A public pension fund sues a bank for systematically transacting foreign exchange trades at or near the worst price of the day — irrespective of when the order was actually entered and executed. The bank's retort? It had no fiduciary responsibility to the customer. Both are wrong.

The issue here is the price set by a dealer or market maker on a transaction with a customer (not with another dealer). Is the dealer required to trade with its customer at the market price that would have prevailed in a transaction between dealers?

An answer was proposed by the group of 24 dealers who created in 1792 the organization that later became the NYSE. Their founding instrument, the "Buttonwood Tree Agreement," required them to "give preference to each other." In other words, they agreed to accord their nondealer customers worse prices than those reached in trades between dealers. In the era of quill pens, this customer pricing was not necessarily transparent.

A much better way to achieve transparency and more efficient competition in prices and fees evolved subsequently:

The customer places an order with a broker-dealer. This order is exposed to competing bids and offers in a market, for best execution. The customer's broker-dealer may or not be a market maker, but his bids and offers as principal will have no advantage over any other market maker's in capturing his customer's transaction. The broker-dealer imposes a stated commission. So, the customer receives a less advantageous net price than a dealer would, but he knows how much he is paying for what.

This system has the virtue of full disclosure of pricing and fees. The customer can compare the commission he pays with what competing brokers offer. He has the assurance that he received a reasonable approximation to best execution.

That's one reason why establishing a transparent market mechanism for trading derivatives is so badly needed and so ferociously opposed.

Nothing remotely resembling transparent market trading and brokerage fees has been practiced in foreign exchange markets, either, and for the same reason. Here's a concrete example of the results.

An American recently sold real estate in Australia for AUD 2.6 million, which she needed to convert to USD. The dealer market for the AUD/USD pair is utterly transparent, if you know where to look.

Over the last 10 years small firms, at first in the U.S. and Europe, began to offer customers the opportunity to speculate in foreign exchange. They publish quotes on the Internet that are updated constantly, and they stand ready to transact at these quoted prices. A typical spread for AUD/USD is 0.0004. As prices fluctuate, this spread remains quite stable.

The big forex dealer banks had very good reason to facilitate entry by these specialized firms accommodating speculative retail trading. This activity provided additional liquidity and trading volume. Furthermore, having ignorant speculators enter a market is bound to be profitable for well-informed market makers.

One crucial condition was imposed: the new firms could not actually receive or deliver currencies. All flows of funds to and from customers had to be in USD. Here's why:

When the American holder of 2.6 million AUD wanted to convert them to USD, large and small banks quoted, not the prevailing market spread of .0004, but a spread of 0.025 — 50 times as big.

This amounts to a "commission" or markup of over $30,000 for brokering one trade. But it's a hidden markup, expressed as an arbitrary spread. 0.025 doesn't sound like much. It's a big rip-off.

If the firms that invite speculative currency trading were able to receive and deliver the currencies in which they trade with customers, maybe one of them would have done this trade for a reasonable fee. Let's say $1,000 or even $3,000, rather than $30,000. Delivery might cost them $100 at most, so it would still be highly profitable.

Such transparency would facilitate competition and result in fairer pricing. This is what has already happened in foreign exchange conversions for credit card customers.

For years, the conversions were carried out primarily through MasterCard and Visa at artificial exchange rates that cost U.S. customers as much as an extra 3% on all their purchases in foreign currencies. Eventually litigation put an end to this. Banks then introduced a foreign transaction fee — for instance, 3%. But that fee was plainly disclosed, and subject to competition. The result is that some banks have achieved competitive advantage by eliminating the fee! Customers benefit from transparency.

The idea that only consumers need protection — or that they need more protection than a company or a public pension fund owned by consumers — is hogwash. Let's require disclosure of market spreads and commissions or markups to all customers on all standardizable tangibles and intangibles.

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