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Last week I attended the excellent “European Market Liquidity” Conference, organised by AFME (the industry voice for FX & Fixed Income).

The theme was summed up by the oft repeated phase from various speakers that

“A tsunami of regulation is headed your way”.

A few thoughts from the conference:

Engage with regulators: Whilst many proposed rule changes still lack detail, and in some cases timescales for implementations are ‘worryingly’ short, there is no doubt that the impact of Dodd Frank, MiFID II and Basel will have an enormous impact on many existing business models. In order to minimise the ‘unintended consequences’ of poorly drafted regulations undermining the efficient functioning of the market, it’s clear that the industry, and it’s various trade bodies must continue to lobby and ‘fully’ engage with regulators, to make sure that effective legislation is created.

Here are a few examples where the proposed introduction of regulation creates more problems than it seeks to solve:

§         FX Central clearing to reduce counterparty risk: Counterparty risk is not a major issue in FX, so mandating central clearing will not benefit the market. Over 90% of the risk in an FX trade is settlement risk, which is already managed by CLS. Central Clearing is therefore not required for FX (as discussed in previous blog here). However, that may not stop regulators from introducing some form of partial clearing, with perhaps spot, fwds and short dated swaps remaining as OTC, whilst say NDFs, long dated swaps and FX Options centrally cleared. Regulators will need to look carefully at the interaction between these products, and the cost benefits involved. For instance, FX Options only make up some 5% ($200bln/day) of global daily FX volumes according to latest BIS data (here).

§         Use of CCPs could result in fragmentation of risk: The introduction of mandatory clearing for multiple products through a multiple central counterparties (CCPs) could actually increase risk, rather than reduce it. Whilst banks would still benefit from netting exposure across products within a single CCP, the use of multiple CCPs may result in a fragmentation of otherwise netted risk, as banks would not be able to net exposure across multiple CCPs.

§         Pre-Trade Transparency for Swaps: Will the publication of a swaps trade ticker really improve the execution quality for clients? My thanks to Mireille Dyrberg from TriOptima, who pointed out that the most liquid swaps (the 10Yr US Dollar Swaps), only trades some 800 times in a 24hr trading day. That’s roughly one trade every 7 some minutes – the trade ticker will be more like a slow lighthouse illuminating the market once every 7 minutes!

Investment in technology key: The ability to support a centrally cleared model across multiple asset classes will require a huge technology investment by banks. The top banks are looking at regulation on a global basis, and the infrastructure needed for clients to trade efficiently in this new paradigm will become a key differentiator amongst global banks. Links to CCP clearing, collateral management, managing initial and variation margining and financing, wrapped with real time reporting have all traditionally been the preserve of Prime Brokerage Services (typically focused at servicing Hedge Funds). Banks such as Deutsche (here) and BarCap (here) are investing heavily to provide global OTC execution and clearing capabilities for clients. Perhaps we may start to see tier 2 banks leveraging the OTC clearing infrastructure of global tier 1 banks in order to service their clients.

Single Dealer Platforms (SDP): Far from being the death knell for SDPs, I see role of bank SDPs as becoming ever more important. Whilst it’s true that an SDP cannot be a SEF (as that’s prohibited by ownership and multi participant quotation rules), banks will continue to be the dominant client relationship channel delivering liquidity, execution, expertise and now DMA routing to SEFs/Bond exchange for centrally cleared products, and full suite of OTC clearing solutions. However, this will require banks to work hard to upgrade their SDP’s to support the ability to route trade requests as required to SEFs. One can imagine a bank’s swaps platform where the same product might trade on the SDP or be routed to a SEF, depending on the size of the trade, and whether it’s standardised or customised maturity.

Changing Role of Salespeople: Sales people will remain essential to clients, but their role will change. eTrading platforms will continue to deliver price discovery, and of course consistent pricing is still key for clients, but according to Jason Vitale (Head of FX Prime brokerage at Deutsche), the role of the ‘best’ bank salespeople will become more akin to “Infrastructure Sales” delivering the full strategic capabilities of banks to clients, as above.

Costs will rise and revenues will fall: The sobering comment from Mike Bagguley (Global Head of FX Trading, BarCap), was that the implementation of global regulatory compliance, will result in a significant rise in costs for the industry, and a corresponding fall in revenues as banks and clients get to grips with the new paradigm. However, the bar is being raised, and those banks who fail to invest, risk being marginalised, and according to Mike, there are only a few banks will be able to compete globally – perhaps I should add the ability to provide global OTC clearing to the key factors that “Separate the men from the boys to global FX” an earlier blog here.

We will follow this blog up with more comments on specific areas in due course.

Filed under: FX | Tagged: CCP, FX, Swaps |