Regulators seek to restore FX’s broken trust covenant
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Foreign Exchange

Regulators seek to restore FX’s broken trust covenant

The debate around how to strengthen the regulation of FX markets continues to rage. Advocates highlight examples of regulations that have benefited the markets in the long run, while detractors warn of unintended consequences and cite their own examples of risk-mitigating measures evolving naturally within the industry.

Proposals to create a central clearing utility through which all FX trades should be cleared have been compared to the breaking up of the historical stock exchange monopolies in the EU equities market in 2007.

frederic ponzo
 The idea of creating a central marketplace order book has encountered push-back from banks, but it will happen one way or the other

Fred Ponzo

That move, which was not universally popular at the time, led to a dramatic reduction in execution fees, which were slashed by around 10 times, says Fred Ponzo, managing partner at GreySpark Partners.

It did create some new problems, such as reduced ticket sizes and, in turn, increased algorithmic, high-frequency trading, he acknowledges, but he believes the benefits have outweighed the problems.

The comparison is far from perfect. Where Mifid broke up entrenched monopolies to encourage competition, the Financial Stability Board’s (FSB) proposals suggest concentrating clearing activity on a single platform. This would be just one of a package of measures designed to ensure no repeat of the FX benchmark fixing scandal.

The recently proposed regulatory changes would have more in common with Reg NMS, says Ponzo, the 2007 regulations that increased competition by introducing interoperability in a fragmented US equities market with decimalization, normalized tick size and market transparency.

At the heart of the debate around regulating FX is the question of whether the market needs any additional regulating, and if so, how much?

While there is no doubt there has been wrongdoing in the FX market, it is debatable whether a new set of rules is the solution. If so, the rules need to resolve specific problems in the functioning of the market, and be designed in such a way they minimize disruption to the existing market.

“Our big concern is the risk of an excessive regulatory response,” says James Wood-Collins, CEO at Record Currency Management, one of at least 36 institutions that provided feedback for the FSB consultation. A heavy-handed regulatory response will increase costs for the market’s users, he warns.

GreySpark’s Ponzo says: “The FX market works very well. It is cheap, efficient, competitive and liquid. The commercial impact of malpractice in FX fixing was frankly immaterial, but it did break the trust covenant so a regulatory response was inevitable.”

Opinions divided

The creation of a central clearing utility is just one of 15 FSB proposals, and opinions are divided about whether it is a good idea. Commerzbank and National Australia Bank, for example, support the proposals, at least tentatively.

“Centralizing all fixing orders in a clearing utility outside of the individual banks, ideally one applying a netting mechanism, would dramatically reduce the risk of manipulation and malpractice in relation to execution of fixing orders,” says Commerzbank in its response to the FSB.

“Such an external utility could ensure that any fixing order placed by a client would be outside of the knowledge of the FX trading desk and the netting of matching fixing orders would add another layer of certainty to reduce the risk of individual misbehaviour.”

However, Deutsche Bank expresses reservations. “While a single global utility would fully maximize netting opportunities, we have concerns about the feasibility of creating a central, global utility and its impact on competition and choice,” it says. Regulatory endorsement of such a plan could stifle innovation that might solve the problem better in a different way, it suggests.

Unintended consequences are at the root of industry concerns. The Financial Markets Association (ACI), in its consultation response, states: “Having a central utility would create enormous single-point of failure risks.

“ACI recognizes the value of specific utilities for their specific purposes, but supports a global free market for trade execution. A concentration in a single global point for trade matching would in the event of failure pose a significant risk for the market.”

There needs to be a middle ground that applies to everyone universally – not just the biggest sell-side institutions
Marshall Bailey

Instead of developing a new top-down set of rules for the FX market, ACI believes its own model code could be used as a standardized, industry-wide code of conduct to ensure best practice across all institutions.

While some outside the financial industry might scoff at the idea of a code of practice as an alternative to legally binding regulation, Wood-Collins believes such a code – with the endorsement of the FSB – would carry considerable weight.

“The FSB represents central banks and so has considerable authority,” he says. “We believe if it spelt out a code of best practice, then banks would fall into line.”

Marshall Bailey, president of ACI International, says: “It is hard for institutions to develop their codes of practice in isolation. Every institution wants to find the right balance. If it is too tight, they risk being at a disadvantage relative to their peers. If it is too loose, the rules risk being breached, which opens the institution up to the risk of potential sanctions and other disciplinary measures.

“There needs to be a middle ground that applies to everyone universally – not just the biggest sell-side institutions, but smaller banks and buy-side institutions as well.”

Any incidents of benchmark fixing or other fraudulent activities should be treated as a criminal matter. The key to restoring confidence might be the successful application of the rules, not the development of new ones that will again be ignored.

“A lot of progress has already been made on the enforcement front,” says Bailey. “The UK authorities already introduced individual executive management accountability so the people responsible for overseeing compliance know they will be held responsible if things go wrong, and that has been very helpful.

“Ultimately, it is no different to any other law which needs to be enforced. What matters is that an ethical code is taken seriously.”

Bailey believes a central clearing facility could be useful, but argues it should be developed organically from within the market, not imposed on it by regulators. There are several commercial ventures in the market offering a similar service to the one envisaged by the FSB, he notes.

One such service is owned by State Street Global Markets, which also submitted feedback to the FSB. It said the initiative, with which it would be in competition, deserves further study, but warned it would take a long time to prepare and be difficult to implement from a technological perspective.

“The FX market has a history of creating innovative solutions that improves the market ecology, and I’m sure this will be the case again,” says Bailey.

A case in point: continuous linked settlement (CLS), which is a multicurrency cash settlement system that mitigates settlement risk for FX transactions in 17 currencies in spot, forward, swap and OTC credit derivatives markets.

“CLS is an example of how the market can respond to these kinds of challenges,” says Bailey. “It was a credit construct to mitigate settlement risk in FX transactions and was backed by regulators and trading institutions, but it took a while to take off.

“Now it is seen as a vital part of FX infrastructure, and demonstrates what the industry and regulators can achieve by working together and coordinating their efforts globally.”

CLS scepticism

When CLS launched, it was met with some scepticism, but it won people over because it proved the benefits to the wider market, says Bailey, adding: “We would like to see any new central clearing platforms evolve in a similar fashion and the market remain free to decide which solution to use for itself.”

However, as much as the market protests it can police itself, authorities might be in no mood to give ground. Ponzo says: “The idea of creating a central marketplace order book has encountered push-back from banks, but it will happen one way or the other.

“Banks are principally concerned about their profitability. It will force them to rethink the relationships with their clients. Bankers need to stop considering them as necessary counterparties for their trading activities, but as customers to whom they offer a service worth the fees charged.” 

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