FX trading focus : HFT : Dan Barnes

January 12, 2017

FX: THE PHANTOM LIQUIDITY MENACE.

The sterling flash crash is indicative broker liquidity has gone; the buyside must look for alternative counterparts in FX. Dan Barnes reports.

The flash crash in sterling /dollar on 7 October, 2016 saw the pound fall to $1.1840 at 12.09am BST from $1.2609 at 12.06am BST, then bounce back to finish the day at $1.24, according to Bloomberg data. These events have occurred in several key markets before with US equities in 2010 and US treasuries in 2014 being the most notable. The latest occurrence is under investigation by the Bank of International Settlements (BIS) following a request from the Bank of England, but if it follows the pattern of previous investigations it will find a common pattern as the cause.

There will be several contributing factors cited including thin liquidity, a high proportion of automated trading as well as liquidity provision by high-frequency trading (HFT) firms and phantom liquidity – the placing and cancellation of a high volume of orders by HFT firms. The reduction of traditional broker dealer liquidity will also be on the list. A source close to the BoE reports that initial indications point to electronic trading issues rather than a ‘fat finger’ error.

It has been documented that the FX markets faced some of these circumstances on 7 October. In a note issued on 5 October 2016, around 40 hours before the sterling flash crash, Bank of America Merrill Lynch FX strategists warned that the market was looking increasing fragile “as phantom liquidity creates the illusion of stability.” The firm reported that its volume-based analysis showed market liquidity had materially worsened with market impact of a given volume some 60% greater than in 2014, while volatility events had increased in frequency and amplitude. The sterling crash was conducted in Asian trading hours when liquidity tends to be at its thinnest, exacerbating these factors.

“The HFT firms, and e-Commerce algos and hedgers at the banks, have been very successful in establishing a 24/7 view of a currency in terms of transparency and reference point,” says Darryl Hooker, co-head EBS Brokertec Markets. “They are not necessarily equally as additive in terms of putting liquidity to those prices. So in Asia you can see a great price in sterling at 7pm New York time, but then you try and hit that price for ten pounds and you would probably only get one done.”

Take your partner

For the buyside FX trader, thinner sellside liquidity, the consequent potential for greater market impact and volatility, increase the importance of finding a wide circle of liquidity providers. The growth of electronic trading is making that choice easier, says David Scilly, head of fixed income & currency dealing at First State Investments. “The electronic environment allows buyside traders flexibility to make their own choices around how they execute. There is enough flexibility in most e-trading systems for us to be able to choose whether or not we do an RFQ, whether we take advantage of available liquidity at the time or whether we work an order into the system over specific parameters.”

Where broker-dealers are falling back, electronic liquidity providers (ELPs) are moving in. These firms are part of the wider HFT demographic, which was estimated to be approximately 40% of volume in spot FX across 2014-15, having fallen slightly from about 42% in 2012-13, according to analysis by Aite Group.

Representing such a considerable chunk of actionable liquidity, makes HFT firms a potentially valuable counterpart for investment managers. The heads of trading on buyside desks have matured their ability to interact with HFT liquidity, often due to experience beyond the institutional investor market. The result is that relationships between buyside firms and HFT firms are getting stronger.

“In the public view HFT was often seen as ripping off buyside firms, generating decent profits because of little knowledge at buyside firms about HFT activities,” says Christoph Hock, head of multi-asset trading, Union Investment. “This is clearly not our view. From our perspective HFT is not bad for markets per se. But it is important to differentiate [between types].”

He draws a distinction between electronic liquidity providers (ELPs) which offer automated market making and provide additional liquidity in markets, and firms that are active in markets with pure proprietary strategies like latency arbitrage and short-term momentum trading.

“In this field we implemented measures in the past to give us a high level of protection against these activities,” Hock says. “For seven years I worked myself in the hedge fund space and looked at these kinds of market making and prop strategies in detail, so I am quite familiar with the dos and don’ts.”

For traders seeking to avoid HFT altogether, some platforms offer mechanisms that limit the types of trading strategy that can be used, in order to remove the risk of any predatory practices.

Dan Marcus, CEO of trading platform ParFX says, “FX trading counterparties rely on a range of trading venues to act as neutral facilitators of liquidity and the onus is on these venues to put mechanisms in place to protect their customers against any forms of disruptive trading behaviour. However, this was not occurring in many instances.”

ParFX was developed in partnership with several large currency trading institutions and incorporates a number of preventative measures and mechanisms that discourage ‘disruptive’ trading, including free market data distributed in parallel, to prevent any counterparty gaining an advantage, and the introduction of a randomised pause of 10-30 milliseconds.

“The pause is meaningful enough to nullify disruptive traders whose strategies rely solely on speed,” says Marcus. “Essentially, what this does is deliberately randomise trading instructions so the fastest, latency-dependent traders have no guarantee of being the fastest. However, it is meaningless to those that come with a genuine trading need, who seek firm, executable liquidity and who compete on strategy.”

The liquidity picture

The challenge firms have is not only the risk posed by counterparties, but how to determine real market liquidity, where a large volume of orders might be cancelled, creating a phantom liquidity picture and potentially increasing market impact for the unwitting.

Overall spot market trading activity has been in decline, falling by 19% to $1.7 tn per day in April 2016 from April 2013 according to the BIS Triennial Survey. It noted that the decline was the first picked up in a report since 2001. While liquidity does not correspond directly with volume, a shallower market makes bigger orders easier to detect.

Working with non-bank sources of liquidity will help, but it will not be a salve. Daily spot turnover with hedge funds and proprietary trading firms as a counterparty declined 29% in the three years to April 2016 to $200 bn. Forwards and FX swaps also saw a decline in trading with those counterparties, falling by 29% and 37% over the same period.

Given these circumstances, finding liquidity will be down to a combination of the right tools and platforms. Scilly says, “You don’t necessarily have full transparency into liquidity as a user, but increasingly you are being directed through EMSs and through other smart trading platforms to execute in a certain way, using the systems’ internal workings to take advantage of the liquidity that is available.”

There is a more radical option, notes Hooker. A regulatory intervention that forces internalised liquidity back out in the market, just as ‘dark trading’ in the equity markets has faced volume caps under impending MiFID II rules.

“If regulators or central banks said banks were not allowed to internalise more than 50 per cent of flow, the amount of liquidity that would pour back into the market would be tremendous in terms of helping to ease these stress events and show that there was real liquidity out there,” he says.

©BestExecution 2017

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Regulation & compliance : MiFID II : Francesca Carnevale

Ian Rycott

January 12, 2017

PREPPING FOR MIFID II: A RICH FIRM’S GAME?

Although seemingly hitched to an endless reset button, MiFID II looks to be as transformational as its predecessor, MiFID I. The breadth of the directive’s scope and the depth of clarifications required to understand its reach takes it into new territory. Francesca Carnevale asks if everyone is prepared for the consequences of its implementation?

The teenage years of each century brings its own brand of change. In the 20th century it was about politics, de-industrialisation and advances in transportation, with all the wars and social change that implied. This century it’s about climate, technology and finance, which in combination will generate its own paradigm shifts. MiFID II is firmly in this change set, helping define two of the century’s drivers, at least in a European context and maybe even a little outside it – after all, much of its remit is set by G20/FSB prescriptions.

