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The senior FX trader at one of the top-15 banks in this year’s survey smiles grimly at his phone. He has been telling how the bank recently devoted several man-years to compiling and delivering vast files of historical data on FX trades, running to billions of individual items, to one of the US regulatory agencies. It had been sniffing around the market for evidence of banks failing to provide best execution to customers. There is no single source for historical price and trade data in the over-the-counter FX market and so the regulator had approached several large banks to supply it. The banks’ pleas that the regulator was looking in the wrong place for the wrong kind of evidence in a market that had functioned well throughout the financial crisis were dismissed. The regulator wanted the data and the banks would be ill advised to cross it.
“Now, here come the excuses,” he says and reads the message on his phone. After several weeks sifting the vast rows of data and with the deadline by which it had committed to provide initial findings now passed, the regulator had decided that the data it had asked for was useless. The banks had given it too much data and it couldn’t process it or deduce anything from it.
“Man-years-worth of work,” he says and shakes his head. “Still, I’m sure they’ll be back asking for some more data before long.”
Regulation hasn’t hit the FX market as hard as it has rates and credit, but banks find themselves having to prepare for various contingencies. Regulation, especially of FX options could have a severe impact on the markets. And while the banks breathed a sigh of relief last November when the US Treasury indicated an exemption on FX swaps and forwards from mandatory clearing and exchange trading under Dodd-Frank, concerns persist, not least in Europe, over a financial transactions tax.
Managers of FX businesses say that grappling with regulation is their second-highest priority, coming only behind managing IT resources. Dealing with customers and managing currency-market risk exposure, once the beginning and end of the job, now rank way down the list. The common warning is that banks will have to pass on to customers the cost of regulatory compliance in one form or another, making the cost per unit of risk transferred higher.
It sounds like special pleading, especially given so much of the discussion in FX of spurious volume and phantom liquidity, but regulation could have unintended consequences. Kevin Rodgers, global head of foreign exchange at Deutsche Bank, says: “One of the unintended consequences of the regulatory burden on banks could be that, along with the high IT costs, fewer may be willing to stay the course in foreign exchange and the market may depend on fewer banks. What then might happen to the supply of capital allowing risk transfer in foreign exchange in the event of another banking crisis, or an extreme stress event such as possible euro exit?”
It’s a good question given the high degree of concentration in the vast and often taken-for-granted FX market.
In the FX derivatives markets, dealers say the stress on banks’ capacity to manage the counterparty credit risk component of FX swaps and forwards much longer dated than two years – and to provide capital against the associated risk-weighted assets – is already reducing volumes. Some corporates that normally prefer to hedge with forwards, now seeing constraints on their bank credit lines, are turning instead to options, even though they don’t like paying option premia up-front.
But the options market itself is subject to the greatest regulatory uncertainty, especially over how various categories of counterparties will cope with requirements to post initial margin and to regularly recalculate margin and meet new collateral demands. “Just the initial process of getting options clients signed up for central clearing on swap execution facilities (sefs) is going to be very resource intensive and that will be particularly difficult for the smaller foreign exchange banks,” says Anthony Hall, global head of FX derivatives trading at UBS.
Jeff Feig, global head of G10 FX at Citi, says: “Moving non-deliverable forwards, which have traditionally been a voice-broker market not an electronic market, onto sefs could bring big changes to that market. There are only about eight large banks that are a factor in non-deliverable forwards and yet we could see some of the smaller banks under pressure to pull out.”
The biggest unknown remains over initial margin in FX options. Nothing regulators have done has made FX markets that much more expensive for customers to deal in yet. The two things that could do so are initial margin and a financial transaction tax.
Option market volumes have picked up this year despite the regulatory uncertainty. Market participants point out that the size of this one corner of the bilateral OTC FX market that is being pushed onto exchanges is such that, when initial margin requirements are finally set, the overall sums involved could be huge.
Some corporates just aren’t set up for this potential change. Many dealers talk about a reduction in corporate activity so far in 2013, even as investor activity has soared.
“I spent six hours last week with a small number of large European corporate clients, talking through how they might transition their foreign exchange hedging to a Dodd-Frank world,” says Tim Carrington, global head of currencies and emerging markets at RBS. “Now corporates have a longer-term time horizon to most investors and a greater capacity to absorb volatility. They do have generally well-governed risk management processes. They also have a cost of hedging. And if the cost of insurance goes past a certain point, they just won’t buy it.
“It seems to me we could be moving to a position where the FX options market looks more regulated, but where the result is that corporates are accepting more risk and more P&L volatility. I’m not entirely convinced that that’s such a good outcome.”
