As the FX industry squares up to the impact of prudential and market regulation, James Kemp of the GFMA believes new business models will emerge.
Representing 24 sell-side institutions that collectively account for more than 90% of the FX market, the global FX division of the Global Financial Markets Association (GFMA) was established in 2010 to promote efficiency and international convergence in regulation of the global FX market.
While the early days of its existence were mainly focused on the implications of the US Dodd-Frank Act, and included lobbying for an exemption for FX swaps and forwards from some of its key provisions, the group’s role has evolved in recent years, not least with the advent of conduct risk as a growing concern for the industry.
“Against the tough economic backdrop, I see three key challenges that the FX market is now dealing with – prudential regulation, changes in market structure driven by market regulation and conduct risk,” says James Kemp, managing director of the global FX division. “With these big pressures coming to bear on the industry, many banks are undertaking well- publicised strategic reviews and thinking about what business models and services will make sense in the new operating environment.”
Those three pressures will impact the FX market in different ways. Prudential regulation, for example, encompasses Basel III capital, liquidity and leverage requirements as well as the Volcker Rule, all of which will increasingly constrain the amount of capital banks can commit to market making across asset classes. Most of the FX market is less capital-intensive than other asset classes, but it will still be impacted.
Meanwhile market structure changes encompass trade reporting, central clearing and trading on electronic platforms as well as margin requirements for uncleared derivatives. Those developments may not all have had a big impact on FX products so far, but they could well do so in the future.
With the additional burden of dealing with conduct risk, there has been a renewed focus on the agency model of execution as a more cost-efficient way of handling client orders in the current environment.
“It has become clear that banks can’t take the kind of risk on a principal basis that they did in the past and this has the potential to impact liquidity provision,” says Kemp. “New nonbank entrants may step in to provide this liquidity and we may see more agency- like models emerge – though this does shift execution risk back to the end user. What is clear is that financial markets are endlessly innovative and we are likely to see new market structures evolve in FX.”
Having chaired the FX expert group that contributed to the UK’s Fair and Effective Markets Review last year, Kemp has been closely involved in the work to address failings in market conduct. The development of the global code of conduct will, he believes, help to deal with common misunderstandings and conflicts that surround key industry practices.
“Our members have been big supporters of the concept of a single code of conduct because when it comes to managing conduct and surveillance, no one wants to be trying to comply with multiple rulebooks,” he says. “This is a global market so it makes sense to have a global code.”