The current effective go-live date across Europe is January 2nd, 2018 and while some firms remain indifferent or in denial, others, particularly tech providers, are hitching their operations to MiFID II’s star. Longer term, in the UK, Brexit clearly offers an opt out; though the Financial Conduct Authority (FCA) is insistent that unless it specifically says different the UK’s securities markets should assume blanket compliance with EU market directives.

Algorithmic and high-frequency trading, direct electronic access, market data and OTC markets are a smattering of the specific areas addressed by MiFID II. Its importance lies in that it touches all trades, all traders and all assets. Moreover, it tries through a complex web of rules to achieve efficient, transparent and by extension ‘safer’ trading. Whether all these elements are conducive to globally competitive (i.e. cheaper) and open and free markets where perfect price discovery is a constant is moot, particularly as MiFID II is not alone in exerting a regulatory burden on both the buy and sellsides.

As Matt Gibbs, product manager at Linedata points out, “with both the Securities Financing Transactions Regulation as well as initial margin requirements for non-centrally cleared trades under EMIR also requiring attention, the process of responding to regulations on an individual basis [is] proving both costly and time consuming.”

Just how costly was highlighted by a straw poll of 25 banks and asset managers by PA Consulting in late September 2016. Respondents variously estimated the cost of MiFID II compliance to range between less than £3m to over £20m. Three quarters thought the directive’s transparency requirements were the most expensive to meet, while transaction reporting was the least costly because it could be readily outsourced.

The best execution challenge

Even so, the effective harnessing of market data to secure best execution of trades is a touchstone of the directive. Dermot Harriss, head of development for market surveillance at OneMarketData says any effort to secure MiFID II’s legacy lies in best execution; but that achieving it is not easy and the quality of underlying market data is essential for proving it. “Clients really want to see it, and to achieve best execution you need data, data storage, record retention and data reconstruction. MiFID II will take Europe a long way towards best execution, though some questions remain open. How do you, for example, effectively price illiquid trades, particularly in markets that were once OTC?”

Harriss says the opportunities for firms such as OneMarketData to innovate compliant products that help the market meet both best ex and transparency requirements have multiplied in the run up to MiFID II’s go live date. “There’s a certain hesitancy about what best execution might mean, and from our discussions in the market many firms across Europe are still looking for guidance in terms of both definitions, measurement and reporting,” says Harriss.

Michael Horan, head of trading services at BNY Mellon’s Pershing agrees and explains some of the scope for support: “Best execution is always about process, and MiFID II requires ‘sufficient’ efforts – as opposed to ‘reasonable’ previously – by market participants to deliver it. Firms also must be transparent in the venues they utilise (by value), the trading strategies they employ and their best execution statistics. However, there is still some legroom in how these terms can be interpreted.”

One drag from MiFID II is the money that will inevitably be diverted towards compliance, and its application of compliance, across the whole firm and away from investing in growth. Horan acknowledges the consequent dynamic: “The common theme for firms large and small is the high cost this could entail and it might be that only larger firms will be able to survive these requirements. Certainly, it could result in a new round of market consolidation. Of course, firms can outsource some functions to third-parties for example to analyse trades, but even small firms must record all calls.”

He adds that “moreover, regulators are looking at trades in a granular way; for example, looking to have a consolidated view of trading at a given point in time, which involves synchronisation of clocks to a universal time. Synchronisation of all internal applications and then introducing processes that trace trades on a synchronised basis could be problematic for some firms. It all adds up to more expense and I am not convinced that all firms are ready for or can afford this level of compliance, particularly as MiFID II covers all types of tradable securities.”

Fran Reed, regulatory strategist at FactSet points out that MiFID II should be looked at as a dynamic process and while ESMA has shown flexibility in allowing firms the legroom to find their way towards compliance, the stop start approach to implementation of the directive and delays in elements, such as the time lapse between the start of MiFID II in January 2018 and the start of the Systematic Internaliser (SI) regime nine months later (in September) belie its intentions.

“It will confuse the market as to the different ways of reporting in the interim period, involving approved publication arrangements (APAs), approved reporting mechanisms (ARMs), consolidated tape providers (CTPs) and the obvious real time stuff that MTFs and OTFs must do,” says Reed. “It will be particularly problematic for buyside firms,” he adds.

He believes the significance of MiFID II is about bringing all trades into the light of day and in that regard, Reed says, “It is vital that all buyside firms understand how the directive will affect their business and begin to implement the processes that will enable them to meet the regulator’s requirements. Particularly, given the delay in the SI assessment period, the obligation to report through an APA or ARMs will be essential for the buyside.”

Reed says that compliance with MiFID II should be viewed as a long string that will roll out over time. Even with the latest reset of implementation to January 2018, much will remain in flux he believes and remains convinced that not all firms will be ready even by the delayed implementation date. “In part this is because the directive cannot be seen or complied with in isolation from the raft of other European regulation in play (among them PRIIPs and Market Abuse Regulation) and the backdrop of a challenging market environment.”

Given the complexity and depth of the directive, both buyside and sellside will likely resort to external help to fast track compliance; and redolent of Michael Horan’s implication that ultimately compliance with MiFID II is a rich firm’s game. PA Consulting’s survey results dovetail with Horan’s view, with most respondents (78%) stressing their reliance on third party solutions to help them through, earmarking transaction reporting, record keeping and best execution as the key areas to be enabled by new technology.

©BestExecution 2017

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Trading infrastructure : Consolidation : Lynn Strongin Dodds

Ian Rycott

January 12, 2017

A SENSE OF DÉJÀ VU.

The latest round of exchange mergers took place in 2016 but politics may scupper the headline grabbing Deutsche Börse/LSE deal. Lynn Strongin Dodds canvasses the scene.

Exchange consolidation is not a new theme but one that rears its head from time to time which was the case in 2016. Activity ranged from Deutsche Börse and the London Stock Exchange Group hoping to reignite their merger flame to the CBOE and Bats as well as Nasdaq and ISE looking to broaden their operations. Meanwhile, at the smaller end, Euronext took a 20% stake in clearing house, EuroCCP.

“The new wave we are seeing is the latest chapter in a continuing story,” says Justin Schack, a partner at Rosenblatt Securities. “The drivers are the same in that the exchange industry operates on a fixed cost infrastructure and from a financial standpoint and for their shareholders, they are better off consolidating to achieve economies of scale. A newer trend is diversification away from highly commoditised transaction-services businesses into the provision of data and ancillary services.”

Andy Nybo, a partner and global head of research and consulting, at TABB Group, agrees, adding “If you look at each transaction, there are different factors although they all revolved around wanting to expand asset classes and geographies. Now that they are all publicly traded entities they have to focus on revenues and growth especially as trading volumes have declined. This has created new areas of growth such as market data and licensing whereas ten years ago, growth came from transaction fees.”

