Taking the first steps towards a new market structure - Assessing the impact of MiFID II and the FX Global Code

Looking back, 2017 will be seen as a watershed year for the FX market. After a year of deliberation, the FX Global Code (“the Code”) was published on May 25th and a new Global FX Committee (GFXC) was formed in order to promote and maintain the Code, putting standards and principles into the spot FX market for the first time on a truly global scale.

The year 2017 will also mark the beginning of the end for how FX derivatives trade in the future, as the regime of the second Markets in Financial Instruments Directive (MiFID II) starts. This EU-rubber stamped legislation takes effect on January 3rd, 2018, and comes more than eight years after the G20 meeting in 2009 at Pittsburgh, and like the Code, its underlying principles are based on transparency in financial markets. 

Both pieces of work aim to fundamentally change the way FX is traded in the future. Regulators saw fit to reform financial markets in the wake of the 2008 crisis, and the reform of the spot market in particular came about following the actions of individual traders at major banks which led to billions of dollars’ worth of fines being dished out across the industry as a means of settling legal disputes. 

David Puth

David Puth

“Our goal is to promote fair and effective markets around the Code and recognize the market has a more broad and diverse set of participants than any other.”

Global Code

As FX is a truly global market and hard to regulate through one piece of law-binding regulation, the Code was a culmination of ideas from 16 international trading centers, with representation from both the public and private sector, to come up with a set of standards and principles that everyone could get behind. 

“Our goal is to promote fair and effective markets around the Code and recognize the market has a more broad and diverse set of participants than any other. We’ve created a strong dialogue from people in major FX centres, but also in countries like South Korea, India, China, Brazil and Mexico. This was to ensure that we addressed concerns of broadest set of market participants,” says David Puth, vice-chair of the GFXC and Chief Executive at FX settlement system, CLS. 

While market participants do not have to adhere to the Code in the same way as MiFID II, the best practice guidelines are being viewed as a way to enhance transparency and openness in the market, encouraging firms to publicize their own adherence. 

“We launched the first public register of market participants at CLS which is focused on the 66 settlement members. For now a small handful have placed commitment to code on public register, but we expect to see that pick up pace significantly. Firms have until May next year, and some of the uncertainty around principle 17 of the Code might have been a reason to wait,” says Puth. 

Principle 17 refers to the contentious issue of last look and pre-hedging. It caused quite a stir in the marketplace when the first iteration of the Code had the work “likely” included within its text for principle 17 which led many participants to feel as if the actions of abusers of last look would continue. 

After receiving enormous feedback from the industry, on November 15th, principle 17 of the Code was adjusted to indicate that “market participants should not undertake trading activity that utilizes the information from the client’s trade request during the last look window”.

“The GFXC has made a number of decisions that will help to strengthen and embed the Code across the global market. I am grateful for the detailed feedback provided by market participants on last look in response to our Request for Feedback,” said Chris Salmon, chair of the GFXC at the time of the release.

But the truth is participants have already been adjusting to the spirit of the Code. For example, XTX Markets, a non-bank market-maker, eliminated discretionary hold times for trades when trading directly with clients, and many other liquidity providers, including banks, have done something similar or at the very least reduced the 100 millisecond hold time they imposed on their own clients. 

“The execution principles and agreements that liquidity providers had in place with customers prior to the FX Global Code being published – many of them have already changed. We’ve already seen a difference in the market already. Some execution agreements have explicitly stated they will not use the information within the last look window for trading, and others have moved to zero hold time so participants can’t use that information to pre-hedge,” says Roger Rutherford, Chief Operating Officer at ParFX and ACI FX committee member.

“It does appear that platform providers have been encouraged to involve themselves and to some extent police improvement in fairness and market conduct as a result of the Code and potential changes to last look disciplines,” says Paul Chappell, Chief Investment Officer at C-View and ACI Director of Education. “In reality it is the bilateral relationships between the market makers and customers using their services where actually improvement their conduct is required - that being the case, widespread adoption of the global code will assist in this.”

