would lead to future transactions.

In a perfect world the broker would say look, give me 3 pounds a year (or some other negotiated rate) and Iâ€™ll buy or sell any orange you want and youâ€™ll always get daily closing price â€“ thatâ€™s a transaction that the dealer can price and hedge. Instead, no one will make such a deal, so the risk mitigations (as mainly described in the longer piece) are likely to occur.

Where risk mitigation crosses the line into unfair dealing is difficult because the one thing thatâ€™s never defined in any of the transactions, at whatever price, is what value does the buying service bring to the customer. In the analogy, at a minimum, it saves the customer the walk to the market and the dealer brings to bear his business relationships with the various orange dealers, not least his brother. The customer doesnâ€™t have any of these, nor does he seem that willing to pay for these on a direct basis.

It seems the dealer should have some opportunity to be compensated for his value added, which is clearly worth more than 1p. At a commission of 0.36%, the dealer isnâ€™t being compensated for his value added let alone his risk and should have some leeway. At 3.6%, the opposite is probably true.

In the real world (not oranges), very often a broker dealer is placing FX transactions that save or hedge the customer against millions of dollars of currency risk and is doing this for a few hundred dollars a deal. Its not an unprofitable desk at most firms, but the transactional part of the business (as differentiated from prop trading) isnâ€™t exactly the most lucrative business. If it wasnâ€™t for the likelihood that the customers were also producing revenues in other parts of the firm (issuance, equity, banking etc.) most FX desks wouldnâ€™t be selling their services for 1p on the orange.

22

TM 11.13.14 at 7:16 pm

The example is too contrived to shed light on any real world economic situation. Why would anybody waste time with games like that?

23

Joshua W. Burton 11.13.14 at 7:17 pm

I was taught too early to remember, and my children have known from about age four, that it is execrably rude to serve yourself “on the way” when someone at table asks you to pass the gravy. The gravy boat may have been right in front of you; you may have been on the very point of silently reaching for it yourself; you may even pretend not to hear the request over the dinner hubbub and thereby serve yourself first, if you think you can get away with it deniably — and, if you are caught, this last is a much lesser sin than offering help and jumping queue.

Common decency creates a presumption that those who serve, either for good fellowship or for consideration, put themselves behind the person they are serving for the duration of the service. That mutex is held for the full duration of the transaction, first nod to last handshake, and anyone who feels differently should eat in the kitchen, trade his own account, or find a job where someone better reared can handle the customer-facing end.

In the practical situation offered, the business mistake was accepting the job at an unprofitable price of 10p. If I was experienced enough to know that a 25p spread on the trade was an unusual worst case, this might have been a calculated business cost, rather than a business mistake.

24

mpowell 11.13.14 at 7:33 pm

Joshua @ 23: Okay, so everyone who knew better than to make that business mistake quietly stepped out of the FX business over 25 years ago and the people who are left were those willing to do it for 10P or less? I don’t know how you go from asserting that something that is rude at your dinner table is also illegal. That’s not an argument.

25

Joshua W. Burton 11.13.14 at 7:47 pm

Thatâ€™s not an argument.

The OP offered as an explicit proviso “nothing to do with reputations, repeat business etc.”, so there’s not going to be enough of the problem in scope to frame an argument. At best, we can lay out a moral principle here; the argument, to be made after repeat business, is that businesses falling short of their customers’ moral intuitions do not prosper except by opacity, and that opacity in market making is generally bad.

I had a one-time business interaction with a fellow in rural Alaska a few years ago; his assistant screwed up an air shipment, making it right cost him about four times what I’d paid him at the dock the previous week, and the chance I’d ever see him again was slim. One phone call, no hassles — he ate the courier fees, and we ate our salmon. I’m delighted to pass along a recommendation, if you have relevant travel plans.

26

Trader Joe 11.13.14 at 7:59 pm

jwb @23 & 25
Did you read the full article? The issue is not at all opacity. Indeed opacity has very little to do with it when customers ask for a particular, specific clearing price that is published in a daily newspaper. The question becomes what legitimate ways of trading are available to the agent/dealer to satisfy that price when the fee specific to trading is slender at best.

At your dinner table if there was only one dinner roll left and your guest asked for it, you are right, you should deliver it and not take it for yourself.

If however, there were a mountain of rolls sitting between you , and your guest said he didn’t care whether he received the biggest or smallest or any other one, he just wanted a dang roll, would you be obliged to find him the best most perfect one anyway, or would it be ok to flip him the one nearest to hand and then spend several minutes silently scoping out one you’d like to keep for yourself.