Take the unexpected CBOE’s $3.2 bn high-profile acquisition of Bats Global Markets which when hitched will rival the likes of the Intercontinental Exchange, Nasdaq, and CME Group. The Chicago based group, which invented the options market in 1973 with the Chicago Board Options Exchange, is now the country’s largest options platform is an old school operator that still uses trading pits. By contrast Bats is a technology-focused upstart founded in 2005 that has grown into the second-largest US stock exchange by shares traded.

The Bats deal will enable CBOE to forge new territories of foreign exchange and market data while also take advantage of Bats sizeable footprint in Europe and its proprietary trading technologies. The aim is to move all its trading onto the Bats platform and generate around $65m of cost savings over the next five years.

“The acquisition has given the CBOE a new lease of life,” says Herbie Skeete, managing director at Mondo Visione.” I think we will see more mergers between exchanges that are long in the tooth and fintech companies as well as cash and derivatives exchanges because cash is a low margin business and there is a great deal of competition. However, with derivatives and commodities, you have a franchise with contracts that you own and if they are successful, then it belongs to the exchange.”

Nasdaq leads the way

Nasdaq, on the other hand, is a veteran of the acquisition trail, hoovering up several technology, data and exchanges groups over the past ten years. In the first half of 2016 alone, it was juggling six purchases including Chi-X Canada to grow its equities-trading business beyond the US and the Nordics, Boardvantage, to extend its Director’s Desk offering which is a protected portal for board directors that replaces their big loose-leaf binders and Marketwired to build on its global newswire services.

The biggest though was the $1.1bn acquisition of ISE, operator of three electronic options exchanges, from Deutsche Börse. Together they will command over 40% of the market, cementing its lead as the number one US exchange operator. The deal also increased its stake in the Options Clearing Corporation, the world’s largest equity derivatives clearing business, to 40%.

The transaction also enabled Deutsche Börse to pursue the LSE again. After three attempts the two launched a $20bn all-share merger earlier in 2016 although the jury is out as to whether it will succeed. “It’s all about clearing and it is uncertain as to whether we will see the sale of LCH.Clearnet in France being enough to satisfy the regulators, or if CME will come in and be a white knight,” says Alasdair Haynes, CEO of Aquis Exchange. “The other deal breaker could be location as London was to be the original headquarters but now that the UK decided to Brexit, it may not be the case.”

Clearing is at the heart of the deal because combining LCH.Clearnet and Eurex would allow customers such as banks to offset the capital requirements from overlapping trades. However, the sheer size of the amalgamated derivatives clearing operations has sent a shiver down the European anti-competition regulators’ collective spine. This is why they have narrowed their focus and dropped equities trading and clearing, exchange traded funds, indices and fixed-income ‎trading, from further investigations.

The main fear is that collectively they would wield too much influence and reduce the competition in derivatives clearing and the repo market, which provides a crucial source of short-term funding for banks. Although the LSE has already announced that it is willing to part with its French clearing house subsidiary LCH in order to gain the Commission’s approval, the margin pool of around Ä26bn at the end of August is a proverbial drop in the ocean compared to the total of around Ä150bn margin held by LCH as a whole.

Interested buyers circling were thought to include Euronext, the Paris-based exchanges operator that uses LCH SA, while CME Group and Nasdaq were also supposed to be in the mix although their attention has somewhat cooled.

Location, location, location

As for location issues, Brexit poses a problem and the political machinations are likely to continue if the recent comments by Michael Boddenberg, head of the ruling Christian Democrats in the Hessen regional assembly, are anything to go by. The market watchdog in the German state of Hesse, where Deutsche Börse is headquartered, can block mergers that threaten the development of the Frankfurt exchange and may do so unless the city gets more favourable terms.

Boddenberg said that it was “sensible” to apply certain conditions. These include “the seat of the joint exchange holding company after a possible merger of Deutsche Börse, and the London Stock Exchange must be Frankfurt and the financial base in Frankfurt and the development of Deutsche Börse in international competition must be strengthened through the merger. After the vote of the UK to leave the EU it is in our view ruled out that London can be considered as the [combined company’s] seat.”

Brussels has to deliver a decision by March but Patrick Young, an exchange consultant and director at DV Advisors, is doubtful that it will get the green light. “I call it a merger of equal desperation as I do not see the strategic value. They are promising all types of offsets in their clearing operations that no one else has been able to achieve. However, the anti-trust issues are insurmountable when it comes to clearing in European derivatives because there is fundamentally no remedy short of destroying the value of the LSE.”

Looking ahead, the next logical stomping ground would be Asia, which over the last five years has seen Australia reject Singapore’s bid and the union of the Tokyo and Osaka exchanges. “I think the region has a long way to go,” says Skeete. “There may be more mergers in Japan before you have a national champion while if you look at other countries, India is over exchanged but they have had a few scandals and the upstarts have run out of money while in China, the government controls the two large groups – Shanghai and Shenzhen.”

©BestExecution 2017

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FX trading focus : Change & progress : Allan Guild

Ian Rycott

January 12, 2017

FROM REGULATORY CHANGES TO TECHNOLOGICAL PROCESS.

Allan Guild, global head of regulatory change and FX options business management at HSBC

As part of the ‘Dealing Room of Tomorrow’ insight programme, HSBC Global Markets has put an emphasis on identifying and anticipating major market trends and disruptions that are impacting trading floors and investors’ businesses. From regulations, market conditions and technology developments, what are the key changes to expect in the FX market?

A redefined FX market: more transparency, less liquidity

Post-crisis financial regulation has helped re-define markets in a more transparent and secure way. As an indirect consequence, it also contributed to re-shaping the trading business as we knew it. The Volcker Rule in the US is a prime example: it is designed to scale down proprietary trading at investment banks, and it has led a number of trading desks to spin out from banks, often in the form of hedge funds. As a result, banks are taking on far less trading risk, and this is partly causing liquidity issues in the FX market.

Other contributory factors that can also explain the reduced liquidity in the FX market include Basel III requirements. Basel III imposes higher capital requirements on banks, and this is having a similar impact as firms become increasingly risk averse, mindful of the implications that certain transactions, particularly uncleared OTC positions, can have on their balance sheet obligations. There is an already noticeable trend of declining volumes in the FX market (source: Euromoney FX survey 2016), and the capital requirements are one of the drivers behind the drop.

The migration of FX trading to swap execution facilities (SEFs) was also a key vector of change, initially causing market fragmentation due to the lack of standardised rules; for instance it temporally precipitated a return to FX voice trading in some segments of the market.

A global regulatory push: clearing, margining and reporting

Mandatory centralised clearing is a key market reform outlined in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) and the European Market Infrastructure Regulation (EMIR). Both require OTC instruments including interest rate swaps and credit derivatives to be cleared via a central counterparty clearing house (CCP) subject to initial and variation margin requirements. Transactions which are not centrally cleared will maintain the status quo and trade bilaterally, and this will include FX non-deliverable forwards. Despite the bilateral nature of these transactions, counterparties will be subject to newfound margin obligations, which could necessitate additional costs.

The Basel Committee of Banking Supervision (BCBS) and the International Organisation of Securities Commissions (IOSCO) are imposing stronger margin requirements on uncleared transactions, which will entail increased daily margin calls. This could create incentives for financial institutions (and some non-financials such as certain large corporates) with FX exposure to build processes to effectively manage the movement of their collateral.

