FX probe digs the dirt to clean up market structure
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FX probe digs the dirt to clean up market structure

A high-profile investigation into market manipulation has heralded increased scrutiny of FX trading practices and could see major changes to the way the industry operates. But scratch below the surface and the tide may be turning towards a healthier market structure.

The foreign exchange market has been through some fairly seismic structural shifts in its time, from the birth of the European single currency to the advent of electronic trading platforms. The exact nature of the next shift cannot be known with any certainty, but the market faces some strong regulatory and technological headwinds in 2014 that will ultimately cause fundamental changes to the way currencies are traded.  Up until recently, the market appeared to have survived the financial crisis in fairly good shape. Having sailed through the upheaval of 2008 without missing so much as a heartbeat – largely thanks to the resilience of the industry’s infrastructure – it consequently escaped the most punitive elements of post-crisis regulations, with an exemption from mandatory central clearing and electronic trading for FX spot, swaps and forwards in the US. 

Then in 2013, details began to emerge of a regulatory probe into alleged manipulation of benchmark exchange rates. Dealers, it was claimed, had shared confidential client information in online chat rooms and colluded to trade large orders in such a way as to influence a popular and widely traded benchmark known as the WM/Reuters 4pm fix. By April 2014, numerous regulators had announced they were investigating the allegations, well over 20 traders had been suspended or dismissed from banks, and the Bank of England had been caught right at the centre of the scandal amid allegations its officials may have ignored or even condoned market manipulation. Very little is known about exactly what market malfeasance has so far been unearthed, and it could still be months or even years before the full ramifications are known. But however serious or trivial it all turns out to be, some believe the increased scrutiny will inevitably mean a clamp-down on certain parts of the market that had not previously been subject to stringent oversight.

“There are unwritten mechanics of how the FX market works, and certain practices that are legal but may not look very sensible when you put them under the microscope,” says Phil Weisberg, global head of foreign exchange at Thomson Reuters. “That will have to change and FX will gravitate towards being a more operations and technology oriented business, with clear rules of engagement and more explicit fees for individual services.”The role and sophistication of technology in foreign exchange has evolved at a rapid pace in recent years, to the extent that retaining a lead as a market maker now requires substantial investment in risk management and price distribution technology, as well as single-dealer portals and algorithmic execution tools.  But in an environment in which banks are required to hold much more capital and devote far greater resources to compliance costs, technology budgets are under pressure, and many expect concentration on the sell side as a decreasing number of banks have the resources to dominate the market in the way they once did.

“The biggest disruption in FX at the moment is the changing role of the sell side and the ability of banks to act as market makers,” says Rupert Bull, managing partner of Expand Research, a subsidiary of the Boston Consulting Group. “Relatively few banks in the future will be able to be all things to all people and the focus will shift from market share to profitability.” The way in which banks trade currencies for clients is also likely to change, and a well-documented shift from traditional risk-taking to an execution model where banks act as agents rather than principals is continuing to play out in the FX market. As banks’ use of balance sheet comes under pressure, the agency model offers a way for them to remain active in the market while taking less proprietary risk.

The shift to agency is largely a response to regulatory constraints but it could ultimately make banks more profitable in the FX market as they could theoretically take on larger client orders than if they were warehousing the risk on their own books. For corporations and asset managers, it should also mean more transparency on how the bank is trading its orders.

“There weren’t very clear lines in the past to delineate where banks were principals and where they were agents, but those lines will have to be drawn in future. While it will still be possible for banks to be both, they will have to be much more explicit with the client about how they are trading their orders,” says Phil Weisberg.The nature of bank liquidity provision may be changing, but the rise of non-bank market makers, including high-frequency traders (HFTs), has also been a recurring theme in recent years. Such firms may provide valuable liquidity, but questions have been raised about whether their commitment to the market would endure during times of stress. Meanwhile the proliferation of trading venues in recent years – many of which have still to show signs of gaining real traction – has been predicated on a move to answer the needs of an increasingly diverse market ecology. For example, it was a collision of cultures between banks and HFTs on primary platforms that led to the creation of new venues such as ParFX, which brought fresh rules and functionality to the market to discourage disruptive behaviour.

“A lot of the innovation in FX is focused on client segmentation, and trying to deliver functionality that appeals to particular groups of customers. Many venues have segmented their pools to attract different types of participants and protect users that may not want to interact with certain types of flow,” observes Sang Lee, managing partner at Aite Group, a research and advisory firm.

For the buy side, the increasing complexity of the market structure and the growing number of execution options that are available from both banks and third parties means the priority in the coming years will be to more explicitly measure and prove best execution.  Sophisticated use of transaction cost analysis (TCA) technology has developed in the equity market over a period of many years, and FX traders are increasingly now also looking to TCA as a means of benchmarking execution quality. But TCA is more complex in FX, largely due to the higher volume of trades and lack of central data sources.

“FX is a fragmented over-the-counter market and trying to aggregate separate data feeds to create a holistic view of the market is exceptionally difficult. TCA has been one of the biggest drivers of investment from an IT and research perspective and I expect it to be a major focus in the next few years,” says Sang Lee.

The FX market will clearly face some big challenges in the years to come, but there are also some bright spots  on the horizon. Foreign exchange remains, for the most part, a deep and liquid market, which will be less affected by onerous regulations than other OTC asset classes.

There will also be major growth opportunities in emerging markets. The Mexican peso and Chinese renminbi, for example, are now the eighth and ninth most actively traded currencies, according to the 2013 triennial turnover survey by the Bank for International Settlements. As the renminbi continues its path towards full convertibility and greater offshore trading, many market participants are positioning themselves to benefit from its growth.

And some believe even the potentially more damaging developments could turn out to be positive in the long term. “Whenever people fundamentally re-examine their business, good things happen,” says Phil Weisberg. “We may not necessarily be spending time on the most important problems first, but when people know and understand better the cost of doing business and the way FX is traded, that can only be a good thing.” 

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