27

Billikin 11.13.14 at 8:28 pm

The Kantian solution is c), take the average. Universalization means not asking whose oranges and saying one person’s oranges were more expensive than another’s. (Unless there is a difference in quality.)

But there is another option, as david @ 6 points out. Tell the guy what happened. One problem with that is that then the guy may claim that his oranges are the cheaper ones. The thing is, OC, that there is no such thing as “the market price” in this case. There are two market prices.

28

Collin Street 11.13.14 at 8:48 pm

> The thing is, OC, that there is no such thing as â€œthe market priceâ€ in this case.

Market clears at 55, surely. Supply-demand curves [well, points] and all.

29

Joshua W. Burton 11.13.14 at 8:59 pm

flip him the one nearest to hand

Oh,dear. Paging P. G. Wodehouse . . . .

Opacity is very much of the essence when newspapers come out only once a day (and screen updates come only ten times a second): the dealer is closer to the fruit market than the client, so (if the market is poorly regulated) he can do things that he ought not to do — the ethical question the OP invited and I engaged with a dinner homily — and furthermore will not succeed in doing in a regulated, transparent market. The ethical question becomes a practical business question when Daniel fully discloses his sharp trade to the stranger, and the stranger pays Daniel’s competitor a fair price to fetch him fair apples tomorrow.

To pinpoint the spot where the OP reasoning went off the rails, Daniel writes:

Itâ€™s also the point at which your profit from the overall transaction (10p) equals the wage that he said he would pay you.

Only in corrupt markets that have captured their regulators is “cost-plus” billing considered as a (false) standard of fairness. In free markets what the customer pays you has no relationship to any assured profit you may think you are due; you eat your own business costs, or get out of the business.

30

Trader Joe 11.13.14 at 9:14 pm

@29
Wodehouse is a joy, to be sure.

The line you pinpoint takes solely the side of the customer. I’d have pointed to this line “You ask whatâ€™s the maximum heâ€™s prepared to pay for them and he says â€œDonâ€™t care â€“ whatever the market price isâ€.

To me, the ‘Don’t care’ implies the same lack of price sensitivity as my question to you about which dinner roll should be proffered….which is to say, the customer cares first and foremost about having – alternatively – 5 oranges, a dinner roll, or a properly hedged FX transaction. What they do not care about is 1) whether that costs 50p or 55p 2) whether its the largest roll in the stack or at what price or spread the FX transaction was struck.

Had the agent not asked after price sensitivity there would have been a quite strong case for 50p as the only price which should be charged (i.e. best possible fill)…since he did, its apparent that the customer cares most about execution and least about price, leaving the agent some leeway to judge a fair price.

Suppose the agent had 5 oranges in his pocket and said – I happen to have some right here and I want 55p for them….would he be obliged to seek out the man and give him back 25p when he arrived at the market and learned he hadn’t given him the best market price? Would it have mattered if he had bought the oranges the day before at 60p and willingly sold them at loss with the hope he could replace them yet better? What if he had bought them the day before at 40p? These are all the things the trader actually thinks about in clearing a trade – he rarely thinks for one second about the 1p or 10p or anyother immaterial spread he gets for execution.

31

Joshua W. Burton 11.13.14 at 9:15 pm

Billikin @27: The Kantian solution is c), take the average.

Only if you are also flipping a coin to see who shops and who pays the convenience fee. Trade inherently creates an asymmetric relationship between providers of service and holders of liquidity: both have an obligation to give good value, but for the buyer this is fully satisfied by honest coin of the realm. Good value from the service provider is good service.

In my experience, financial service providers (at least at the retail level) understand this about as well as cashiers and blue-collar tradespeople. It’s professional services (medicine, law, architecture) where I have sometimes encountered the repugnantly antidemocratic notion that relative wealth has some bearing on who waits for (and, implicitly, upon) whom. But postings like this one make me wonder whether, at more rarefied levels, securities dealers are similarly confused. If so, it is our common duty as citizens and potential customers to set them straight.

32

Joshua W. Burton 11.13.14 at 9:35 pm

Had the agent not asked after price sensitivity there would have been a quite strong case for 50p as the only price which should be charged (i.e. best possible fill)â€¦since he did, its apparent that the customer cares most about execution and least about price, leaving the agent some leeway to judge a fair price.

