With the foreign exchange market reeling from global investigations into the possible manipulation of trading, Frances Faulds looks at the impact more onerous regulation might have on the market.



The $4700bn-a-day currency market is one of the financial world's least regulated, with transactions conducted over the counter (OTC) and away from exchanges. But ongoing global investigations into the manipulation of benchmark foreign exchange (FX) rates and front-running of client orders have put the FX market firmly in the spotlight.

Allegations of collusion, market manipulation and improper practices by FX dealers of the WM/Reuters (WMR) benchmark have plagued currency markets since the middle of 2013. Earlier this year, the Financial Stability Board, an international advisory group on financial regulation, announced it would create a sub-group for FX to be chaired by Guy Debelle, assistant governor at the Reserve Bank of Australia, and Paul Fisher, executive director for markets at the Bank of England. The new group will analyse market practices in relation to the use of FX rate benchmarks. Its findings will be presented to the 2014 G20 summit in Brisbane in November.

Some senior industry sources believe there is no clear-cut case and that regulators need to take a balanced approach. “The market works extraordinarily well most of the time,” says one. “You can’t throw the baby out with the bathwater with regard to independent benchmark fixings. WMR is widely considered the most independent benchmark at the moment. At the end of the day you have to engage with the banks – they have to be part of the solution. That said, there are certainly ways to improve this process. That clearly needs to happen.”

World’s biggest market

The sheer size of the global FX market should not be underestimated. In a recent piece for the Financial Times’ Alphaville blog, former FX trader Joy Rajiv argued that the scale of FX trading meant “it would take collusion of inordinate magnitude for such a strategy [of manipulation] to work reliably and consecutively”. He added: “The spot [euro-dollar] market is the biggest market in the world. A conservative estimate using volumes from banks and exchanges alone implies that the daily volume turnover is in excess of €200bn.”

Mr Rajiv called for an improvement in the benchmarking process rather than a regulatory backlash, which he believes would simply increase costs and lower liquidity, and perhaps not even provide an FX fix.

Many agree on the need to review and improve the FX benchmarking process, which was designed in the 1990s, broadening the number of benchmarks and the ‘fix’ time window. But the implications for the FX market stretch beyond these allegations of market manipulation, reopening the debate on how, if at all, the market should be further regulated.


Clearing goes live

In 2009, G20 leaders at the Pittsburgh summit ruled that all standardised OTC derivative contracts should be traded on exchanges or swap execution facilities, which are regulated platforms. They also said contracts should be cleared through central counterparties. Those that were not centrally cleared would be subject to higher capital requirements.

Due to delays in regulation, clearing of non-deliverable forwards (NDFs) is unlikely to become mandatory in the US until later this year. In Europe, regulation will not come into force until late 2014 or early 2015. Furthermore, given the difficulty of designing a clearing mechanism for physically delivered products, it is unlikely that clearing for FX options will be mandated for some time yet.

Despite the regulatory delay, LCH.Clearnet, the UK-based central counterparty and clearing house, has cleared more than $1484bn in FX NDFs in the two years since launching such a service in March 2012. Clearing for NDFs is also live and growing at CME Group and the Singapore Exchange, even though there are no regulatory requirements to do so.

As yet, there is no blueprint available for centrally clearing FX options, which would involve delivering both the currency sold and the currency bought. This could result in a liquidity disruption of an entirely different magnitude from that of NDFs. A year-long study conducted by the Global Financial Markets Association (GFMA) indicates that the size of the same-day liquidity shortfall could be as high as $161bn across the 17 currencies settled by clearing house CLS, which could be reduced only if the industry adopts a clearing solution that uses a net settlement mechanism.

While industry sources believe this is eminently solvable, CLS uses gross settlement. A mechanism to create a multilateral net settlement of the underlying payment-versus-payment system still needs to be designed and built before any deadlines for centrally cleared FX options are considered.


G20 push

The thrust by G20 leaders to tighten the OTC market was further strengthened in 2011 when they agreed to add margin requirements on non-centrally cleared derivatives to the reform programme. They also called on the Basel Committee on Banking Supervision (BCBS) and the International Organisation of Securities Commissions (IOSCO) to develop global standards for these margin requirements.

