A panel at this year’s Sibos, held in Geneva, discussed the impact of regulation has had on the FX market and whether the associated cost of complying with regulatory requirements is incentivising a switch to centrally cleared products, and more standardised contracts.
Although eligible for clearing and multi-lateral netting, standardised contracts would require margins and default fund obligations, and a shift in the FX market and the ‘futurisation’ of FX that the market may not be quite ready for.
Chaired by Keith Tippell, Managing Director, Head of Securities and FX Markets, SWIFT, the panel began the discussion in full agreement that the regulatory changes have impacted the FX market, and will continue to do so.
Allan Guild, Global Head of Regulatory Change and FX Options Business Management at HSBC, said that for a long time it was difficult to assess the impact on liquidity but has now become clear that liquidity has been restricted in the FX market by a range of regulations from the Volcker Rule to the introduction of SEFs, bilateral margin rules, OTC clearing and increased capital charges, so that the cost of doing business has increased. He said: “There is no single reason for it but packaged together, so much focus over the last 5-10 years has been on implementing regulation and this has naturally taken the focus away from innovation, growth and customer service, so that liquidity has been restricted although the markets have been resilient.”
However, the panellists also agreed that the regulatory drivers are now providing economic reasons for moving to central clearing, even though there is no mandate for clearing FX derivatives. Jeremy Bell, ForexClear Product Director at LCH, said that over the past few months the new capital and margin rules have been incentivising banks to use central clearing as a way to better manage costs. He said: “We are breaking new record volumes every day on our NDF clearing service. We’ve gone from clearing about 2-3% of the overall market to now up to around 15-20% daily. This is the banks looking at how they better manage their bilateral margins to contain costs.”
Steven French, Head of Regulatory Strategy and Product at Traiana, added that although he believed the regulators had got it right in not to impose a mandate on the FX market, the tipping point had now come with the introduction of new margin rules on uncleared products. He said: “The main impact we have seen under Dodd-Frank was that it wasn’t just about clearing and SEF execution, it was also regulatory reporting. Regulatory reporting ties into clearing so you can’t look at reporting, clearing or pre-trade/credit checking as a just a regulatory requirement and with the uncleared margin rules and what is to come with MiFID II/MiFIR the focal point is finally there. LCH has led the way in dealer to dealer clearing but MiFID/MiFIR has given a focal point and clients and dealers, for the first time, now understand what their responsibilities are and what they can do to best comply with these regulations and no longer treat them as bolt-on activities to their typical workflows.”
According to French, compliance with regulatory reporting was a particularly painful exercise for the FX market due to the fragmented execution that exists – there is no one central affirmation platform, but multiple single dealer platforms, ECNs, regulated SEFs that all play a part in reporting, once it is kicked off by the clearing house used. “Understanding it is one thing; implementing it is something else. With some of the more complex workflows, around prime brokerage, there are still some uncertainties about the way prime brokerage reporting should be handled,” he added.
But the single greatest consequence of regulation, whether intended or not, was that the new bilateral margining requirements, with the increased focus on cost of capital and the challenges of implementing regulatory reporting, had made some of the tier one and two banks take a closer look at who and where they offer liquidity and the impact of this had been a slight contraction in the market, according to LCH’s Bell.
But HSBC’s Guild argued that fragmentation was a strength of the FX market, as the market has responded to the many different users of FX, but added that despite the fact the regulators have come together to look at harmonisation of rules, the industry has yet to see the results of this.
He said: “FX is a cross-border market by definition and the market needs consistency in terms of regulation across different jurisdictions. The market is global, and areas like margining, reporting and execution rules have got to be consistent.”
Guild added that the implementation of margining rules was not globally harmonised – the US went first, and within the US, because of the nature of the rules, there were four different agencies involved in implanting those rules and they were not joined up. “There is a lot of support within the industry for what regulators are trying to do at a high level, but the difficulties come in terms of how they are implemented and the differences,” he said.