No quarrel here — in fact, I learned a lot of things I hadn’t known from Flash Boys about the many baroque order types that are available at the pointy end where microseconds matter (and, also, why IEX doesn’t offer them). People who ask for that, should get it. My stand begins and ends where — as, for example, at the retail level where I trade — â€œDonâ€™t care â€“ whatever the market price isâ€ can be clearly interpreted as a market order. The “is” in that sentence pinpoints an instant of time if uttered directly to a seller; if uttered to an agent, it locks a mutex for the duration of the fiduciary relationship they have undertaken with me.

If the market moves while you’re getting my trade in (using whatever diligence you led me to expect to get there promptly), that’s my risk. But if your own trades move the market, that’s your risk, because you (ought to have) stopped working on your own behalf relative to me at the instant you took my order, and started again at the instant you discharged it.

33

Joshua W. Burton 11.13.14 at 9:44 pm

Suppose the agent had 5 oranges in his pocket and said â€“ I happen to have some right here and I want 55p for themâ€¦.would he be obliged […] ?

Of course not. “Sell me oranges” is trade. “Buy me oranges” is service. Only the latter creates an asymmetric fiduciary obligation beyond the laws against fraud.

34

Trader Joe 11.13.14 at 9:50 pm

@32
Fair enough and I agree, agency is different than transactions.

The difficulty can be that “at the market price” while sometimes a very obvious and literal observation, as it is in many simplistic examples, is also sometimes like asking what color is blue. We can agree on a range of things that are fairly described as blue, but might differ as to which shade of blue is “truest.”

35

Joshua W. Burton 11.13.14 at 9:54 pm

We can agree on a range of things that are fairly described as blue, but might differ as to which shade of blue is â€œtruest.â€

Sure, with other people. But if you compete with me, while acting as an agent on my behalf, I am blue and you are untrue.

36

J Thomas 11.14.14 at 1:43 am

“Suppose the agent had 5 oranges in his pocket and said â€“ I happen to have some right here and I want 55p for themâ€¦.would he be obliged […] ?”

Of course not. â€œSell me orangesâ€ is trade. â€œBuy me orangesâ€ is service. Only the latter creates an asymmetric fiduciary obligation beyond the laws against fraud.

So, you want 5 carloads of oranges on January 5. I sell you an option for that. January 5th you decide you do want your oranges at that price and you expect me to deliver them.

If I have them on hand then it’s a sale. If I don’t have them and I have to buy them for you, is it a service?

I’m not sure we can draw clear distinct lines. The markets have had centuries to find profitable ways to blur the lines.

37

Daniel 11.14.14 at 2:01 am

Because I come from an equities background, where best execution is a fundamental principle, I can see where Joshua is coming from. But the FX market really doesn’t work on the basis of a duty of best execution and Joshua’s first comment tells you why – if you want to be treated with the same solicitousness as a guest at the dinner table, you need to be paying proper commissions.

In the wholesale FX market, the convention has always been that it is an inter-dealer market in which everyone is a professional, and everyone is responsible for monitoring their own execution, which is why it supports such incredibly low dealing costs. A lot of what went wrong is that people who had this responsibility tried to shirk it, while still wanting pricing that only made sense if they hadn’t.

There is and was absolutely no fiduciary responsibility – clients in the market were regularly polled on whether they thought that the FX market should have a duty of best execution and they always said no.

38

John Quiggin 11.14.14 at 2:03 am

Isn’t the core problem that there is an inherent conflict of interest when agents/brokers act as traders on their own account?

39

Daniel 11.14.14 at 2:03 am

But if you compete with me, while acting as an agent on my behalf, I am blue and you are untrue.

This sounds like it might make sense, but actually it would make the wholesale FX market as it is currently structured (in which all the dealers are market makers) totally impossible to exist at all.

40

Daniel 11.14.14 at 2:10 am

#38: yes there is! But this is, to an amazing extent, the cheapest way to structure the market. The big question has always been to what extent the conflict of interest should be regulated, and to what extent it should simply be dealt with by the fact that the FX market is amazingly competitive and incredibly transparent (to make my analogy accurate as regards clients dealing at the WM fix, the client really ought to be surrounded by a dozen video screens all showing “ORANGES MARKET PRICE” which he can’t be bothered to look at).

Obviously that’s a tradeoff that needs to be dealt with on a case by case basis – the FX market had always operated on the basis that everyone was a big boy and could look after themself. A lot of what seems to have gone on in the FX scandal (which as I say in the Medium piece, has a lot less systematic dishonesty in it than LIBOR, although obviously not none at all – but it’s interesting that some banks like Deutsche Bank have actually been totally cleared) is that the regulators have moved the bar in terms of the fiduciary duty of agents to principals, giving clients a degree of regulatory protection when in the past it had been assumed that they would expend monitoring effort themselves.

