Structural shifts upend troubled FX franchises

By:
Farah Khalique
Published on:

The foreign-exchange industry has been caught in a perfect storm of falling volatility, difficult trading conditions and regulatory challenges. Many of the senior figures in FX have stepped aside, leaving a new generation to come to terms with a radically different market.


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Zar Amrolia, co-CEO of XTX Markets

FX dealers hoping for a renewed bout of volatility have had their hopes dashed. Some now talk of a structural decline in trading volumes. Bank of England statistics show that daily reported UK foreign exchange turnover was just over $2 billion in October 2015, a fifth lower than a year earlier and the lowest daily turnover since 2012. 

Such declines are mirrored by the votes of 3,500 FX clients globally in this year’s Euromoney foreign exchange survey, with 2015 volumes down more than 20% compared with the previous year on a like-for-like basis. 

Towards the end of last year, the majority of market participants were convinced central banks were about to embark on a period of prolonged and protracted monetary policy divergence. The US Federal Reserve raised market expectations with talk of four interest rate hikes in 2016, in stark contrast to the European Central Bank’s monetary easing policies. 

But in a relatively short period of time, the market completely re-assessed its position as the Federal Reserve took a more cautious stance on raising rates. The subsequent end of the one-way dollar-strength story has led to a pullback in terms of trading volumes, volatility and risk positioning.

“People are now less convinced about the outlook for strong policy divergence, and consequently we see much narrower trading ranges in G10 FX,” says Adrian Boehler, global co-head of FX at BNP Paribas. “If there is less clarity and lower levels of conviction among certain client segments, then this will naturally translate into lower trading activity.”

The decline in trading volumes is also partly to do with the new randomness of market volatility, which has made currency markets more challenging. In previous years, volatility came when it was expected to come, with the release of economic data and policy announcements. 

“That has changed somewhat,” says James Bindler, global head of foreign exchange at Citi. “The Swiss National Bank event and the flash crash in equities last year translated into more random FX volatility. Event volatility is greater than in the past, such as when the Bank of Japan cut to negative rates.”

Structural changes in the marketplace mean longer periods of low volatility interspersed with shorter periods of higher volatility, leading to big, discrete gaps in the market, argues Chris Murphy, co-head of foreign exchange, rates and credit at UBS. “The move from voice to electronic trading and algorithmic-driven trading means that when a price is stable you get ample liquidity, but where there is a re-pricing in the market, all of a sudden that liquidity starts to vanish.”

Events like the SNB’s currency peg removal and increasingly common stock market flash crashes have forced banks to re-assess how they let counterparties such as hedge funds use credit through their prime brokerage arms. The conclusion has been that credit was priced too cheaply. Now prime brokers are much more discriminating about which clients they extend credit to.

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Adrian Boehler,
BNP Paribas

The SNB event also forced banks to question the protocol governing electronic trading and the size of inventory they run to facilitate anticipated client business. “It may also have triggered some market participants to review their market-making strategy when it comes to derivatives in currency regimes, which are not classically free-floating,” says Boehler.

FX market making has continued to become more expensive, says Russell La Scala, global head of FX spot trading at Deutsche Bank. “[This is] due to the costs of credit, separation of processes, compliance, legal, and the continual investment in technology.”

Dealers therefore anticipate that this year’s triennial survey from the Bank for International Settlements will show a drop in global foreign exchange trading volumes of as much as a quarter from 2013. 

Passive alternatives

Such a steep decline in a notoriously low-margin, high-volume business cannot be explained away purely by volatility and the pullback in prime brokerage. Dealers point to the bigger long-term trend of global equity investors ditching expensive active managers for cheaper passive alternatives like index-tracking funds.

According to George Athanasopoulos, co-head of foreign exchange, rates and credit at UBS, there is an important trend for assets under management to move out of certain types of hedge funds into other alternatives. “This migration of assets is relevant for foreign exchange, it has definitely had an impact on the decline in volumes. Capital is moving out of portfolios that traded frequently into more passive vehicles, which impacts FX volumes.”

