FX survey 2015: Rebuilding foreign exchange

Reeling from the long-running benchmark manipulation scandal and resulting fines, and an extended period of low volatility followed by the ructions caused by the Swiss National Bank (SNB) in January, most FX business heads struggle to recall a more challenging period.

“I’ve worked in FX for 25 years and experienced many cyclical ups and downs, but these were all unprecedented shocks to the industry concentrated in a short period of time – from the original allegations of collusion in 2013 to a massive uncorrelated drop in volatility and then the chaos unleashed by the SNB,” says one industry veteran.

This unique string of challenges has transformed an industry in which banks had always competed fiercely for market share, but were also known to be chatty and collegiate, sharing information where necessary and working together to address common areas of concern.

With the revelation that information sharing had morphed into collusion and manipulation of client orders in some corners of the industry, conversation has evaporated from many trading floors, with staff often unsure of what they can and can’t say to their colleagues, clients and competitors. As authorities wrap up their investigations and ring in the fines from banks, internal controls and codes of behaviour consume the attention of senior management.

Until the scandal is consigned firmly to the history books, many banks remain tight-lipped about foreign exchange; Citi, Barclays, HSBC and JPMorgan all declined to comment for this article. But those that are raising their heads above the parapet are quietly optimistic that the industry may be about to turn a corner.

“I think the industry is definitely poised for a more positive cycle. So much work has been done to correct conduct within banks, and once all outstanding issues are fully resolved, all market participants will have more confidence to re-engage in the business and show how far the industry has come in the past two years,” says Chris Purves, global head of FX, rates and credit macro flow at UBS.

It is now two years since allegations were first made in a Bloomberg article that FX traders had colluded to manipulate the WM/Reuters 4pm fixing rate. In the time that has passed since, regulators around the world have trawled through thousands of chat-room transcripts and phone records to get to the bottom of the allegations and take remedial action.

The rash of fines handed out to FX firms – and the expectation of more to come – has naturally caught public attention around the world, while also taking a significant slice out of bank revenues, but less-well publicised is the raft of remedial measures that have already been taken by central banks, regulators and industry participants to address what went wrong.

A Financial Stability Board (FSB) working group was established in early 2014 to look at FX benchmarks and issued its final report in September. Several of the group’s recommendations were implemented in February 2015, including the widening of the calculation window for the WM/Reuters fix from one minute to five minutes to reduce incentives for manipulation.

Meanwhile the regional central bank-sponsored FX committees have come together for the first time to look at ways of better aligning their codes of conduct to ensure that the industry adheres to a globally agreed set of standards. A key eight-page statement, Global Preamble: Codes of Best Market Practice and Shared Global Principles, was published jointly by the eight committees on March 30, while the Bank for International Settlements announced on May 11 that a new working group chaired by the Reserve Bank of Australia’s Guy Debelle would look to facilitate a single global code of conduct and principles.

These developments highlight the growing recognition among central banks that although a model of self-regulation might still work for the FX market, given its global nature, banks do need a more consistent set of standards to properly regulate the behaviour of their staff. Market participants have welcomed the move towards a single rulebook as a way of helping them to prevent future misconduct.

“Getting consistency in conduct rules is absolutely key, because it doesn’t serve anyone’s interests to have misaligned principles that can be arbitraged. The clear message from policy-makers is that there will be a framework of global principles into which all FX businesses must fit, and we certainly welcome that,” says Chris Allington, global head of FX at Standard Chartered in Singapore.

But this only tells part of the story of the rebuilding of the foreign exchange business. Behind the closed doors of the industry’s largest banks, major internal reviews have been initiated to regulate behaviour on the trading floor and eliminate any potential for collusion or improper communication.

As the market manipulation derived from sharing of confidential client information between traders at competing banks, an inevitable consequence of the investigation has been the near-total suspension of any kind of interbank dialogue, as well as a considerable reduction in the level of conversation with clients.

Whether that reduction in industry chatter has hit the core business is a point on which few banks want to comment, but some buy-side firms clearly feel there has been an impact. In a survey of nearly 2,500 clients conducted by Euromoney, 30% of firms felt that litigation and its consequences had affected their ability to trade.

“The industry issues have certainly put a dampener on the conversation between buy side and sell side, which should be an exciting, colourful conversation that drives investment in FX as an asset class. Having globally consistent codes of conduct and best practice should allow that conversation to be reignited,” says Purves.

The Global Preamble tackles confidentiality at a broad level, setting out key expectations on non-disclosure of client information, but it is left to market participants to determine how the high-level principles should translate into internal rules governing day-to-day communication on the trading floor.