To this end, the Working Group on Margining Requirements was formed. In September 2013, it published margining requirements for all non-centrally cleared derivatives except physically settled FX swaps and forwards. Although the use of variation margin remains a “prudent risk management tool that limits the build-up of systemic risk”, according to the group, its enforcement by way of supervisory guidance or national regulation is up to each country.

Variation margin in the FX market is exchanged through the use of credit support annexes. At the time of that announcement, James Kemp, managing director of the global FX division of GFMA in London, said: “This BCBS/IOSCO report recognises that risk in the FX market is already well managed, with its existing key focus on settlement risk reduction and rising industry usage of credit support annexes. Exempting FX forwards and swaps from a mandatory initial margin regime will ensure corporates and investors continue to benefit from a well-functioning and cost-effective FX market.”

The exemption of FX swaps and forwards from initial margin came nine months after the US Treasury announced in November 2012 that the products would be left out of the clearing and trading requirements of the Dodd-Frank Act.

While the FX market breathed a sigh of relief that swaps and forwards would be largely free from regulation, some expressed the belief that longer dated contracts might benefit from some form of counterparty credit risk mitigation. Furthermore, many believe the increased focus on risk-based capital in the run-up to the implementation of Basel III and the Basel Committee on Banking Supervision’s requirements to collect and post initial and variation margin on non-centrally cleared trades, which will be phased in over a four-year period beginning in December 2015, will actually incentivise voluntary clearing for bilaterally traded instruments.


Forwards to futures

According to consultancy Greenwich Associates, even though FX swaps and forwards received exemptions from trading and clearing requirements imposed on derivatives in other asset classes, they will still feel the impact of trade reporting requirements, anti-evasion authority, business conduct standards and Basel III capital requirements. These factors are likely to encourage a shift of some FX swaps and forwards business to futures. A share of NDFs and FX options flow should move to futures as well, says a report published in January by Kevin McPartland, head of market structure and technology advisory services at Greenwich Associates.

Mr McPartland believes that many ignore the impact of derivatives reform on FX at their peril. This is because trading in FX forwards, swaps, NDFs and options have all become more expensive and, he believes, this will drive more business to the exchanges for cheaper alternatives. “A conservative 5% move out of OTC FX derivatives into futures would cause FX futures volume to grow by more than 50% – a huge boon for futures exchanges,” he says.

He points to what is already happening in NDFs – in terms of the trading and clearing requirements, and the high margin rates they bring – as setting the stage for their users to migrate some of their trading to futures as well. Greenwich Associates’ data shows that the trend away from trading NDFs has already started. Whereas more than half of investment firms used NDFs in 2010, at the end of 2012 only 35% did. Hedge funds led the pull back.

Mr McPartland says: “The bottom line is that some trading volume will shift to futures because under the new rules, futures will provide a cheaper means of accessing the FX market. These are not exotic products. FX futures contracts have existed for years providing exposure similar to that offered by OTC contracts and among the major global exchanges, FX futures liquidity has steadily grown over the past few years. Investors are already comfortable with the products and now they will have a big incentive to make much more use of futures.”


Uphill challenge

While many believe the FX market will eventually morph to something that looks more like the exchange-traded model, it will be a very long road and the need to carve out exceptions for the vast differences in the market will continue to challenge both regulators and market participants. Attempting to create a level playing field and harmonise policy across the world’s central banks, with their often vastly differing monetary policies, will be no easy task.

“OTC works because there is liquidity; it is just the idea that banks have every incentive to keep things opaque that is a problem, but this is being whittled away now,” says one senior banker. “Many investors navigate the market well, while others do not. All participants need some sense of price competition, price discovery mechanisms and oversight to ensure they are in line with the rest of the market in terms of execution quality.”

How the FX market will be impacted by the ongoing regulatory requirements for OTC instruments is not yet known. But whatever happens, the requirements of the Dodd-Frank Act for non-deliverable currencies do not make sense for the FX market. “Under the guise of ‘best execution’, it is forcing the market to compete in illiquid markets and disincentivising the liquidity providers to step-up, forcing them down a road that will give investors worse pricing at the end of the day,” says the banker. “The pendulum is swinging for more regulation and more transparency, which is good on some levels, but it can negatively impact the market and have unintended consequences if not properly managed.”

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