Foreign exchange market enters new dawn post-footnote 88

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A new Isda report reveals how the fight for currency liquidity is on as foreign exchange trading venues struggle to adapt to the new regulatory landscape

The Commodity Futures Trading Commission’s new derivatives legislation was never meant to be an edge-of-the-seat read, but nothing packed a punch quite like pages 22 and 23, a small section that has wrought havoc across the credit and FX markets.

The new CFTC rules, which were part of the Dodd-Frank regulations that are being implemented by US regulators, demanded that most swaps be transacted through registered venues known as swap execution facilities (SEFs), routed through central clearing houses and reported to data warehouses known as trade repositories.

Buried in those pages was footnote 88, which states that "a facility would be required to register as a SEF if it operates in a manner that meets the SEF definition even though it only executes or trades swaps that are not subject to the trade execution mandate". This meant that anyone trading any derivatives anywhere in the world, and planning to trade with a US person, would have to register with the CFTC as a swap execution facility – and do so by the October 2 2013 deadline.

Footnote 88 sent the European industry into paroxysms of panic as some non-US platforms warned ahead of the deadline that they would not register as SEFs and warned users designated as US persons – such as non-US arms of US investment banks – that they will not be allowed to trade on the platform after the SEF registration deadline. This, the industry feared, would result in a reduction in liquidity.

A survey published this week by the International Swaps and Derivatives Association (Isda) suggests that the industry’s worst fears are being confirmed. The survey, entitled ‘footnote 88 and market fragementation’ was launched on November 19, and asked 44 participants a series of questions designed to uncover where and how market fragmentation might be occurring in the new regulatory environment. In its findings, Isda said that post October 2, liquidity “has been fragmented across platform and cross-border lines resulting in separate liquidity pools and prices for similar transactions”. In particular, 84% of survey participants said that non-US persons are choosing not to trade on SEF platforms as a result of CFTC rules coming into effect in all swap categories: interest rate, credit, foreign exchange, equity and commodity derivatives. Meanwhile, Isda said several participants revealed that total derivative trading volume measured as a percentage of notional amount decreased from October 2, particularly in credit and foreign exchange derivatives.

Speaking before the publication of the Isda report, James Kemp, managing director of the global FX division at the Global Financial Markets Association, said: “We must avoid seeing further fragmentation of liquidity which would negatively impact on investors and corporates and be detrimental to a well-functioning FX market. It will also be interesting to see how Europe manages the transition to its own execution regimes under proposed Mifid II rules.”

Some investors have sought to escape the clutches of footnote 88 by moving back from electronic to phone-based trading for some products. The Isda survey bore this out, showing that 61% of participants believe trading has been redirected from electronic to voice trading as a result of the CFTC-SEF rules.

Since the financial crisis, foreign exchange liquidity has ebbed away from single-dealer trading platforms operated by investment banks in favour of multi-dealer platforms, and the proliferation of MDPs has given the buy side more choice when it comes to trading FX. Many predict that as more MDPs become registered as SEFs, liquidity will continue to fragment and move away from single-dealer platforms.

According to US-based Greenwich Associates, global trading volume on multi-dealer platforms climbed to 44% in 2011, up from 38% in 2007, as single-dealer volume dropped to 42% from 49% during the same period. Currently, the biggest beneficiaries of this shift among institutional and corporate FX market participants are FXall with 29% market penetration, 360T with 18% and Bloomberg with 17%, Greenwich said.

But in a report published on November 12, Greenwich said that, while in the long term MDPs will win the fight for liquidity, the disruption and confusion currently afoot in the market could provide a short-term boost to single-dealer platforms. The report said: “Regulations requiring multi-dealer platforms to register as SEFs may drive more trading volume to single-dealer platforms in the near term as clients look to minimize the impact of new regulations on their trading process.”

Greenwich Associates reckons FX trading on single-dealer platforms will remain steady or grow slightly in the next six to 12 months, especially among financials, which are already the heaviest users of these systems. “The good news for multi-dealer platforms is that we see this shift as a transitory phenomenon,” says Greenwich Associates head of market structure and technology advisory service Kevin McPartland.

Kemp adds: “It’s too early to reach any conclusions on SEFs and, understandably, a degree of ‘bedding-in’ is needed to adapt to SEF status. The recent confusion around SEF confirmations – which arose due to insufficient time for participants to build the functionality – along with the ‘US person’ definition have muddied the waters. But any new market needs time to develop and venues will be developing their business models to enable them to attract liquidity.”