One FX business head at a leading bank describes an intensive three-month process of writing explicit rules for client engagement with detailed input from legal and compliance to come up with policies on the kind of information that can be shared. For other banks, reducing the granularity of information that is shared with clients has been a priority in the wake of the investigations.

“The way market participants interact with clients has changed dramatically,” says Allington of Standard Chartered. “We began an initiative last year to deliver anonymised, non-specific market colour to clients so that they continued to have a flavour of what was going on in the market without it being specific about particular flows or orders. That kind of interaction will be central to how participants communicate in the future, because being too specific puts both parties at risk.”

But banks are naturally conscious of the need to ensure the pendulum doesn’t swing too far towards sanitised communication, so that clients can continue to access the services and information they need from the sell side in spite of the increased oversight.

“We have to strike the right balance because we have a service to provide to clients and they rely on having clear and continuous communication from their counterparties,” says the head of FX at one large bank.

Beyond a lack of respect for client confidentiality, a further issue highlighted by the scandal is the failure to recognise conflicts of interest on the trading floor. For example, if banks act in both an agency and principal capacity, as many often now do, regulators have stressed that they must clearly address any potential conflicts.

The FSB report recommended that banks must establish internal systems and controls to address conflicts of interest that may arise from managing customer flow, while the Global Preamble also recommends that firms should identify both potential and actual conflicts of interest that might arise from FX trading, taking measures “either to eliminate these conflicts or control them so as to ensure the fair treatment of counterparties”. Exactly where conflicts of interest may arise remains to be seen, but some banks are particularly keen to make sure their traders are ready to spot them.

“As an industry, we have really come to understand what it means to have a conflict of interests. Our traders are trained to identify and remediate conflicts when they arise, with the support of management and compliance, because conflicts can exist anywhere and can quickly come into being in places where they didn’t previously exist,” says Purves.

Damaging as the benchmark scandal may have been for the integrity of the industry, it has not been the only challenge with which market participants have had to contend over the past two years. An extended period of very low volatility in major currency pairs, running through much of 2013 and 2014, caused a big drop in client activity as it became harder to generate returns from FX.

As interest rates were kept mostly at near-zero levels and the economic recovery remained slow, major trading pairs failed to break out of their ranges, creating little incentive for investors or corporates to take active positions. Deutsche Bank’s currency volatility index (CVIX), which had reached a record high of 24.24% at the height of the financial crisis in October 2008, fell to a record low of 4.93% in July 2014.

The contrast between those two extremes is further highlighted by FX market turnover, with trading platforms and central bank turnover surveys reporting a fall in activity in line with the low volatility. Icap’s EBS platform achieved an average daily volume of just $70.6 billion in July 2014, 71% less than the average daily volume of $243.8 billion reported in October 2008.

While the decline in volume on EBS was driven partly by structural changes and the increased propensity of large banks to internalise flow, it does illustrate a substantial decline in trading and investment as a result of the low volatility.

Towards the end of 2014, volatility returned to some currencies as the eurozone and Japan moved towards quantitative easing (QE) while the US and the UK began to consider hiking rates. That divergence in the monetary policy of major economies, coupled with concerns over Greece and the Ukraine, led to a spike in FX market activity.

On October 31, for example, when the Bank of Japan surprised the market by expanding its QE programme, the CVIX rose to 7.78%, while volume on EBS soared to $250 billion, marking its busiest trading day in three years. The return of volatility and trading activity has finally given participants cause to be more confident about the outlook for the market.

“We are very optimistic about the prospects for the FX business,” says Russell Lascala, global head of FX spot trading at Deutsche Bank. “This is a macro-driven market and we are seeing a major interest rate divergence between Europe and the US. This has increased the need to hedge for our clients, particularly for those in Europe. FX has been renewed as an asset class and this has brought new participants to the market.”

Although 2015 has seen those positive themes continue to some extent, no one had been prepared for the curveball thrown at the market by the SNB when it suddenly abandoned its minimum exchange rate policy on January 15.

The SNB had first implemented the currency floor in September 2011 to stem the appreciation of the Swiss franc, which had been driven higher by safe-haven flows during the eurozone crisis. The central bank vowed to buy unlimited quantities of foreign currency to keep €/SFr above 1.20, standing resolutely behind the policy right up until January.

While the currency floor had only ever been a temporary policy measure, the unexpected announcement of its removal created an unprecedented risk event in a market that was already struggling to get back on its feet after the challenges of recent years.