41

tgh 11.14.14 at 10:17 am

AFAIK this does story doesn’t actually represent what happened on the FX market. It should be: You are one of the big orange merchants. A guy tells you to buy 5 oranges at the orange auction which will take place in 15 minutes. You then go to the auction, share notes with the other big merchants, see that you can buy a few oranges now at a lower price, arrange for the auction to be a higher price, and charge the guy the higher price. The “arrange” in fact is always dubious, because maybe there will be a merchant you don’t know about who comes in and stuffs the market at the auction, but that is life…

Traders are caught between a rock and a hard place in terms of fixings. They are supposed not to distort the market at a fixing. In this case they need to know whether their counterpart will be facing them. (If you’re buying 40% of the expected volume at a fixing because you have an expiring derivative, then you will move the market unless the counerpart will be selling the opposite 40%.) But knowing what your counterpart is doing (or contacting them beforehand) can be construed as collusion. It isn’t now, but post hoc apparently the rules may change.

The regulators are being coy. Compliance is being coy. The lawyers are being coy. Most traders aren’t looking to make a buck on fixings; they just want to stay out of jail. But the word is: “You are responsible for what you do, not your boss, not your bank, not the regulators. On the other hand, the law is not clear. Tough luck.”

42

ZM 11.14.14 at 10:40 am

“There is and was absolutely no fiduciary responsibility â€“ clients in the market were regularly polled on whether they thought that the FX market should have a duty of best execution and they always said no.”

I have never heard of polling as being a mechanism to establish fiduciary trust – it is a legal matter.

Your suggestion would be like gangsters polling themselves and their clients as to whether gangsters should have to be law-abiding and the answer being no.

This would not then mean the gangsters did not have to abide by the law because laws are not made by gangster polls.

43

Collin Street 11.14.14 at 11:03 am

Isnâ€™t the core problem that there is an inherent conflict of interest when agents/brokers act as traders on their own account?

I thought so too at first, but after I sketched it out the tensions when you’re buying oranges for two people [who gets the cheap ones] remain the same, I think.

apropos of nothing:

We can agree on a range of things that are fairly described as blue, but might differ as to which shade of blue is â€œtruest.â€

Oddly enough… colour processing is largely done by dedicated neural circuitry, so it’s pretty uniform between people.
http://en.wikipedia.org/wiki/Opponent_process

Bluest blue is more in the cyan range, although darker than printer’s cyan. Zenith-sky-in-summer, sort of area.

44

Trader Joe 11.14.14 at 12:47 pm

@37 daniel
You touch on a significant point – most people’s frame of reference is the equities market where (on most mature markets) there is continuous pricing, often on multiple exchanges and the market generally has a degree of depth that makes it significantly more difficult to influence “market prices ” (whatever they migth be defined as) on a recurring and repetitive basis.

Fixing markets are inherently different and the structure of the market itself and the fact that its primarily comoditized products that are sold on such markets create their own trading norms. Its also important, as you mention, that this isn’t widows and orphans pension funds that are involved in the trade – its all professional traders – i.e. the guys that main street loves to hate are on both sides of the trade and suddently there’s sympathy for the guy who paid 5p too much for his oragne.

Equally, no one asks for an orange and gets shown a tangerine because they’re too stupid to know the difference – an orange is an orange is an orange, none are bruised, none are sour, they are all the same, all the time every day. So unlike the OP analogy where one merchant might be inclined to sell his oranges for less because of their inherent quality, that’s never the case in these markets.

Its a repetitive daily game and everyone playing it understands the rules. Just like on the football pitch, some are better at than others, some are less scrupulous than others, but the rules are known. Outsiders might not understand the rules and they might no like the rules, but then they aren’t the ones playing the game. Mandate a new rule and its as sure as oranges cost 50p that someone will find a way to game that rule too….maybe the new rule will have unintended consequences, maybe not, but there’s few bright lines that can’t be colored gray (or blue).

@43 Collin
I’m sure you are correct, but when I go to the paint store with my wife and we’re confronted with about 60 of those little strips that all have 5 shades on them – I can promise you there is plenty of room for disagreement about which one represents the “true” blue that we want on the dining room wall.