Many believe these margin requirements for bilateral OTC trades could encourage financial institutions into clearing. This is particularly true of FX trading where many believe an evolutionary trend towards centralised clearing is inevitable as market participants become frustrated at the high costs of bilateral OTC transactions. However, the migration of FX to CCPs has been slower than expected, particularly for deliverable transactions where CCPs have found it difficult to design a service with the appropriate guarantees around FX settlement. In addition, different regulatory regimes across the US, Europe and Asia-Pacific have adopted varying approaches to the BCBS-IOSCO margining rules for uncleared derivatives.

On the reporting side, both EMIR and Dodd-Frank mandate that financial and non-financial derivative users report information on their transactions to trade repositories or swap data repositories as they are referred to in the US. This applies to FX transactions.

Again, differences between US and European regulators are noticeable. The U.S. Commodity Futures Trading Commission (CFTC) states that single sided reporting is acceptable. In other words, only one counterparty to a transaction is obliged to report. Most buy-side firms rely on bank counterparties to do this work. In Europe, EMIR mandates dual-sided reporting be implemented whereby both trading counterparties to an OTC transaction must supply the relevant data to trade repositories, which then make it accessible to the European Securities and Markets Authority (ESMA). Industry experts have pushed back urging regulators to reconsider a single sided reporting protocol.

Fragmentation driven by regulatory divergence could be a challenge for the FX market, cross-border by nature. Individual markets with multiple regulatory agencies are likely to struggle to adopt harmonised approaches to enforcement.

Moving forward: from futurisation to artificial intelligence

Some experts believe futurisation of the derivatives markets is likely to take off among users. A futurised swap has embedded characteristics of both an OTC and a listed contract. The main difference between a futurised swap and an OTC is that the latter is customised whereas the former is more standardised. However, achieving standardisation is not always a simple process, and this could limit the success of futurised derivative products.

The role of innovative technology, such as blockchain or artificial intelligence, could also play a role in the FX space. Blockchain has been identified as a potential solution for financial institutions’ regulatory reporting requirements, and it could be leveraged to enable trade reporting. Permissioned access would enable regulators to monitor reported transactions on a blockchain for systemic risks.

The reality is a bit more complex. Blockchain has a number of critics who question its scalability and the fragmented nature of its development. Others wonder if it will be able to work with legacy systems, some of which are 25+ years old and have been subjected to repeated upgrades and restructurings. The cost of implementing innovative technology such as blockchain should not be downplayed either by financial institutions. Problems could occur if blockchain is incorporated into the post-trade infrastructure – such as CCPs – but not integrated into the execution functionalities. It is important that different ecosystems of financial services can interoperate. As such, blockchain must be adapted or adaptable throughout the transaction life cycle.

Artificial intelligence could also help regulators in their role. Huge volumes of data has been reported to trade repositories on derivative transactions, yet it could take time for the regulators to digest it. Having machine learning or artificial intelligence systems mining through this data could enable regulators to better identify systemic risks in derivatives markets.

©BestExecution 2017

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FX trading focus : Market opinion : Jannah Patchay

Ian Rycott

January 12, 2017

THE CHALLENGES VS THE OPPORTUNITIES OF FX REGULATION.

Jannah Patchay, Agora Global Consultants

The very existence of an ever-more interconnected global economy is predicated upon the ability of economic actors (whether firms, governments or individuals) to access foreign currency, and to hedge currency risk. Consequently, the global FX market has historically been characterised by its liquidity, responsiveness, adaptability, transparency and resilience, despite, until recently, being subject to little or no regulatory oversight. The effects of the post-crisis avalanche of financial markets regulation, arguably, are not entirely positive for either FX market participants or end users. Regulations such as Dodd-Frank in the US, MiFID II and EMIR in the EU, the various reporting regimes and venue trading obligations of other G20 countries and the enhanced Basel III capital adequacy requirements are primarily aimed at addressing the very real issues of counterparty, market, liquidity and systemic risk in the credit and interest rate derivatives markets that led to the crisis in the first place. The application of these rules to FX derivatives, without full consideration of the implications and impacts to participants and market structures, has often been criticised due to the potential for a whole raft of unintended and undesirable consequences, to the particular disadvantage of end users.

Many entrepreneurial new companies and start-ups now expect that, if not from the outset then certainly at some point, they will conduct business on a cross-border and hence cross-currency basis. Accepting foreign currency payments, and hedging or managing the associated risk, is a basic expectation for these firms. In the EU, the introduction of the Payment Services Directive, which harmonised the European legal framework for payments, opened up new opportunities for competition and broke the grip previously held by banks, with their often-disproportionate FX and transfer fees. Competition between new ‘authorised payment institutions’ (APIs) helped drive down costs for customers and improve services. Furthermore, many of these newcomers were able to build or buy new infrastructure specifically tailored to their pared-down business models, reducing their operations and technology footprint and allowing them to profit further.

Regulators, in recognition of the vital role played by FX markets in the real economy, have traditionally steered clear of certain products such as FX forwards and swaps. A US Treasury exemption specifically excludes FX forwards from the scope of Dodd-Frank. In the UK, all FX trades having a settlement time of <T+7, and forwards deemed to be for ‘commercial purposes’ (a test whose criteria encompassed hedging activity) were excluded from the scope of MiFID I and EMIR. That is about to change significantly. MiFID II introduces a more stringent test whereby a forward transaction (defined as having a settlement time of >T+2, for the major currencies) must be entered into for the demonstrable purpose of effecting a payment for goods or services, in order to be excluded from the regulatory scope. Anything falling outside the bounds of this test, including transactions entered into for hedging purposes, or those that cannot be tied to a known payment, will be subject to the full force of European regulatory requirements.

Another example is the introduction of more stringent margin and collateral requirements for uncleared derivatives. Due to the sheer volume and size of FX transactions, and the logistical complexities, they have typically not been mandated for clearing (with the exception of NDFs, which are mandated for clearing by Dodd-Frank, and may be voluntarily cleared in several other jurisdictions). However, margin requirements have been set by regulators globally with the intention of dissuading trading in uncleared derivatives, and pushing more of this trading activity onto clearinghouses. While some clearinghouses have already begun building out support for a wider scope of FX products, this benefits only those market participants that are able to use this to their advantage. The vast majority of end users in the FX markets are firms, often small-to-medium enterprises, that are unable to benefit from the reduced costs associated with clearing. Fortunately, the US regulators recognise this disparity and have exempted end users from margin requirements for uncleared derivatives. From the perspective of service providers, however, these clients may increasingly be viewed as more expensive to deal with, requiring a higher and more expensive degree of operational support in an environment that is increasingly geared towards light-touch trading and straight-through processing of trades.

Then there is the sheer regulatory burden faced by both incumbents and newcomers to the FX markets. Regulatory requirements around organisational arrangements, monitoring, record-keeping, client assessments and disclosures are onerous and expensive to implement. Smaller incumbents, such as brokers, that often aim their services at an end-user market, may find their profits squeezed and may even be forced out of the market due to the high cost of implementing and demonstrating compliance. For newcomers, the barriers to entry are higher than ever. APIs, which have come to fill an increasingly vital role for firms in providing access to foreign currency and managing their FX risk, will have their role further restricted to FX spot transactions and payments to goods and services only, unless they wish to take on the considerable additional regulatory overhead of becoming authorised to provide services in FX forwards and other derivatives.

