Regulatory reform, including Basel III, Dodd-Frank, EMIR, and MiFID II has led to significant changes in market dynamics including the move to-exchange-style trading and centralised clearing for products that traded over the counter, even within the FX market. However, despite years of discussions and proposals, many aspects of the regulation of OTC FX markets remain unresolved. For example, neither European nor US regulators have reached consensus on mandating clearing of FX non-deliverable forwards (NDFs) and it is not yet clear when the final decision on this matter will be made.
REGULATORY REALITIES
While specific regulations directed at the FX market largely have not become a reality yet, FX market participants have certainly felt consequences from broader regulations aimed at reducing risk in the OTC marketplace. In September, higher capital requirements imposed by Basel III will make it more costly for global banks to hold uncleared OTC derivative positions.
The issue of cost is exacerbated by margin requirements for uncleared derivatives which will soon be implemented globally based on a framework established by the Basel Committee of Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO). Beginning in September, margin will apply to all uncleared FX derivatives. This increases the importance of collateral activities and the related costs for firms.
Specifically, for firms it has the following implications:
• An increased volume of daily margin calls, which entails more frequent collateral movements
• Increased collateral posting as firms connect to or use more CCPs
• A move towards intraday management of collateral and risk
• A need to “transform” ineligible collateral assets via repurchase or securities lending arrangements, or the reuse of collateral via rehypothecation, where such activities are permitted
Margining OTC trades will be a burden also because many participants separately post margin for their exchange traded derivatives activity. It will be expensive and operationally complex to post additional margin directly with counterparties. This is especially true since firms are not allowed to post just one set of collateral across asset classes and net out their margin requirements between the futures/options exchange clearinghouse and the CCP for OTC products.
The increased cost for uncleared products driven by Basel III and margin requirements is likely to further incentivize participants to centrally clear FX derivatives, even without a specific regulatory mandate. Indeed, beginning in 2011 , the industry began to clear NDFs voluntarily and cleared volumes have been steadily increasing ever since. We anticipate clearing will expand to other FX products and already LCH and CLS are collaborating to bring central clearing for FX options to the market.
Another way to mitigate capital charges is to expand the use of trade compression in FX. Multilateral compression of uncleared positions reduces outstanding notional amounts, helping firms achieve their targets for leverage ratio. Compression becomes more viable when compression services have access to a large centralised population of matched and confirmed trades which do not require manual intervention before entering the compression cycle. Furthermore, with centralisation comes the ability to adjust confirmed trades after compression and automatically update participating firm’s risk systems, accordingly. Markit’s FX trade confirmation and affirmation services are trade sources suited to efficient trade compression in FX.
Directly affecting the FX market are business code of conduct rules developed by central banks in cooperation with FX market participants which aim to restore trust in the FX market. This code is meant to be comprehensive, global, capable of evolving over time and defines proper conduct for the widest of audiences: the sell-side, the buy-side, nonbank participants, technology vendors, and e-trading platforms.
The new code is being released in two parts:
• Part 1: Published in May 2016, covers market ethics, information sharing, execution costs (including mark-up), trade confirmation, and settlement with a focus on transparency and automating the front to back-office process.
• Part 2: Will include governance, risk management, and compliance as well as more specifics dealing with issues related to execution, including e-trading practices, choice of e-FX platforms, use of last-look quoting, prime brokerage and unique FX product features.
Here too, one can understand how greater centralisation of workflow and systems can help firms cope with the regulation. Active compliance and best execution are among the many facets of FX trading subject to code of conduct rules that require better integration of the pre and post trade technology stacks and the standardization provided by centralised workflow solutions.
FUTURE PROOFING WITH THE NEW FX POST-TRADE PARADIGM
Even if direct regulatory pressure has been limited, the FX industry is responding with a growing focus on modernising post trade infrastructure and centralising key functions such as trade affirmation and confirmation. These moves make firms more agile, making it easier to scale up or down depending on market conditions, devote more resources to client service, and reduce operational risk.
This same agility gives firms the ability to tailor their operations to multiple and changing regulatory protocols. In the absence of regulation mandating clearing, for example, firms should work to create as much flexibility as possible in terms of how they manage their FX business. It might make economic sense to clear certain product and not others. Using centralised trade confirmation and its underlying network and workflow provides that flexibility. For clearing, the network provides a single point of connectivity that makes it straightforward to do business at multiple clearinghouses and SEFs/OTFs. For compression, having a large central population of confirmed trades provides the backbone for managing, distributing and updating relevant transaction data.
Given the degree of uncertainty about the extent of direct regulatory impact on the FX market, firms’ strategies should focus on future proofing. Modernising FX post trade infrastructure now will provide several operational advantages as well as the flexibility required to adapt to multiple regulatory scenarios.