45

Barry 11.14.14 at 12:56 pm

Daniel: “…has a lot less systematic dishonesty in it than LIBOR, although obviously not none at all â€“ but itâ€™s interesting that some banks like Deutsche Bank have actually been totally cleared) ”

I don’t know how it works elsewhere, but in the USA actually holding megabanks to the law is rare, and major bank executives hold the higher offices in the Treasury.

It ‘s about like pointing out that Al Capone was never convicted of any crime by the city of Chicago.

46

TM 11.14.14 at 3:41 pm

I’m genuinely curious: why come up with a contrived example that bears no meaningful relation with the situation you would actually like to analyze, rather than just talk about the situation you would like to analyze? FX markets clearly don’t function by people asking strangers on the street to run an errand fro them.

Contrived economics examples are a terrible habit. They always lead to bad thinking and bad science. I’d blame a lot of the mushy thinking prevalent in the discipline on the habit to think in contrived examples.

47

ckc (not kc) 11.14.14 at 8:18 pm

…a contrived example

I thought so, too, until read the longer essay (linked in the Update above – the analogy makes much more sense in that context.

48

Greg 11.14.14 at 10:07 pm

The uniqueness of the transaction is a red herring. The important things are the general practice of the buyer and seller of orange-buying services, ‘the customer’ and ‘you’.

If you are known as a person who will buy oranges on behalf of other people for a consideration, you are in trade. In which case, Western custom and law is that the interests of your client come before your own.

This is moderated very occasionally by the doctrine of the expert client. If the customer habitually uses the services of orange-buyers, and can be expected to know in detail the operation of the orange market and the effect that their order will have, while you are inexperienced in such matters (you’ve just hung out your shingle), the customer could be expected to bear some of the risk and loss. This is an edge case, however.

If neither of you are in trade, then again Western customs are that you refuse payment and share the oranges equally.

49

TM 11.14.14 at 10:33 pm

47: The analogy between a guy on the street doing a stranger a favor and professional high-finance traders makes no sense whatsoever and I can’t fathom why anybody would want to pretend otherwise.

50

J Thomas 11.14.14 at 10:50 pm

#49 TM

The analogy between a guy on the street doing a stranger a favor and professional high-finance traders makes no sense whatsoever and I canâ€™t fathom why anybody would want to pretend otherwise.

They’re trying to create a sense of what’s fair.

When it’s expert traders and expert customers who have long-standing relationships, then the result of any one small transaction is likely to come out in the wash. It’s hard for any outsider to be at all sure what the relationship is. Transaction costs might get padded consistently, and then one piece of revealed information per year could be worth far, far more than that.

So he wants a situation which has some of the same qualities, where the extra, maybe-secret parts are left out. A random stranger does a single transaction with you, and then it’s done. What’s the fair price then? If we get an idea what the issues are for that case, then maybe we can start adding complications that make it more like actual traders.

51

Daniel 11.15.14 at 1:09 am

Iâ€™m genuinely curious: why come up with a contrived example that bears no meaningful relation with the situation you would actually like to analyze, rather than just talk about the situation you would like to analyze?

Because I wanted to explain the concept of “duty of best execution” without bringing in a load of industry jargon that would put people off, and show that DBE is always a market and regulatory convention, not a fundamental or common law concept intrinsic to the nature of fair dealing.

I have a question in return – I’m genuinely curious why you decided to ask that question in such a sarcastic and exaggerated way, if you wanted an answer? As it is, you’re very lucky that I was in a good mood and decided not to just ignore you as another passing rude bastrd.

If you are known as a person who will buy oranges on behalf of other people for a consideration, you are in trade. In which case, Western custom and law is that the interests of your client come before your own.

This isn’t true though. When Marks & Spencers go out to China and see that it’s possible to get a really good deal on underpants, they don’t have any duty to pass that cost reduction on to the customers if they don’t want to; in fact, M&S hold an inventory of pants that they bought ahead of time, and “fix” the price of underpants in their shops so as to maximise their own profits, in exactly the way that it would be illegal for a FX trader to do.

There is no general principle in Western custom or law about the conventions appropriate to different types of market, because market microstructure is a complicated matter. Different markets develop their own conventions to handle the intrinsic conflicts of interest; sometimes these end up being formalised and legally enforced, sometimes they are just left to the competitive market.

52

ZM 11.15.14 at 1:18 am

Daniel,

“show that DBE is always a market and regulatory convention, not a fundamental or common law concept ”

I am doubtful it is only a convention. I suppose I do not really know enough about it.