FX is a truly global market and hard to regulate through one piece of law-binding regulation
FX is a truly global market and hard to regulate through one piece of law-binding regulation

The effects of the Code are already being felt as a result, says Chappell. “General adherence to the Code will certainly make market participants examine their execution systems and bilateral relationships notably in those instances where their market participant counterparties are not adhering to and do not intend to adhere to the code,” he says. 

While the changes may be greeted enthusiastically today, market participants need to make sure adherence to the Code and its requirements are maintained some time from the present day. Only then will the market know if it has been a success, says Neill Penney, co-head of trading at Thomson Reuters.

“The mood of the industry has changed to be aligned with the Code and I think that happened post the financial crisis and heightened while the code has been under development. We really need to nail things down not just for now but for potentially when things might kick off in a few years because the Code becomes more significant as memories fade. The proof in the pudding will be how the industry is in 10 years, but the industry seems well aligned to the Code now. People have been steadily evolving since the first draft came out in May, 2016, and there has been a lot of work done already on how to segregate information, order handling processes, so this should be a very smooth transition,” he says. 


What some market participants don’t expect from MiFID II – unlike the Code - will be such a smooth transition. Even with such little time to prepare, there are still numerous sticking points that make it harder to say with any certainty that a firm will be MiFID II compliant on January 3rd, 2018. 

Compared to the Dodd-Frank Act, there are pre-trade transparency requirements and the products covered are wider, as they include non-derivative products, such as bonds. The definitions for executing on a trading venue are still unclear in terms of metrics, waivers and whether deferrals will apply, as well as precise clarity on market structure points such as how venue workflow will operate, explains Dan Marcus, global head of strategy and business development at Tradition.

Paul Chappell

Paul Chappell

“It does appear that platform providers have been encouraged to involve themselves and to some extent police improvement in fairness and market conduct as a result of the Code and potential changes to last look disciplines.”

“It’s impossible for anyone to say with 100% certainty that they will be MiFID II compliant on January 3rd. In the case of Dodd-Frank, prior to the introduction of SEFs there were a number of no-action letters issued to help with uncertainty around certain Rules being used to implement elements of the law. We can’t do that in Europe,” he says.

Regardless of the difficulties, market participants have been getting ready as best they can, busying themselves for the inevitable crunch ahead of the deadline next year. Part of getting to grips with the regulatory text has been what customers would be required to do under MiFID, what legal structures they have and how they relate to MiFID. This became more complicated as the conversation quickly turned to firms with different legal entities, and trying to accommodate them between using an MTF and an off-venue facility in Singapore, for example. 

“MiFID II has without question placed an onerous burden of reporting and cost upon all market participants, this unfairly penalises the small and medium-sized players on the market making but particularly on the buy side,” says Chappell. 

One of the effects of MiFID II, given the requirement for increased transparency and the level of complication that the regulation brings with it, will be to streamline execution in a way that increases the use of algorithms in the marketplace. 

“I do think it will change strategy and push people in the direction of using algorithms more than they might have done previously,” says Thomson Reuters’ Penney. “The Code will intersect with that as it has openness and transparency within it, and that begins with execution - explaining how a price was made or on the buy side explaining why I took the price I did. These tools are the right mechanism to capture both intent and action.”

Commonality & Differentiators

What is certainly most in common with both the Code and MiFID II is the level of transparency that both documents aim to bring to financial markets. 

“These principles are about raising a level of transparency and understand among participants about how to transact business in the most effective way. That transparency takes many different forms but the Code has surfaced some of those issues that may have not been as easily understood by market participants in the past. Last look is one and we’ve put in place some fairly clear guidelines on how last look operates to markets,” says Puth. 

Dan Marcus

Dan Marcus

“Every time you put a regulatory burden in place, it can in some cases reduce competition, which in turn, can impact liquidity.”

Increasing transparency will also improve education among clients, says Penney, which will in turn force the banks to become more open about how they sell their own services.

“The benefits of the Code will make conversations between customers and banks more specific, it will make the buy side more educated consumers, and force the sell side to be clear about what products they offer and how they differentiate from the capabilities they have. So each side will be able to make more informed decision about the way they execute a given customer’s risk profile,” he says. 

