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Foreign exchange

Slow burn: FX market structure changes

The structure of the FX market won’t change overnight, but the implementation of the FX Global Code and Markets in Financial Instruments Directive II (MiFID II) will drive a gradual evolution.

The FX Global Code and MiFID II appear to share little in common – one is a voluntary set of principles designed to promote good conduct in the global FX market, while the other is a binding rulebook intended to reshape trading processes across multiple asset classes within the EU.

Yet in the space of less than 12 months, these two very different documents could drive lasting changes in the structure of the FX market. The FX Global Code is not explicitly intended to reorganise the market structure, but when combined with MiFID II and the host of associated trading and data requirements, it is clear that change is coming.

Chris Leonard-Appleton, director of Regulation at Thomson Reuters, says,“Participants in the FX market have not been accustomed to dealing with regulated venues in the past, so they now need to re-examine their execution systems and relationships as they prepare for MiFID II. This is a huge one-off change that everyone is having to grapple with.”

MiFID II, due for implementation in January 2018, introduces a number of different types of trading platforms, including Organised Trading Facilities (OTFs), multilateral trading facilities (MTFs) and systematic internalisers (SIs).  Most existing electronic communication networks will need to meet the criteria required of MTFs, while interdealer broker systems will need to reflect OTF characteristics and large banks that match trades internally must apply themselves to the SI criteria.

As those entities prepare for the requirements of MiFID II and make the necessary adjustments to their platforms, buy-side firms must make sense of these new regulatory wrappers and determine how their sell-side relationships and execution processes will need to change from the beginning of 2018.

The MiFID II trading requirements are subtly different from the Swap Execution Facility (SEF) framework under the US Dodd- Frank Act; this difference is likely to drive greater division between US and European markets in the future.

“There are a lot of moving parts to this process and we have a big team working on MiFID II. We are in dialogue with all of the platforms we use in order to better determine where they will, or think they will, be placed in the new framework,” says Lee Sanders, head of FX Execution at AXA Investment Managers. “This is still a bit vague given the setup of some of the platforms we use – that said, we think most of our electronic FX business will be transacted on regulated MTFs next year.”

This is a big change for users of the FX market, which has always operated efficiently on a global basis with fairly light-touch regulation. Only a decade ago, the market was still largely phone-based and smaller customers may not have always sought multiple quotes before trading. Even with the advent of electronic FX trading, relationships continue to play a role in supporting the buy-side through the more complex trading landscape.

Now for the first time, European market participants will have to comply with a much stricter rulebook, selecting counterparties and trading platforms on the basis of their regulatory status as well as the quality of service and pricing they provide. The MiFID II trading requirements are subtly different from the Swap Execution Facility (SEF) framework under the US Dodd-Frank Act; this difference is likely to drive greater division between US and European markets in the future.

John Cooley, head of FX Buy-Side Trading at Thomson Reuters, says, “FX always used to be a single, global market that operated across borders but it is now starting to become balkanised by these different rules. With SEFs in the US and MTFs in Europe, dealers and customers need to be much more conscious of which jurisdiction they are trading in, which adds to the fragmentation of liquidity.”

One of the biggest operational challenges associated with MiFID II is the requirement that all funds on whose behalf a buy-side firm might trade must be tagged with a legal entity identifier (LEI). The generation of those LEIs and communicating them to the relevant trading venues require major investment of both time and budget.

Further data also needs to be gathered to identify key personnel within individual firms. This data is often fairly sensitive – ranging from names and dates of birth to passport numbers – so there needs to be a clear process in place for gathering that data and storing it with the appropriate level of security. These data-gathering exercises cannot be left undone too long if they are to be done properly.

“None of the data requirements are conceptually difficult and they don’t require much strategic thinking,” says Leonard-Appleton, “but creating LEIs and sorting out user identification are logistically difficult for a firm that might have several thousand accounts and many traders scattered across different regions.”

As the preparation for MiFID II grinds on, FX market practitioners must also make sure they understand and abide by the newly launched FX Global Code. There is no doubt that the 55 principles enshrined in the Code offer the opportunity to harmonise best practice across the FX industry, but the Code’s true test lies in how widely it is adopted by the buy-side as well as the sell-side.

Drafted over the past two years by a group of central bankers known as the FX Working Group (FXWG) in response to the FX benchmark scandal, the Code was also supported by a broad-based Market Participants Group (MPG), comprising representatives from the sell-side and buy-side, as well as technology and infrastructure  providers.

While the Code presents a blueprint for the level of transparency and the kind of practices that should be promoted, it is very different from MiFID II and other regulations in that it is nonstatutory and does not set out to change market structure. Indeed, on some of the more controversial practices such as trading in the last look window, the Code has deliberately stopped short of being excessively prescriptive.

While neither the FX Global Code nor the implementation of MiFID II is likely to drive immediate changes in the FX market structure on its own, the combined effect will be a subtle and gradual evolution in the way business is transacted between sell-side and buy-side.

“At no point did we contemplate recommending that any useful market practice be curtailed. Similarly, we carefully avoided advocating one commercial model over another. The FX market is exceptional in a number of ways, one of which is numerous participant choices over the manner by which execution can take place,” said CLS Group CEO and MPG chairman David Puth on launching the Code in May.

The FX Global Code has sought to preserve that choice of execution channels, while ensuring participants are always fully aware of the choices that are available to them. Adherence to the Code remains voluntary, but there will be increasing pressure on market participants to sign public commitments that will be collated by new industry registers.

Guy Debelle, deputy governor of the Reserve Bank of Australia and chairman of the FXWG, says, “One reason for a public demonstration is that firms are more likely to adhere to the Code if they believe that their peers are doing so too. That is, an important source of pressure to adhere should come from other market participants. To provide visibility around this, there are a number of market-based initiatives to provide public registries where market participants can demonstrate their use of the Statement of Commitment.”

While neither the FX Global Code nor the implementation of MiFID II is likely to drive immediate changes in the FX market structure on its own, the combined effect will be a subtle and gradual evolution in the way business is transacted between sell-side and buy-side.

Both rulebooks require buy-side firms to take a much more proactive role in order execution than they have done in the past, and this is already driving increased use of Transaction Cost Analysis technology to show how best execution was sought (see article on pages 6-8). But the backdrop of more onerous prudential regulation and associated balance sheet constraints may drive an uptick in the agency model of execution as an alternative to principal risk transfer.

Neill Penney, co-head of Trading at Thomson Reuters, says, “There has long been an idea among banks that it makes sense to take liquidity from larger banks and pass it on to customers, rather than making prices themselves. With the rising cost of being a principal market maker, this model is becoming even more attractive, so we will see banks acting increasingly as agents and sourcing liquidity from multiple MTFs.”

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