We can see that on one hand, changes to the FX markets regulatory regime may disproportionately disadvantage end users, leaving some potentially stranded without cost-effective means of hedging their risk. On the other hand, however, the same events could be seen as creating new opportunities that may ultimately benefit end users. A large part of the challenge to market incumbents in achieving regulatory compliance is their existing business and operational models. Changing these long-entrenched product offerings, systems and processes to work within an often directly conflicting regulatory environment is difficult. Building a new business model from scratch, with built-in regulatory compliance, is in comparison a significantly easier prospect. The UK’s government and regulatory support for the fintech sector has resulted in a flood of interest from investors, who scrutinise the business plans of aspirant start-ups more closely than ever – and this is no bad thing. New software-as-a-service technology offerings and cloud services also reduce start-up costs and create efficiencies for newcomers that are simply out of reach for the incumbents, with their great tangled sprawls of systems and infrastructure. Finally, the knock-on effect of genuinely disruptive technologies (such as blockchain, if it lives up to the promise and hype), will enable savvy entrants to provide offerings light years ahead of anything that can be envisaged by a firm still thinking in terms of a traditional market structure.

©BestExecution 2017

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Market opinion : Impact of regulation : Dan Simpson

Ian Rycott

January 12, 2017

THE LONG AND WINDING FINISH LINE.

Although there have been numerous delays, Daniel Simpson, head of research at JWG Group explains why it is crucial to get the MiFID Implementation right the first time round.

A whole year has passed and the central message around MiFID II has not changed; we are a year from implementation and serious doubts remain about whether regulators, firms or market infrastructure will be ready for the fundamental change that is coming. This poses an obvious question, how, in a year in which we saw the full framework delayed by an entire year, does that remain the case? It also begs a question with, perhaps, more useful answers: what are the key challenges that still need to be overcome? Here we will try to address both points.

As we move to within weeks of the original implementation deadline, regulators and firms are moving closer towards mutual understanding and delivery. There are still many creases to be ironed out in the run up to January 2018, especially with regards to transaction reporting, product governance and algorithmic trading which are major pain points for many firms and areas in which it is generally felt that the rules, as they stand, could provide much greater clarity.

To understand why we are in this position despite a full one year delay to the implementation of the entire framework it is important to consider three factors.

The reason we had a delay in the first place was that the regulators, and in particular, ESMA, could not finalise the level 2 rules in time for the original deadline. Complex rules around liquidity classifications, systematic internaliser (SI) determinations and reference data for transaction reporting could not be finalised in the stipulated timeframes. In this light the extent to which preparations for the deadline could be furthered in the absence of the final rules was limited, and the extent to which the delay has provided additional time has also been limited.

Some, though it must be stressed not all, of the industry treated the delay as an opportunity to prioritise other implementation efforts, of which it is fair to say that there has been no shortage. Whether it has been for Market Abuse Directive (MAR) the deadline for which was July, Packaged retail and insurance-based investment products (PRIIPs), which has now also been delayed by a year as of last month, or one of the many other regulations being implemented in this window, many have reallocated MiFID II resource to these efforts. The result is some have not used the additional year to further their MiFID II efforts as far as others have.

There has been a lack of the industry wide standards efforts that are required to meet tough MiFID II requirements. Efforts have often been siloed to individual jurisdictions or asset classes, in some cases both, and some of the requirements that really need industry wide agreement and standards such as target market definitions, costs and charges disclosures or inducements definitions are lagging behind, despite the delay.

Overcoming the hurdles

Regardless of all of this, there is now one year left until all of this needs to be in place, and numerous challenges remain.

For example, the guidelines on transaction reporting, order record keeping and clock synchronisation under MiFID II have recently been published by the European Securities and Markets Authority (ESMA). This document is largely scenario-based; however, these scenarios do not often match with firms’ own scenarios. The latest document is likewise scenario based and the hope is that this will provide greater clarity.

Another major issue is the no LEI (Legal Entity Identifier), no trade stance of the regulators. Although firms have been collecting LEIs for EMIR, there are still concerns that clients outside the EU may not feel obligated to obtain an LEI, with whom firms would be required to not trade under MiFID II.

There have been some positive steps as industry initiatives have been launched to provide a co-ordinated approach, continuing the theme of standardisation and co-operation that has permeated throughout the sector in response to regulation in the recent years. However, it remains an especially sore point, as it seems that the regulator will not budge: no LEI, no trade; so, it is important that the industry co-ordinates a solution to address this.

The MiFID II challenge

Transparency is a huge theme in MiFID II, whether it covers prices, process, of risk or product. This means that customers, competitors and regulators receive more information than ever regarding the nature of operations, products and services on offer from investment firms. While the impact on the marketplace remain unclear, the one thing that is certain is non-competitive products will be uncovered and firms need to be well placed to ensure that they are not on the wrong side of this.

One of the most fundamentally challenging aspects of MiFID II is the assessment of the client’s investment goals and risk tolerance. Alongside transparency, this is one of the cornerstones of the MiFID II framework because both inform the firm’s ability to create, market, sell and manage financial products and services. Subsequently, it will be key to the overall client experience in the new MiFID II world.

Taking into account the large expenditure that firms are likely to face on reworking internal processes, repapering clients and reconfiguring systems, getting MiFID II right the first time in the most efficient manner should be paramount. Otherwise even bigger budgets will be needed to tweak new policies, select suppliers and recalibrate new systems builds.

Ultimately firms should be looking to leverage this inevitable regulatory spend to not only successfully meet the requirements but also to enhance their service offering, gather more useful and accurate data and most crucially boost competitiveness.

©BestExecution 2017

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FX trading focus : FX TCA : Willis Bruckermann

Ian Rycott

January 12, 2017

DIFFUSION WILL BRING MIFID II-LIKE OUTCOMES TO THE SPOT FX MARKET.

Willis Bruckermann, analyst consultant at GreySpark Partners

In October 2016, the UK Financial Conduct Authority (FCA) released the second draft of a consultation paper proposing a uniform methodology that all UK-based asset managers would be required to adhere to. The FCA proposals are important because they would require that asset managers compare the mid-market price of any security – including currencies trades – used to support portfolio investment activity with the execution price as a means of determining total transaction costs. Pensions funds would then be able to take an amalgamated version of this data and report it to their end-investors as a means of increasing the transparency of the costs associated with managing their retirement savings.

The FCA proposals run contrary to the laissez-faire approach to the development of transaction cost analysis (TCA) services in the EU contained within the second iteration of MiFID II – as well as within a number of other EU financial markets regulations – regarding the buyside industry’s utilisation of TCA data as a means of proving best execution on trades done on their behalf across a range of different asset classes. Specifically, under MiFID II, there is no prescribed methodology for how sellside brokers or third-party TCA providers are required to calculate total transaction costs.