“The combined effects of the FX Global Code and MiFID II will result in market participants having a clearer understanding of their bilateral relationships, and terms and conditions,” says Chappell. “This is particularly true in the area of how large market-makers handle orders and conduct themselves and their principal positions around order execution. It is a moot point what effect of the transparency insisted upon by MiFID II and the need for near instant reporting of trading will have upon those relationships.”

But there also some important differentiators between the Code and MiFID II. While the Code has taken on the views of 16 financial centers globally and implemented guidelines as best practice, MiFID II’s closest ally is Dodd-Frank which has some highlighted differences. This could lead to fragmentation of the markets for which they oversee, according to market participants. 

“In the short term, the initial focus of MiFID is to take the way people execute FX and put on regulated venues, so people will carry on with the same activities with the same venues with more transparency and fairness. However, in the medium term, a number of things could drive differences between US and Europe. One is the requirement to trade on venue which will come along with clearing – both at different stages for these jurisdictions. The other is MiFID pre-trade transparency. At that point we might enter a phase where optimal trading strategies are different between two jurisdictions, so there may be some divergence there,” says Penney. 

“Every time you put a regulatory burden in place, it can in some cases reduce competition, which in turn, can impact liquidity,” says Tradition’s Marcus. “Former CFTC chairman Gary Gensler said he expected to see around 200 SEFs go live, whereas there are actually only 23 currently registered with liquidity concentrated in just a handful. The market is fragmented now, and without equivalence it will fragment even more between the EU and US. If equivalence is achieved, we will see a better uniformed, global market.”

“What we have seen over the past few years is the market has become increasingly electronic, and the market has felt that as a trend over the past 15 years or so. What MiFID and the Code and fines have done though is drive a sense that when e-trading there is a complete audit trail that begins with every stage of the price manufacturing to execution. That is very difficult to replicate with a trade that takes place on the phone,” says Penney. 

Increasing transparency will also improve education among clients
Increasing transparency will also improve education among clients

In the longer term trading strategies between London and New York will likely overlap, so the market will figure out what works best, says Penney. In the Code, the only likely fragmentation will not be geographic but rather which customers will publicly sign up to adhere to the Code and those that will not. 

Neil Penney

Neil Penney

“The benefits of the Code will make conversations between customers and banks more specific, it will make the buy side more educated consumers, and force the sell side to be clear about what products they offer …”

“Some customers will expect their banks to publicly adhere to the Code and they will have to explain as part of internal reporting why they’re trading with banks that don’t adhere to the Code. On the other hand a hedge fund might have a different perspective and will look at liquidity performance of their liquidity providers, and they will feel they have the tools and capabilities to really look after themselves,” says Penney. 

For others, the recent onset of the Code means it could be too soon to tell whether there has in fact been any significant changes occurring. However – one controversial theme that followed the benchmark scandal was information sharing. David Puth feels that practice could now become standardized among participants.  

“We spent the greatest amount of time on pre-hedging and information sharing for the buy side and sell side. The market recognized there had been a seizing up of exchanging of market information following the benchmark scandal that took place. We would expect information sharing is now something that is taking place in a little bit more open and seamless manner while conforming again to a standard set of practices,” he says.  

A final thought on data

What new regulation and guidance does bring is new opportunities for the industry. With requirements for increased transparency, this will likely lead to a wealth of data coming to the market which businesses can make use of, says Tradition’s Marcus. 

“Regulatory technology is a nascent area. As soon as complications are introduced by regulations, people try to innovate to make the market more efficient. It will be a challenge for any new Fintech provider to make money when you are fighting against incumbents who have been doing this for many years and have the ability to adapt their business model, but it’s certainly a big revenue opportunity,” he says.

This will likely lead to a reliance on TCA for the buy side, says Chappell: “The insistence within MiFID II for best execution and the requirement that this is clearly shown as to how it is arrived at will definitely increase demand for technologies to assist in displaying this. TCA analysis particularly contributes to this.”