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Foreign Exchange

FX guest column: Kenan Maciel, Lab49, surveys the regulatory horizon

Lab49 is a consulting firm that provides strategic consulting and advanced technology solutions for the financial services industry. Kenan Maciel is a director in the Lab49 strategy group. In this guest post he surveys the possible regulatory outcomes for FX derivatives and the potential impact on FX trading from the banks’ perspective.

 In the statement from last September’s Pittsburgh summit, G20 leaders agreed that “all standardized OTC derivatives contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at latest. OTC derivatives contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.”

In July, president Barack Obama signed the Dodd-Frank Bill, making it law in the US. The legislation imposes a requirement of central clearing for derivatives transactions between dealers and “major swap participants” (loosely defined as users with a “substantial position in swaps” which are not used for hedging commercial risks). Where products are required to be centrally cleared, they are also required to be traded on an exchange or “swap execution facility” (SEF). The latter is defined by the bill (Part II, Sec 721) as “a trading system or platform in which multiple participants have the ability to execute or trade swaps by accepting bids and offers made by multiple participants in the facility or system”.

European legislation is some way behind that in the US. The European Commission has issued a consultation paper on potential regulatory reform for derivatives. The paper focuses on clearing, the rules governing central clearers and the reporting of derivatives transactions. A further consultation paper was issued in late July on exchange trading, with the EU wanting to incentivize exchange trading for standardized products. The EC has stated that European legislation will be implemented “in a way that is coherent with proposals now being finalized in the US”.

Impact on FX

The US legislation gives the Treasury secretary the discretion to exclude FX derivatives from the clearing and trading rules. The European legislation will evaluate each asset class to determine whether mandatory clearing and exchange trading is beneficial. Given the current status of regulation there are a number of possible prospects for FX derivatives. In increasing order of impact on existing transaction processes these are:

1) No change to the current rules for trading, clearing or reporting;
2) Only an obligation for post-trade reporting to a repository;
3) Obligation to centrally clear transactions and report them to a trade repository; or
4) Obligation to trade on an exchange or multilateral trading facility and centrally clear and report transactions.

1) No change to the current rules for trading, clearing or reporting
Likelihood: The US legislation requires FX forwards and swaps to be included in the reporting requirements even if they are exempted from the clearing and trading requirements, so this outcome – maintaining the status quo – is not a likely one for the US market unless rules are changed. The EU position is that each product type will be individually evaluated. Given that there is a desire to align US and EU rules, it is unlikely that the EU will not require any change for FX derivatives.

Impact: None – the current race for capturing FX market share continues as per usual.

2) Only an obligation for post-trade reporting to a repository
Likelihood: The industry (through ACI-The Financial Markets Association and other lobbying groups) is pushing for an exemption from the clearing requirements of the legislation. The argument is that, since 74% of all FX transactions mature within seven days (BIS Triennial survey 2010), settlement risk (rather than credit risk) is the primary issue. Settlement risk is already addressed through the use of CLS and other mechanisms, such as internal accounts with FX dealers to settle FX transactions.

Impact: Banks would maintain existing strategies of using single-dealer platforms to capture market share, enhanced by a sales team with advanced sales tools showing client positions and limits updated in near real-time. They would only need to factor in some additional functionality to ensure reporting obligations are met, ideally with electronic links to swap repositories. Transaction reporting would, of course, increase post-trade price transparency and, thus, put some pressure on margins.

3) Obligation to centrally clear transactions and report them to a trade repository
Likelihood: In the US, the regulator could determine that for FX forwards and swaps, only a clearing requirement exists. However, this would be a deviation from the legislation, which clearly states that, where clearing is mandated, products subject to clearing must also be traded on an exchange or SEF. European consultations have not explicitly tied together central clearing and exchange trading so this outcome is possible under current proposals.