Instead, the EU regulations assume that market demand and consensus would drive the development of TCA toolkits and uniform methodologies would then eventually emerge for best execution purposes to ensure that buyside firms can evaluate the performance of their brokers. MiFID II assumes that competitive pressure among buyside firms, especially among asset managers and institutional investors, would inevitably force the companies to congregate around sellside execution franchises offering the most cost-effective level of service.

Additionally, MiFID II and the other EU regulations assume that, in order to evaluate the performance of these execution franchises, buyside firms would then insist upon uniform broker-provided TCA methodologies that accurately reflect the costs incurred for each trade. As such, the FCA’s proposals uproot the EU’s assumptions regarding the development of TCA somewhat by proposing that fully comparable performance metrics for execution services must be available by January 2018, which is when MiFID II is set to enter into effect.

MiFID II does not mandate that sellside FX dealers prove spot FX best execution to their buyside clients. Instead, the regulations only mandate best execution reporting for FX derivatives such as options or non-deliverable forwards (NDFs). Nevertheless, GreySpark Partners has observed in recent years that a large number of asset managers and institutional investors are expecting that – in addition to providing best execution on equities and fixed income trades – investment banks would need to prove best execution on spot FX transactions done in the EU, and that doing so would de facto become a point of competitive differentiation between brokers competing for buyside client market share on a cross-asset basis.

Our observations are partially borne out of the fact that the long-standing differences between buyside spot FX market participants and their sellside brokers are rapidly diminishing. For example, the largest asset management firms began to develop in 2015 the same level of technological sophistication as their sellside counterparties to effectively aggregate spot FX liquidity.

In doing so, the buyside of the spot FX market could then begin to develop centralised trading desks designed to ensure that the currencies leg of every trade done across every other asset class would become efficiently processed into the marketplace as a means of controlling costs and retaining value for end-investors. In tandem, some banks also began to develop more sophisticated, hybrid agency-riskless principal trading models for spot FX flow internalisation and market-making as part of a long-running effort across the industry to mature so-called FICC business models.

MiFID II’s pre- and post-trade transparency requirements play an undeniable role in incentivising these types of structural changes within the spot FX marketplace. Take, for example, the entry of hedge fund XTX Markets into the top-10 of the Euromoney market share list in 2016 – not only does MiFID II’s mandates incentivise the buyside to compete more effectively with the sellside in spot FX pricing, it also incentivises some buyside models to pivot so that they can compete directly with banks for client market share.

Whether or not MiFID II is eventually amended by the European Commission to include spot FX as being in-scope for best execution reporting is a moot point. We anticipate that, regardless of a regulatory mandate, spot FX will – for all intents and purpose – be in-scope for trade and transaction reporting purposes for both the buyside and the sellside, and that any currencies trades that are done as the leg of a complimentary equities or fixed income trade will be one of the primary drivers behind industry attempts to scope-in spot FX as a form of informal best practice.

The FCA’s TCA methodology proposals released in October are simply another nail in the coffin of the inevitability of spot FX best execution reporting under MiFID II for the EU financial marketplace. However, industry best practices in this regard offer up a series of interesting benefits for the buyside of the spot FX market.

Specifically, we anticipate that the availability of spot FX best execution data will allow asset managers and their institutional investor or end-investor clients to highlight the variable performance of different sellside execution services. To that end, broker-provided TCA toolkits will be forced to compete more directly with one another for methodology transparency around a baseline of mid-point data, which would ideally be generated by neutral market participants such as benchmark provider NewChangeFX or by the plethora of dealer-to-client spot FX RFQ trading platforms.

Direct competition for TCA services should also organically drive down the costs associated with their provision over time, which are already reasonably minimal in terms of buyside spend. According to the FCA, asset managers in the UK as a whole will likely incur one-off costs of GBP 125,000 to buy or build the systems needed to provide pensions providers with TCA. Those costs then recur on a per annum basis at an estimated GBP 775,000, according the agency.

As of September 2015, there were 60 asset managers in the UK managing retail funds used to support defined contribution pensions schemes, and the top-10 largest of those firms manage 90% of all defined contribution assets. In 2016, the FCA estimated that asset managers purchasing a TCA system from a third-party provider would be required to pay around GBP 10,000 per year to the provider. Comparably, firms that have already built their own TCA systems in-house are likely paying around GBP 25,000 per year to maintain them, and firms that currently have no system in place but wish to build one in-house would likely require budget of GBP 75,000 per year to do so, according to the agency.

©BestExecution 2017

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FX trading focus : NDFs : John O’Hara

Ian Rycott

January 12, 2017

CONSIDERING THE OPTIONS.

John O’Hara, Global Head FXPB & FX Clearing, Prime Services, Societe Generale Corporate and Investment Bank considers the changing NDF world.

The onslaught of regulation since the financial crisis has wrought both innovation and competition and the field of non-deliverable forwards (NDFs) is no exception. They may be waiting in the wings for their clearing mandate in Europe but over the past year brokers and particularly clearing houses have begun to jockey for position with their new solutions.

FX products have mainly escaped regulatory clearing requirements in the US where non-cleared, physically settled, FX forwards fall outside the scope of the country’s rules. This means dealers do not have to post initial margin on these trades. However, NDFs are still on the agenda along with FX options in the US as well as Europe although a modest timing difference between the jurisdictions persists. The European Securities and Markets Authority (ESMA), and other regulators have scaled back their efforts on FX forwards due to market liquidity and industry opposition earlier in 2016.

One of the stumbling blocks in Europe is that there is no EU-wide definition of an FX forward and, therefore, a consensus has not been formed as to whether it is even a derivative. These issues are supposed to be rectified under MiFID II in January 2018 where a definition is to be formulated and a decision made on whether variation margin should be imposed on physically settled FX forwards.

In the meantime, market forces have taken hold because the cost for uncleared products has become an expensive proposition due to Basel III’s more onerous capital requirements for derivatives, along with tighter margin requirements for non-centrally cleared derivatives, under the European Market Infrastructure Regulation (EMIR), which has been phased in from September 2016.

This has spurred participants, thus far mainly interdealers, to voluntarily turn to central clearing to take advantage of the greater transparency, the potential for tighter bid offer spreads, cost reductions, improved capital efficiency and risk management.

Clearing participants are also benefitting from a simpler and more transparent method for evaluating client positions and portfolios. The challenge for firms trading NDFs outside of a centrally cleared environment has been well documented in that a variety of valuation models are used by trading counterparts. By contrast, the centrally cleared single valuation model reduces these complications with a standardised model and daily reporting.

To date, ForexClear, a subsidiary of London-based clearing house LCH, has the lion’s share of central clearing of NDFs. It has seen its daily notional volume exceed $50bn with activity increasing steadily in the run-up to the US and Japan implementing their respective uncleared margin rules. The group started a client clearing service in the US in 2013 and last year extended the offering to European accounts with Societe Generale as well as HSBC and Standard Chartered Bank as the connecting brokers.

Overall NDFs have experienced impressive growth with the Bank for International Settlements 2016 Triennial Survey showing that global NDF turnover rose 5.3% to $134bn in April 2016 from the same month in 2013, although it still accounts for a small portion – 2.6% – of overall FX trading.

