Lawyers call for clearer rules for FX forwards
As the regulatory landscape for FX continues to evolve – including shifts in best-execution practice and new supervisory frameworks for a slew of products – investment managers have been left uncertain about the implications for some of their trades.
Lawyers have called for European regulators to provide more clarity on whether FX forwards that are entered into for hedging purposes, as opposed to as investments, lie outside the scope of regulation.
Recent regulatory upheaval has left the market uncertain as to where the boundary lies between regulated and unregulated FX products.
Uncertainty about the scope of regulation or how it should be implemented is the hardest thing
As a rule of thumb, spot FX is an unregulated activity while the derivatives markets is subject to heavy oversight. However, there are different views on what constitute spot and derivatives trades.
In the UK, especially, there has been a view that forwards used for hedging do not fall under the scope of regulations, but this is potentially a difficult test to apply because counterparties must judge each trade on a case-by-case basis.
“We hope that the European authorities may issue some guidance on this in due course,” says Hannah Meakin, partner in the financial services group at Norton Rose Fulbright.
European Market Infrastructure Regulation (EMIR) brought these differences of interpretation into focus because it requires both parties to a contract to agree on whether it is a derivative, where in the past the decision was an internal matter. If the two parties take different views, this is problematic.
And this is not the only area where uncertainty crops up. Traders must also contend with a lack of consistency in the treatment of FX platforms, some of which are regulated and some of which are not.
Meakin says: “Uncertainty about the scope of regulation or how it should be implemented is the hardest thing – even potentially more difficult than tougher but clear regulation.”
Yet the changes affecting the FX market have only just begun and there is set to be more upheaval over coming years.
“The law around FX hasn’t changed massively as yet,” says Barney Reynolds, head of financial institutions advisory and financial regulatory group at Shearman & Sterling.
“The Fair and Effective Markets Review (FEMR) brought greater clarity about changes that are needed, but the potential extension of the UK rules to senior managers in all firms involved in the fixed income, currencies and commodities (FICC) markets could take several years.”
And this is just the start. A new global FX code of conduct is likely to take two to three years, while Mifid II rules, which will also apply to aspects of FX, will only apply from May 2017, he says.
For managers, the ideal regulatory landscape is always a delicate balancing act. On the one hand, it is useful for regulation to be specific and calibrated to the securities with which they deal in, rather than taking a once-size-fits-all approach.
On the other, fund managers like consistency, and a single rule-book that applies across a portfolio is easier to work with than lots of different rules that apply to lots of different products. So regulators are always looking for the right balance.
Imogen Garner, partner in the financial services group at Norton Rose Fulbright, says: “Asset managers are generally operating in the regulated sphere. So even if the FX instruments they use aren’t themselves regulated, if that FX activity is part of a wider regulated business, it makes sense for managers to be thinking about it in this broader context.” Yet this can be tricky because of the considerable differences that exist between asset classes. Equities and derivatives markets have pioneered transaction cost analysis (TCA) and behavioural analysis, for example, examining last-look orders by determining how many orders have been cancelled.
However, it takes time for such innovations to be transferred to other markets, which use different sets of metrics.
John Adam, global head of product strategy at Portware, a technology vendor that builds trading systems for the buy side, says: “In equities, the process for TCA, which is very much at the centre of what Mifid II’s best-execution guidelines are all about, is well defined. You benchmark to the arrival price or the volume weighted average price.
“FX is more subjective. There is the price offered by the bank, but this will vary depending on who the client is. The ECN will offer a different price too, and the World Market (WM) rate will be different again. There is far less consensus in price in FX, so the answer is to go composite.” Similarly, there is less clarity on volume in FX, adds Adam.
This can leave some fund managers at a disadvantage when looking for the best price in the market.
Adam says: “In equities it is well understood that some institutions do not want to trade more exotic, volatile or illiquid instruments with certain counterparties. A pension fund may not want to trade a large block order in a venue dominated by high-frequency traders, where any small improvement in price is outweighed by the damage of leaking information.
“Similarly, in FX, a bank may not want to offer its best price to speculators.”
Still, as markets evolve we are seeing a trend towards increasing regulatory convergence in some areas, says Garner.
“Much financial regulation has its genesis in banking, and from there it extends to other parts of the industry,” she says. “We saw that with remuneration, first with bankers and then to fund managers, via the Alternative Investment Fund Managers Directive and then Ucits.
“The same thing is now happening with FEMR, which considers whether some parts of the existing regime ought to apply to unregulated markets.”
And all of this is also driving technological evolution, says Portware’s Adam, adding: “Regulation is one pillar driving change and innovation in technology: the other is liquidity.
“It is the convergence of liquidity and new regulations in response to the market turmoil in recent years, which has in turn given rise to new mechanisms for trading.”