Impact: If we assume that only clearing is mandated, the existing business models for trading FX would be largely unaffected in terms of channels and trading venues. Banks would continue to trade using APIs, single-dealer platforms, multi-dealer platforms and voice. Each venue would now need to factor in links to a number of clearing houses so that transactions could be routed to the clearers; this connectivity to clearers and trade repositories would need to be built. In addition, banks and clients would need to post initial and variation margins with the clearers, resulting in additional funding requirements for clients.

4) Obligation to trade on an exchange or multilateral trading facility and centrally clear and report transactions
Likelihood: If the full US rules on derivatives are applied to FX forwards and swaps then centrally cleared products would need to be executed on an exchange or SEF. Lawyers for banks are attempting to argue that single-dealer platforms should be eligible as swap execution facilities. However, at face value it appears that they do not comply with the definition. The key to this is the term “multiple participants”. Bids and offers must be made and accepted by multiple participants. In a single-dealer platform, the bank makes the bids and offers. Where special execution features are offered, clients can enter trades with their own bid or offer prices inside the bank’s streamed spread, but even in these cases, the bank will be the counterparty for any executed transaction. In the European consultation on exchange trading, the paper states that single-dealer platforms do not meet the Mifid criterion of a multilateral trading facility because of the bilateral nature of all transactions. However, it invites comment on whether there is a place for such platforms if pre- and post-trade pricing transparency was available on the platform.

Impact: The implications of this for banks are significant: 

it would cause a large proportion of FX swap and forward volume to move from proprietary platforms to exchanges or SEFs, putting downward pressure on margins; and
it would allow smaller players to increase their share of the market at the expense of the larger players as the barrier of building expensive bank-specific platforms is removed, as is the issue of counterparty creditworthiness. 

Existing bank platforms would still be able to route client orders to exchanges or SEFs, but there is no guarantee that they would be the counterparty for executed trades; in the limit, they would act only as a broker.

However, this outcome could play into the hands of the leading FX banks, such as Deutsche Bank, Barclays and Citigroup, if they could convert their platforms into multilateral trading facilities and have them qualify as SEFs. (They would need to factor in whether transaction fees would justify the costs of doing so, as the profit from currently internalized trades would no longer be available to them – it is estimated that, in some cases, 50% to 80% of flow is currently internalized.) The move to an SEF for large banks seems quite compelling: 

they could continue to trade bilaterally for those products (such as spot FX) not required to be traded on an exchange or SEF;
if trading for certain products is required on an exchange or SEF, they would see a migration of those products to their now SEF-qualifying venues (at the very least on a brokerage basis) and;
they would also see migration of any flow associated with those regulated products, with some of that flow being bilaterally tradable (such as spot FX).

Non-financial customers account for around 13% of global FX market activity, according to the 2010 BIS Triennial survey. In the US, corporate clients that use derivatives mainly to hedge commercial risks will not be required to have those transactions centrally cleared. In Europe, the proposal is for a threshold volume to be established by the regulators whereby a corporate would fall under the central-clearing requirement only if it exceeded this volume. However, if exchange trading were to become the norm for FX forward and swaps among financial institutions, it would make sense for corporates to use these same venues. The only deterrent would be the additional demand on their working capital from posting margin. The US legislation does call for uncleared transactions to be margined in any case. 
Looking forward

The introduction of the trading requirement could thus change the current landscape of the FX derivatives market. Banks need to prepare now for the coming changes – Goldman Sachs has already announced a link to a central clearing service for its derivatives transactions. There will be a large requirement for technology change to facilitate the routing of orders and the subsequent clearing of executed orders. Larger banks could develop SEFs while smaller banks could prepare electronic brokerage services. The only certainty is that doing nothing is not an option. Even if the regulations were to materialize in the form of no change to the current situation, banks would still need to invest in electronic trading – which is now estimated to grow to 75% of trading by 2012 (Celent Global FX Market Trends 2009) – if they are going to have any chance of capturing market share. Depending on their current standing in the market, banks need to implement strategies that will position them to grow market share regardless of which outcome eventually becomes a reality.

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