The next item on LCH.Clearnet’s priority list is to expand central clearing to FX options, which would be a watershed moment for the industry because it has not been an easy task to develop an appropriate clearing mechanism for deliverable FX instruments. This is because unlike NDFs, interest rate swaps and credit default swaps, FX options, swaps and forwards tend to be physically settled, which means any clearing model must deal with the liquidity shortfall in the event of a member default.

These obstacles were highlighted by the international principles for financial market infrastructures (PFMIs), finalized in 2012 by the Committee on Payment and Settlement Systems, as it was then known, and the International Organisation of Securities Commissions (IOSCO). It said that CCPs must ensure clear and certain ﬁnal settlement, which would require them to have large volumes of liquid assets on hand in case of a default.

This led to an extensive study undertaken by the global FX division of the Global Financial Markets Association (GFMA) which concluded that CCPs would have to be able to manage a same-day liquidity shortfall of $161bn, on a gross basis, across the 17 currencies settled by CLS at the time (it has since added the Hungarian forint).

Following a detailed analysis led by the GFMA, as well as conversations with market participants and central bankers, LCH.Clearnet partnered with CLS last year to develop a clearing platform for FX options. CLS decided that the most effective solution was to create a new settlement session for LCH to settle its cleared FX options activity separately from the core system.

Although the service was due to be launched in 2016, Paddy Boyle, the new head of FX product at LCH’s ForexClear and a veteran in the industry, has said that the clearing of foreign exchange options remains a strategic priority for the company and the service should come to market next year.

Meanwhile, the CME, which started its OTC FX clearing services in 2011, also introduced a portfolio margining service which enables clients to treat cleared OTC FX contracts and exchange traded FX futures contracts as a single portfolio, thereby reducing margins. In addition, the central counterparty clearinghouse (CCP) is working with market participants to launch OTC FX options clearing and recently hired Paul Houston as Executive Director and Global Head of FX, another industry specialist, to help spearhead its campaign.

Looking ahead, it is crystal clear that economic forces will drive the bulk of in-scope FX flow – NDFs and options – to reside within a CCP environment well before the regulators mandate it. The costs are too high to be ignored and while it may take longer than expected, central clearing of options will be a reality. These growing pressures will also force large asset managers, who until now have been absent, to join the fray. They are likely to start with small trades to ensure the plumbing is in good working order before embracing full-scale NDF clearing.

As in many industries, innovation will be the name of the game and both LCH.Clearnet and the CME will have to continue to invest in new trade structures and clearing solutions to ensure that they keep their competitive edges sharpened in the ongoing evolution of currency clearing.

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FX trading focus : The retail sector : Ryan Nettles

Ian Rycott

January 12, 2017

LOOKING OVER THE FENCE.

Ryan Nettles, Head eForex Trading & Market Strategy, Swissquote Bank SA speaks to Best Execution and gives a market perspective from the retail side of the FX trading community.

What are the key regulations impacting your industry at the moment, and what is their effect?

There’s no shortage of regulation, but key at this time to our business are the Pre- and Post-trade Transparency rules and Trade Reporting requirements coming into effect under MiFID II, and the FCA Proposal for Policy Changes. Specifically, those proposals related to:

Leverage Limits on Contract for Difference (CFD) products – which proposes a maximum of 25:1 leverage for retail clients with less than 12 months active trading experience in CFD products or other relevant margined products, and/or a maximum of 50:1 leverage for experienced retail clients, which are set according to the volatility of the underlying asset.
Prohibition on bonus promotions – whereby firms would be prevented from using any form of trading or account opening “bonuses” or benefits to promote their retail CFD products and platforms.

In addition we have to be mindful of the Cyprus Securities and Exchange Commission’s (CySEC’s) proposal for Handling of Client Monies, which was published in October. Under these proposals Cyprus Investment Firms (CIFs) must ensure that client funds are held in accounts separate from CIFs own funds. Also, client funds can no longer be used to margin positions for CIF’s own account trading.

The effect for the retail broker is that these regulations will further increase costs, there will be potentially less client trading volumes and it will be more difficult to attract new clients.

How will different sized brokers be impacted?

The upcoming regulatory changes will potentially have an impact on all retail brokers, but the impact will vary depending on several factors. One will quite simply be the dependency a broker has on bonus promotions to acquire customers.

Another factor will be the amount of leverage the broker offers a client. For example, a broker offering leverage of 100:1 will be less impacted than a broker offering 500:1 leverage. The brokers who will have to reduce leverage for clients who historically were offered higher leverage will be impacted from lower client trading volumes or losing the client to competitors who are regulated by other jurisdictions.

Furthermore, there will be a cost to adjusting technologies to be regulatory compliant which will be more challenging for smaller companies as they may not be able to support these increased costs.

In conclusion, the larger capitalised brokers will be able to mitigate these regulatory changes better than the smaller undercapitalised brokers. As a result, I foresee some consolidation in the European retail FX broker space once these regulations come into play.

What challenges do brokers with smaller marketing budgets have and what alternative schemes will they have to devise to better compete against firms with large marketing budgets?

All brokers will need to cope with challenges related to the planned regulations. The cost of client acquisition will continue increasing and brokers with smaller marketing budgets will have a difficult time competing against the brokers with large marketing budgets. Brokers will need to be more creative and focus on schemes that optimise client acquisition and retention in addition to identifying ways to increase client trading activity.

How have political events such as Brexit and the US election impacted the industry and the firm?

As with regulatory change, political events can also impact the retail FX industry, but it is too early to say how these specific events will impact the industry longer term. However, we are busy analysing all the various potential scenarios and outcomes.

What difference will a divergent interest rate policy make?

Other than political risk, I believe monetary policy divergence will be one of the main drivers of FX volatility in 2017.

Do you think that your credit and liquidity provision business will increase?

Over the past several years, the primary Tier 1 Banks offering FX Prime Brokerage services have significantly increased their thresholds regarding whom they can do business with. As a result of these increased thresholds, an opportunity has been created for other institutions to fill the gap, which has been labelled ‘FX Prime of Prime’.

In addition, the upcoming regulatory changes related to the treatment of client monies by Cyprus brokers will reduce their own account trading and will force many retail brokers to get access to credit and good liquidity in order to sustain profitability. Swissquote Bank entered the FX Prime of Prime space to help fill this void and support those institutions with their credit needs and access to liquidity, and I feel this business will further increase in 2017.

How do you see the retail platform business evolving over the next year – will there will new players?

I believe retail FX platforms will need to evolve by strengthening trade transparency based on the upcoming MiFID II regulations. The most popular retail FX platform is MetaQuotes’ MT4 and this will continue to be the case in 2017. MetaQuotes will continue to push their MT5 platform, which will help solve some of the constraints related to MT4 for brokers such as business scalability, but some traders may not be open to move to MT5, thereby opening opportunities for other retail platforms to compete if they can be more flexible in fulfilling the regulatory, broker and trader needs.

How do you see automation and other technologies developing over the next year?

