FX: Fund managers awake to Mifid II
With the Markets in Financial Instruments Directive II (Mifid II) on the horizon, the regulation is likely to impact FX market structure – indirectly.
Mifid II will bring in new requirements for asset managers, including more specific order execution policies, and although FX spot is not a covered instrument, asset managers might find themselves including it as though it were.
In short, there will be a more detailed requirement for asset managers to report where and why they executed on their chosen execution venues, notes Jill Sigelbaum, Traiana’s head of FX.
And Vikas Srivastava, managing director, business development at Integral Development Corp, suggests asset managers are already rethinking their currency trading systems.
Asset managers have also taken advantage of the availability of FX experts from the hedge fund community to enhance their knowledge and understanding of market pricing and distribution, suggests Glen Sargeant, product manager, buy-side FX at FlexTrade.
“The FX trading teams of asset managers will have had access to deep liquidity in the past, facing a great number of counterparts across all FX types,” he says.
“However, this approach may have to change. The management of forward-dated exposure in compliance with Mifid II requires a great deal of administration and one approach to minimizing this would be to reduce the number of counterparties faced for forwards.”
Not only must an asset-management firm have staff to run a trading operation – it will also require dedicated system resources to help meet Mifid requirements, adds John Halligan, president of Global Trading Analytics.
Another challenge, according to Andy Woolmer, CEO of New Change FX (NCFX), is that fund managers tend to have very repetitive, predictable business in both spot and forward markets, so price-makers can easily guess what they will do each time they ask for a price.
“The price-maker will then make a tight spread, but will skew the price against the manager in the knowledge of what the manager will do,” he says.
“These skews are built into trading systems so a machine will seek to maximize the likelihood of getting the deal and making money from it by making a tight price outside of the market.”
A report by Deloitte on the implications of Mifid II for markets – Navigating Mifid II: Strategic decisions for investment managers – notes that all-to-all trading venues can provide investment managers with an additional source of liquidity, particularly as prudential requirements continue to restrict the sell side.
Anna Pajor, principal consultant and director at GreySpark Partners, says the evolution of market structure from dealer-to-clients to all-to-all presents new opportunities for asset managers to access attractive liquidity pools.
“The market is not yet organized around the all-to-all models, though, which suggests not everyone is aware of or exploring those new opportunities,” she says.
According to Stephane Malrait, global head of financial markets ecommerce at ING, the large asset managers are starting to talk to their execution management system providers to plan for the necessary upgrade for Mifid II.
He suggests the directive provides an opportunity to continue to support the principal trading model.
“The principal model is still very dominant on most FX currency pairs and the main trading model for all emerging-market currencies and FX derivative instruments,” notes Malrait. “For asset managers, best execution and transparency requirements can be achieved under this model.”
In general, asset managers are one of the client segments best suited to principal trading, agrees Jim Foster, deputy head of eFX trading at State Street Global Markets.
“Their trading tends to be non-correlated in the short term, making it practical to internalize their flow and gain access to more aggressive pricing than is available to agency clients,” he says.
“Additionally, many asset managers have complex workflows, trading across many accounts and value dates simultaneously, which are more challenging to provide in an agency environment.”
While there are some advantages to the principal model – for example, internal netting of trades and lower transaction costs – FlexTrade’s Sargeant suggests that increasing compliance requirements – for instance, being able to demonstrate there is no conflict of interest between funds – implies increasing costs.
“As a result, some asset-management firms have abandoned it in favour of the agency model,” he says.
In other cases it makes sense to use a single-dealer relationship, but to tender the business every three years and use an independent rate as a component of the contract to ensure that best execution is achieved on a relationship basis, adds NCFX’s Woolmer.
“For some it may be appropriate to use a multi-dealer approach on either a principal or agency basis, but what is absolutely clear is that these choices can only be made once a sensible understanding of costs has been reached,” he concludes.