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Mark Webster,
Standard Chartered

Investors are also exploring their counterparty options when it comes to their currency trades. The largest currency dealers still maintain their grip on the market, handling 48% of global FX trading, according to a recent report from Greenwich Associates. But Greenwich Associates’ survey of 1,600 global investors also found that 20% of volume was executed through non-bank liquidity providers, up from 16% the year before.

One such non-bank liquidity provider is electronic market making firm XTX Markets, which was spun out of quantitative hedge fund GSA Capital. Industry veteran Zar Amrolia joined its ranks in September after decades on the dealer side, most recently at Deutsche Bank. The B2B firm has already done several trillion dollars’ worth of spot FX through servicing banks and aggregators.

“The top 10 banks have enough critical mass to keep things ticking along nicely,” explains Amrolia. “However there is a mid-layer who are too small to be big, are not really investing in balance sheet, headcount or technology but who are looking to service their clients more efficiently as markets move further towards electronic execution.”

Non-bank players may be boosting their presence in foreign exchange, but on the dealer side many familiar faces have moved or quit the industry altogether in the wake of the foreign exchange rigging scandal of 2013

“The FX market is evolving very quickly. I think we are seeing a very natural process of renewal and soon we will see a different generation of people running this business,” says Athanasopoulos.

However, one industry source describes it as a “bizarre situation”, with newer industry heads seeking advice on everything from market structure to how to respond to regulation. “There’s been a clear-out not only of global heads but entire management teams beneath them. There are some very junior people who aren’t associated with poor conduct issues, but just don’t have the experience,” the source says.

Currency dealers privately admit that quite a bit of experience has left trading desks, prompting some banks to favour a more straightforward agency model over a risk-taking approach.

Fintech brings disruption

The concept behind peer-to-peer foreign exchange trading is gaining favour as an innovative way for businesses to trade foreign exchange at the mid-market rate for a transparent fee. Sites such as Kantox.com match buyers and sellers of currencies on its platform, cutting out costly bank or broker fees. Kantox has transacted more than $2 billion since it was founded in 2011, of which the second billion was transacted in less than nine months. 

P2P FX has caught the eye of ex-Barclays investment banker Rich Ricci, who joined currency exchange freemarketFX as chairman earlier this year. The platform allows users to buy or sell 14 currencies at the mid-market rate, for a fixed cost of 0.2%, via a scheduled exchange that takes place at least once a day. It is primarily aimed at small to medium-sized enterprises searching for competitive exchange rates.

Ricci has a keen interest in disruptive technology and believes the concept of P2P is “a brilliant idea and incredibly scalable". He says: “The challenge we have of course is how do you get enough cut through in place when there’s a crowded market? If we get eyeballs onto it, to me it’s a no brainer.”

A number of currency exchanges have indeed sprung up, but it remains to be seen how many will flourish. Moreover, these platforms still rely on the banks to complete trades in the event a viable match cannot be found between a buyer and a seller. FreemarketFX CEO Alex Hunn says it is impossible to match 100% of the flows, hence the importance of a partnership with external liquidity providers.

According to Chris Murphy, co-head of foreign exchange, rates and credit at UBS, the banks are paying attention: “P2P FX is definitely something we keep an eye on. There is no room for complacency; FX is a highly dynamic, evolving market and some of these emerging players have interesting offerings.

“There is potential room for collaboration; we have had internal discussions about how some of these alternative liquidity providers could plug into our distribution networks. There are definitely some possible synergies, the detail needs to be worked on.”

The benchmark scandal has helped boost the profile of P2P FX. Currency traders at big banks were found guilty of colluding to manipulate a number of currency benchmarks, including the WM/Reuters 4pm London fix, that are relied on by clients such as asset managers. Buyers and sellers of currency now increasingly question how much spread they pay on a transaction and the rate at which it gets filled. 

Another industry source says: “You clearly couldn’t backfill these senior MD positions with [junior staff]. Each bank adapted differently to the circumstances, some had deep benches while others pulled out and went more agency-esque.”

FX sales headcount will fall with the continued rise of electronic trading as clients require less interaction, predicts one currency dealer who wishes to remain anonymous. 

The model of having one team covering clients on the telephone and another selling the electronic platform has had its day, as clients increasingly prefer a single point of contact. “We had that for 15 years, it is well past its sell-by date. We also see more and more cross-over between FX and rates, but also with equities too and we don’t think the model of selling products via dedicated teams is going to remain for much longer,” notes Athanasopoulos.