Once a retail trader has decided to open an account with a broker, they are looking for easy and fast onboarding and payment processing. The broker’s revenue is impacted by how efficient their onboarding is. As the saying goes ‘time is money’. Technology vendors that are able to improve the automation of onboarding and payment processing within the broker’s regulatory framework will be in demand in 2017. In addition, I see a further increase of algo trading strategies, so tools for traders that can easily create, analyse and execute automated trading strategies will be in high demand.

Aside from your retail clients what do you offer the institutional investment community, such as asset managers? Is this a growth market for you?

Yes, Swissquote Bank is already active in the institutional space for asset managers, banks, brokers and corporate clients and we offer the full product range as well as access to credit and margin facilities, liquidity, execution and technology solutions. We have dedicated teams focused on the various clients within this institutional segment and it is fast growing business for us.

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Industry viewpoint : FX trading focus : Asian markets

Ian Rycott

January 12, 2017

FOREX RISING TO THE EAST.

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By Matthew Lempriere, Telstra.

Foreign exchange trading has long been concentrated in the financial hubs of London, New York and Tokyo, but as major western markets face up to structural and macro-economic challenges, turnover is beginning to shift further to Singapore, Hong Kong and Shanghai. Consideration should now be given to the importance of having the necessary infrastructure and connectivity in place in order to capitalise on these movements.

In 2001, the average daily turnover in Foreign Exchange (FX) was $1.2 trillion according to the Bank of International Settlements (BIS) and this has risen to a high of $5.4 trillion in 2013. This significant growth was fuelled by globalisation, currency hedging and speculation.

However, latest figures from 2016 show that daily turnover has declined to $5.1 trillion, representing the first drop in activity in more than 10 years. There are several possible explanations. Firstly, banks were traditionally the greatest source of liquidity in FX trading but stricter financial regulations have forced them to cut back. While other liquidity providers have emerged, they’ve failed to make up the shortfall so far. Then there are macroeconomic factors that have reduced volatility in the FX markets, such as slow economic growth and low interest rates across the globe.

Shift to Asia

Changes are afoot. One of the these is the potential shift of FX trading activity to Asian financial centres like Tokyo, Hong Kong and Singapore. This shouldn’t come as a surprise, as many emerging market currencies are backed by strong fundamentals and Asian financial regulators generally opt for a lighter touch than their western counterparts.

To put this in perspective, London – historically the global FX trading hub given its location and concentration of financial institutions – has seen its share of the FX market fall from 40.8% in 2013 to 37.1% in 2016 according to the BIS. And that is before the possible effects of Brexit kick in.

In contrast, the combined share of Tokyo, Hong Kong and Singapore increased from 15% in 2013 to 21% in 2016. The biggest jump was in Singapore, an up-and-coming player in electronic trading. Meanwhile, the Chinese market share rose from 0.7% in 2013 to 1.1% in 2016 with Shanghai emerging as a possible challenger to the traditional North Asia FX hub of Hong Kong.

Singapore

All three Asian centres – Tokyo, Hong Kong and Singapore – increased their share of FX trading in this year’s survey, but perhaps the most significant was Singapore, where average daily turnover grew from $383 billion in 2013 to $517 billion in 2016, giving it a market share of 7.9%, up from 5.7%. With a well-developed financial centre and strong location to capitalise on South-East Asian flows, Singapore is well-positioned to benefit from a further shift in FX trading to the east. An interesting development is that the Monetary Authority of Singapore (MAS) has recently awarded a grant to Spark Systems, the latest FX trading platform to be launched in Singapore, aimed at making FX trading cheaper and faster in the region.

Hong Kong and China

While Hong Kong has traditionally been the main hub for north Asian FX flows, the rise of China could well see some movement towards Shanghai. The growth of China’s economy and the internationalisation of the renminbi is certainly expected to be one of the most transformative trends in foreign exchange in the years to come. Since 2010, the Chinese government has embarked on a steady process of liberalising its currency for international investment, which has sparked significant interest from financial institutions wanting to carve out market share in the new currency.

Access to liquidity

Banks and investment firms should be aware of these trends and start planning how to take advantage of them. The key thing to remember is that FX trading is bilateral, with no central exchange, so proximity to other market participants is critical. Across the globe FX participants tend to congregate in communities, in established FX data centres. These include Telstra’s data centres, several of which are offered in partnership with the Equinix International Business Exchange (IBX®), which enables firms to share time-sensitive information with partners and gain proximity to the region’s financial exchanges. For the best chance of success new entrants should ensure that their infrastructure and connectivity is integrated with these ecosystems in order to access liquidity and gain market share.

Infrastructure and connectivity

Recognising the importance of these Asian growth opportunities Telstra has taken steps to boost its Asian network with the acquisition of Pacnet, a provider of connectivity, managed services and data centres in the region. This acquisition not only gave Telstra a greater presence in Asia, but also through a joint venture with PBS, a license to provide customers with network and internet data centre services in China. Through its partnership with Equinix, Telstra has made similar data centre investments in the region to provide financial firms with fully managed FX solutions from hardware through to ecosystem hosting and connectivity

Also, in today’s environment, it is often important for banks to be able to move things off their balance sheet, so anything enabling them to operate in the region via an OpEx model, rather than a CapEx one, is positive. Either way, working with an established partner with an existing footprint in Asia is the most sensible approach. That way, a financial firm can feel confident it’s receiving the same standard of service as a Western hub at a reasonable cost, and will give itself the best chance of capitalising on the FX shift to Asia.

To learn more, take a look at “Forex flows to the East” – a Financial Markets Insight from The Realization Group and Telstra and Equinix.

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FX: THE PHANTOM LIQUIDITY MENACE.

The sterling flash crash is indicative broker liquidity has gone; the buyside must look for alternative counterparts in FX. Dan Barnes reports.

PREPPING FOR MIFID II: A RICH FIRM’S GAME?

A SENSE OF DÉJÀ VU.

The latest round of exchange mergers took place in 2016 but politics may scupper the headline grabbing Deutsche Börse/LSE deal. Lynn Strongin Dodds canvasses the scene.

FROM REGULATORY CHANGES TO TECHNOLOGICAL PROCESS.

Allan Guild, global head of regulatory change and FX options business management at HSBC

THE CHALLENGES VS THE OPPORTUNITIES OF FX REGULATION.

Jannah Patchay, Agora Global Consultants

THE LONG AND WINDING FINISH LINE.

Although there have been numerous delays, Daniel Simpson, head of research at JWG Group explains why it is crucial to get the MiFID Implementation right the first time round.

DIFFUSION WILL BRING MIFID II-LIKE OUTCOMES TO THE SPOT FX MARKET.

Willis Bruckermann, analyst consultant at GreySpark Partners

CONSIDERING THE OPTIONS.

John O’Hara, Global Head FXPB & FX Clearing, Prime Services, Societe Generale Corporate and Investment Bank considers the changing NDF world.

LOOKING OVER THE FENCE.

Ryan Nettles, Head eForex Trading & Market Strategy, Swissquote Bank SA speaks to Best Execution and gives a market perspective from the retail side of the FX trading community.

FOREX RISING TO THE EAST.

By Matthew Lempriere, Telstra.

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