But I heard a talk on the conscience law principle of the law of unjust enrichment a while ago. Surely you could argue unjust enrichment applied?

Or another conscience law?

Because common law is not the whole sort of English law.

53

ZM 11.15.14 at 1:19 am

If someone is enriched through unjust enrichment, the judge confiscates all their enrichment away.

54

nivedita 11.15.14 at 6:55 pm

Daniel @52 (and the OP), the reason this example doesn’t represent what goes on in the FX market, is because the FX market is not an agency market. The dealer is not the customer’s agent, even if the transaction is to sell currency at the fixing plus 1pip. The orange example raises different issues, which are relevant in the equity markets or other agency transactions, where the client buys at the price that the agent gets in the market, plus a commission. The FX trade is not that. The dealer doesn’t even have to buy anything in the market, let alone give the customer the best price. If the customer wants to buy immediately, he gets quoted a level. He either takes it or goes elsewhere.

When he wants to buy at the fix, he again gets quoted a level (the spread to the fix). This case is all about what activity that might influence the fix is permissible. The dealer buying at less than the fix or more than the fix is irrelevant to the client, as long as the fixing is not improperly influenced by the dealer.

55

John Quiggin 11.16.14 at 4:33 am

Having read the longer version of the article, it strikes me the kinds of problems we are seeing now are problematic mainly because of the massive growth in the volume and value of financial transactions, relative to real activity. The general assumption behind deregulation was that thick markets would be harder to manipulate. But it looks as if the growth in value has more than offset that: a 0.01 percentage point gain on a trillion-dollar market is worth more than a 1 percentage point gain on a billion dollar market.

56

Chaz 11.16.14 at 7:14 am

If you are acting as an agent for two customers then you should buy the necessary quantity and charge them each the average price you paid plus your commission. This is assuming that you got both of their orders before you had an opportunity to make the purchase.

If one of the two customers is yourself then the same would apply. Except that you should not be trading for yourself because that is an obvious conflict of interest. Ethics permit you to operate in the orange market as either a purchasing agent or a merchant but not both. If you are purchasing oranges just for your own consumption then the quantity will be too trivial to matter.

Your analogy gives emphasis to the fact that you were already on your way to buy oranges for yourself, that you were accosted on the street, and that you are being paid an absurdly small fee. You are presenting it as if you are doing a favor for this person. It is dishonest to analogize a personal favor to profit-seeking business.

57

Chaz 11.16.14 at 7:19 am

Forex fees are small but still profitable. Ten pence to deliver fruit is not profitable.

58

Sumana Harihareswara 11.16.14 at 8:05 pm

from the original post: “Anyway, what do you think?”

I am having a very Carol Gilligan “In A Different Voice” moment here where I want to talk a lot with this thought experiment’s grumpy client and figure out what their real needs are so we can get a deal together that leads to less overall aggravation. That’s my intuition. :)

Anyway – thanks for the post, which is illuminating.

59

Andrew F. 11.18.14 at 9:15 pm

I know nothing about the actions of the banks fined, but the allegations of the regulatory agencies are that the banks fined violated certain relevant regulations, not malleable and grey norms of conduct.

The metaphor is good in some ways, but contains the unstated unassumption that the “orange” market is completely unregulated (and, perhaps, that customers had no expectation of regulation). While aspects of the foreign exchange market may be subject to less restrictive laws and regulations than other financial markets, they are still, within the ambit of each regulator, subject to certain laws and regulations.

The assumption of non-regulation in the metaphor allows it to focus upon economic incentives, particularly those of the orange traders. That focus is the metaphor’s strength, but simultaneously its weakness, since the costs and risks of violating regulations and laws should be factored into an analysis of incentives.

Whether there’s anything to the allegations of the regulators, of course, and whether the regulations and laws in question were sufficiently clear or were too vague, would require adding some specifics about US, UK, and Swiss law.

60

William Timberman 11.19.14 at 7:13 pm

Thanks, Daniel. As Sumana Harihareswara has said, an illuminating parable. It always amazes me how reluctant people are to pay a realistic price for services rendered. Especially interesting is the confirmation that this unfortunate principle is as operative in the fx market as it is in restaurant tips, or in IT projects, where people pay the going price for hardware without blinking, but get incredibly pissy when asked to pay for the software which actually embodies the value. Reminds me of the miser biting his gold coins, or Marx’s commodity fetish, and reinforces my skepticism that the service economy will ever do for aggregate demand what the dark satanic mills once did.

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