The Swiss franc gained nearly 28% against the euro on January 15, with €\SFr plummeting from 1.20 to 0.87, making it the largest intraday G10 currency appreciation in the history of floating exchange rates, according to JPMorgan. The move left many dealers nursing heavy losses, while some retail brokers were forced into dire straits.

“The unexpected removal of the €/SFr floor was a defining moment for the FX industry. It was not thought that a liquid G10 currency could move by 30% so quickly, and it has woken up the industry to expect the unexpected,” says Lascala.

The sudden move in €/SFr also highlighted a concerning lack of liquidity as many market makers are believed to have withdrawn in the immediate aftermath, creating a dislocation in pricing. Some observers have suggested the fallout might show that the growing burden of bank regulation and changes in liquidity provision are beginning to take their toll on the market.

“We learnt from the SNB floor removal that just because a currency has been classified as G10 doesn’t mean it can’t behave like an EM currency. There is now a realisation that one cannot assume anything about the behaviour of assets, and the risk of a currency suddenly becoming illiquid needs to be constantly managed,” says Purves.

Just a week after the SNB decision, the European Central Bank caused further price action with its long-awaited move on QE on January 22. While that announcement came as no surprise to the industry, having been widely trailed in advance, it sent the euro into free-fall, with €/$ breaking out of its long-held range and falling from 1.17 on January 21 to a multi-year low of 1.05 in mid-March.

Reflecting the uptick in volatility this year, Deutsche Bank’s CVIX climbed to 12.11% on January 15, and has remained much higher than it was a year ago – it had fallen a little to 9.39% by May 14.

Recent events have caused another period of introspection in the industry, with some participants now actively limiting their exposure to pegged currencies and thinking more actively about liquidity concerns, but it has also had a positive effect on revenue for those banks that happened to be fortuitously positioned before January 15.

“The huge price volatility following the SNB and ECB announcements will have given most banks a significant boost in earnings for Q1, but in the absence of a rate hike from the Fed, Q2 and Q3 are likely to be more challenging. It’s also clear that the liquidity is shallower due to there being fewer market makers, which creates more intraday moves at times of high volatility,” says Allington.

As banks continue to reflect on this period of unprecedented structural and macro challenges, they are preparing for a future in which running an FX market-making business will require a different set of strategic priorities than it did in the past, not least because of the increased level of oversight and regulation.

While derivatives regulations may not yet be specifically affecting FX products, mandatory clearing is eventually expected to be implemented for non-deliverable forwards and FX options. But perhaps more important is the growing burden of capital requirements and balance sheet restrictions, which is forcing banks to concentrate much more on the profitability of their FX businesses than on market share.

“Traditionally banks have always focused very aggressively on gaining market share in FX, but today’s operating environment forces us to be more prudent about how we grow the business. The contraction in size of the industry wallet means that we have had to become much more selective – it is simply not commercially viable today to aspire to be all things to all people,” says Adrian Boehler, global co-head of FX sales and trading at BNP Paribas.

But as some banks reconsider their commitment to FX in this more challenging operating environment and others restrict their activities to particular client segments or geographies, gaining market share is not out of the question for some banks.

 “The competitive landscape is changing and as some banks retrench, there is a meaningful amount of market share that has historically been very difficult to prize away from its owners that is now up for grabs. This represents an exciting opportunity to grow the business in targeted areas,” says Boehler.

For those banks that are committed to growing their FX businesses, the main focus remains on internal controls and compliance, but hiring staff and investing in technology are also critical.

With the recent exodus of senior heads of business from several banks and the reputational damage caused by the benchmark scandal, some might well find it harder to attract young traders to work in FX, but the flipside is that there are more attractive career opportunities available for those that can prove their abilities quickly.

“There has been a generational shift, but it’s still a very attractive asset class in which to recruit. As senior personnel have left the industry, it creates opportunity for talented younger staff to progress in a way that might not have been possible a few years ago,” says Allington.

“The piece that is more difficult to replace is the managerial experience, so the banks that succeed in the future will be those with strong role models that invest properly in training and mentoring to bring out the best in younger talent and set the right tone in terms of both market capability and conduct,” he adds.

Banks are also continuing to invest in their electronic platforms as client demand for electronic execution appears to be on the rise and banks look to transact more and more flow electronically. UBS, for example, is working towards the automation of more than 95% of all FX transactions by the end of 2016.

“While we have spent a lot of time and investment on regulatory remediation, we are also planning for the future, and we believe having the right platform that supports both principal and agency execution is going to be critical,” says Purves. “Making sure that platform is regulatory compliant and supports the needs of clients will be a higher priority than gaining market share in the future.”