This raises the question of whether or not the role of global head of foreign exchange, once considered one of the best jobs in banking, will soon be a thing of the past. Barclays has even scrapped the position altogether, following a business restructuring. Rob Bogucki and Nat Tyce jointly lead Barclays’ macro trading business, which encompasses foreign exchange, as well as rates and commodities.

There will be fewer people “doing FX the way we used to”, says Mark Webster, global head of foreign exchange sales at Standard Chartered, but the next generation of foreign exchange professionals will find other opportunities in compliance and regulation. Meanwhile, trading will become more of a science and less of an art, says Citi’s Bindler.

“Some of the older roles that can be automated will be done more efficiently. Those who are capable of re-thinking, re-inventing and evolving will have a fantastic future,” says Webster.

Fired but fighting

Regulatory and criminal investigations into the manipulation of currency markets are finally easing off – much to the relief of banks still reeling from billion-dollar fines – but some fired FX traders are not going down without a fight. A number of traders fired for colluding to rig benchmark rates have filed unfair and wrongful dismissal claims against their former employers, claiming they were treated as scapegoats and that senior managers actively encouraged their behaviour.

So far two traders, Perry Stimpson and Carly McWilliams, have won their cases against Citi, with the verdict of a further trader, Robert Hoodless, due imminently. More traders are expected to have their cases heard in due course, including Bob de Groot, former head of spot currency trading at BNP Paribas and Citi traders David Madaras and Baris Ozkaptan, meaning more potentially embarrassing details making their way into the public domain. Employment lawyers are bullish on their chances of winning, given Stimpson and McWilliams’ success. McWilliams is now employed in electronic FX sales at foreign exchange services provider Edgewater Market.

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James Bindler, Citi

The worst may be over, but banks cannot put the currency rigging scandal behind them just yet. “Reputational risk is still an area of focus,” says Bindler. “It’s been two years since the Fair and Effective Markets Review; a new code of conduct has been developed with the help of various market participants from all around the world. The market has responded strongly to restore its reputation.”

A currency chief at another investment bank remains wary of future regulatory probes: “The thing that concerns me most is that we may still be doing things in the industry that we think are best practice, but that regulators will look back at things in hindsight and question them.” 

The industry is keen to move on from the benchmark fixing scandal by creating and adopting an industry-wide global code of conduct. The BIS formed the Foreign Exchange Working Group in May 2015 to develop a robust code of conduct, headed up by assistant governor of the Reserve Bank of Australia and chair of the Financial Stability board’s FX benchmarks group, Guy Debelle. 

Uncleared margin rules hit FX options

Spot FX has become increasingly exchange-like, with platforms such as EBS and Reuters borrowing concepts from the equity world such as central order books, rule books and, more recently, transaction cost analysis. The asset class has even attracted the interest of stock exchanges, with Bats and Deutsche Börse acquiring electronic communication networks (ECNs) Hotspot FX and 360T, respectively, in 2015. 

Will Patrick, executive director of FX products at the Chicago Mercantile Exchange, says: “FX is becoming more exchange-like, which is driving these partnerships.”

Increased regulation of best execution will mean more requirements for standardization and rule-based execution, which the buy-side, like asset managers, can show to investors from trading on exchange.

Foreign exchange derivatives remain largely an over-the-counter market though, especially for more complex options, but this September there may be a greater shift towards simpler options that can be traded on exchanges and cleared. The biggest banks will have to start to comply with new uncleared margin rules on derivatives, putting aside collateral in the form of initial and variation margin against derivatives that cannot be easily funnelled through clearing houses. 

US regulators wrote these rules into the Dodd-Frank Wall Street Reform and Consumer Protection Act, while European Union regulators published the final draft of their equivalent rules in March this year, which fall under the European Market Infrastructure Regulation. 

The world’s largest derivatives players will be the first to be impacted, but from March 2017 smaller players that fall within scope of the new rules will also have to comply.

Margin is a totally new concept for the foreign exchange industry, but one that cannot be ignored, says Patrick: “Bespoke options are still traded over-the-counter, but market participants have got to be fully aware of the cost implications that come with that. Sometimes that is not at the forefront of people’s minds, but it will be come September.”