But the biggest unintended consequence of regulation, and one that the industry is still grappling with, according to Guild, is the SEF regulation in the US. “The SEF regulation intended to try and put more activity on electronic trading platforms – the FX market around NDFs and FX options – the immediate impact, which still hasn’t fully recovered three years on, is to move trading off electronic platforms and back to voice trading because the rules trading on these platforms were unclear and the buy-side didn’t want to engage in them.”
What can be learnt from this, and what has been learned in the clearing space, said Guild, is that when you have a fragmented cross-border market, a mandate is a very blunt instrument. He said: “It is that an incentivised approach, such as the margin rules incentivising the move towards central clearing, that is a more constructive way for the market than a blunt mandate that potentially attacks the fragmentation in a negative way for our customers.”
While Guild could understand why regulators want to learn from what they have seen in other markets, and perhaps try and regulate better, he said the cost of the difference to the industry is not factored in as much as it could be.
‘FUTURISATION’ OF FX SWIFT’s
Tippell asked the panel if the growing sophistication in the FX market, and the multiple uses of the FX market, not only through the emergence of central clearing in FX but also the listed market, was impacting how the FX market evolves.
LCH’s Bell said that he believed that participants were starting to look at FX in a different way and this was driving an uptick in volume. He said: “Banks are looking at FX as a payment mechanism – it always has been – but actually looking at the way they execute, whether FX trades need to go to delivery. We are seeing market participants, in different sectors, asking themselves if that delivery aspect important and if there is a smarter way to execute, or different products within the FX asset class, that can be used in a slightly different way, to get the same hedge, same exposure, and longer-dating it. We are not seeing so much execution in outright spot and forwards but more use of complex products and this is something that LCH, as an infrastructure provider, is working with our customers to understand these new cases are and help the market evolve so that the execution and posttrade of new products, and new uses of products, is easier for the market.”
However Guild cautioned that there is, and will always be a slight difference in how different market participants access the market – particularly between those who are looking at FX from an investment standpoint and those who are looking at FX from a hedging standpoint. He said: “Clients who are investing tend to be more frequent users in the market and tend to have a louder voice, or at least project their views more in terms of shaping the product set. These participants are maybe making more use of listed products and the need for FX as a payments vehicle is still there, in terms of participants investing in different equities and fixed income products but where they are investing in pure FX clearly the payment is no needed, but on the hedging side, it is. This is a conversation we need to have as a market in terms of how we evolve but certainly we’re very conscious that it is incumbent on all of us not to forget that the purpose of the FX market is to underlie the global economy, is to support global trade, and allow participants to hedge their currency exposure. We have to leave ourselves with a market structure that best enables that, and continues to do so.”
CLEARING DELIVERABLE FX
The slow uptake in clearing for FX was also addressed. Apart from the fact LCH can only clear non-deliverable FX products at present, Bell said the market had been focusing to date on the mandate to clear interest rate and credit derivatives and the benefits of clearing only come with scale in terms of operational efficiencies, which is taking longer in the FX market.
LCH is currently working in partnership with CLS to bring to market a solution where to clear deliverable FX products. Clearing for deliverable FX, the lion’s share of the FX market, is the still toughest challenge for CCPs.
But HSBC’s Guild countered that there is less counterparty risk in FX products than there is interest rate and credit products, where there has been growth in clearing. He said: “The clearing opportunities for these products existed pre-2008 so it was in response to the financial crisis, and an understanding that counterparty risk was multiplied up as a result of the crisis, that capital charges were increased around counterparty risk, and bilateral margin charges incentivised the push the towards clearing but I don’t think the benefits will ever be as obvious in the FX market as they were in the fixed income market, which had gravitated towards clearing, pre-2008, anyway.”
To this LCH’s Bell added it is always about efficiencies in operations. He said: “If you look at the growth of SwapClear, our interest rate service, the reason the top tier banks adopted it and wanted to get a lot more into clearing was because it gave them massive operational efficiencies. Using a single central counterparty meant that less conversations and less breaks. I think there’s an interest in this case for FX but I think it is perhaps less interesting in FX because it has so much higher volume already and FX market is used to STP. It is already a welldeveloped, low touch process and actually making that argument is a little bit tougher.”