The cost of counterparty margining will be a larger factor with the introduction of capital requirements against uncleared trades, predicts James Bindler, global head of foreign exchange at Citi. As such, the cost of capital will increasingly be reflected in pricing, with greater impact on longer dated trades and derivatives.

Meanwhile, clearing is a distant prospect for the foreign exchange industry, as regulators have yet to officially mandate clearing for any foreign exchange products. 

The clearing hurdle remains high, says Bill Goodbody, head of foreign exchange at Bats Hotspot: “There are mandates [in Dodd Frank and Mifid II] that should come into play for some FX derivative products, though the timings of these are unclear. Whether or not similar mandates ever come round to the spot market is anyone’s guess.”

The first phase was due to be published as Euromoney went to press; the full code is scheduled to be announced in May 2017. Debelle fired a warning shot at banks last year, requiring them to implement the recommendations in a preliminary report, which appears to have been successful. A number of changes have already been made, such as segregating client requests for dealing at the fix from the rest of traders’ order books, offering clearer payment options for dealing at the fix or renting a bank’s algorithm to trade at the fix.

The code of conduct is intended to force even greater transparency and create more consistency for clients. “Its adoption will be a big moment for the industry,” says Amrolia. “It is still evolving and more work needs to be done, but nonetheless it will be a huge step forward. The number of people who have been involved in bad behaviour has been small relative to the size of the industry, but it doesn’t matter because it tarnishes the entire industry in the minds of people. Anything that restores trust and confidence in the system is a defining moment.”

The industry is keen to receive guidance on grey areas that potentially pose areas of conflict, such as the dissemination of market colour, order handling and electronic trading. The second phase of the code is expected to focus on the nuances of electronic trading, notably the controversial practice of ‘last look’

Banks can pull a quoted price from trading platforms, even after a customer has clicked on it and placed an order, hence they get the last look. It was initially introduced to weed out toxic flow from unwanted high-frequency traders, who hunted for minor discrepancies in banks’ pricing to work to their advantage. But the practice has come under fire for discriminating against genuine customers too. 

Last year, Barclays was fined $150 million by US regulators for abusing its last-look policy on currency orders. Deutsche Bank has been hit by a law suit filed in New York that claims customers lost money on trading platform Autobahn due to last look. Deutsche Bank denies the allegations.

The industry is still divided over last look, but market participants are hopeful of receiving more guidance from the code. Some clients are happy to accept the practice and tolerate rejected trades, if it means they get tighter pricing on their completed trades. Others do not want it at all, as they prefer to complete all their trades even if it means they get slightly worse prices overall. In time, the debate may come to a natural end as markets move closer towards real-time. 

The outcome of all these investigations is that market users want more transparency in currency markets. For now, the only way to accurately calculate global foreign exchange trading volumes is to wait for the BIS to publish its triennial survey. Individual platforms like EBS and Bats Hotspot regularly publish volumes, as do central banks like the Bank of England, but it is much harder to paint a global daily picture. 

To that end, a group of electronic communication networks (ECNs) and market makers have joined forces to create a central tape for FX. It would provide a last-sale data feed with price, size and timestamps.

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Bill Goodbody,
Bats Hotspot

Bill Goodbody, head of foreign exchange at Bats Hotspot, welcomes the move: “The benefit of the transparency of a central tape is not having to wait three years for a comprehensive look at FX volumes from the BIS; we can do better than that.”

The concept faces many hurdles, not least that it would require multiple venues to collaborate and share data. Foreign exchange is traded across an astonishingly wide range of platforms and many parts of the market operate off-venue. Data privacy might also be a concern.

“People can feel there is a risk in giving up that information unless it’s truly anonymized. We would need a data repository where people can send trade information and a third party would need to run that,” says Goodbody.

One solution would be to report big trades only at the end of the day, so there is a meaningful time delay and market impact is limited.

It could also prove tricky to compile data for niche currencies that are not widely traded. Standard Chartered’s Webster is not convinced: “I don’t see a central tape for FX as compelling. It throws up issues, particularly in extremely illiquid emerging market countries. Trying to work out major clients’ interests over a protracted period of time is counter-productive.”