Banks and institutional investors are still trying to figure out their roles in FX trading as new rules shape market behaviors and structure.
The result of the structural changes in the FX market has been reduced liquidity and decreased risk appetite among market participants, affecting participant behavior.
This sentiment was supported by a Q1 2016 survey of FX managers participating in The NeuGroup’s FX Managers’ Peer Group (FX MPG) Summit, sponsored and hosted by Thomson Reuters.
The FX execution and holistic risk management survey found that changes in the market have indeed created concerns around liquidity and the growing need for the buy-side to take a closer look at their execution strategies and methods.
Increase in electronic trading
Electronic trading increases efficiency, particularly when electronic liquidity access and execution capabilities are provided in the context of a firm’s workflow, including post-trade.
Although all survey participants already use electronic methods to execute at least a portion of their FX transactions, 15% cited (increased) electronic execution over the last two years, and 20% said that improving technology is their top project/priority for 2016.
When asked to choose the statement that most closely matched their perspective on bank service levels, 39% said that their focus for trading electronically is to get tight pricing.
A further 28% said they intentionally perform some of their FX trades over the phone to maintain good relationships with their banks.
New execution strategies
Because of the structural changes and heightened scrutiny in the market, the need to achieve, evaluate, and demonstrate best execution is more important than ever.
At the same time, there’s recognition among the buy-side that regulation is constraining banks’ ability to provide liquidity.
In an effort to adapt to this changing environment, corporates are seeking additional execution strategies.
20% of members polled in the survey use bank algorithms (algo), with 37.5% of those saying that their frequency of algo use has increased over the last two years. The top two drivers of algo usage are size of deal and efficiency, according to the survey.
Reinforcing this trend, a recent review of trading activity on Thomson Reuters’ FXall showed a strong and steady increase in the use of algos over the last 18 months.
Performance measurement to improve execution
Institutions are increasingly being asked to justify how they transact their FX business and to prove best execution.
To assist clients in evaluating execution quality, Thomson Reuters offers Execution Quality Analysis reports (EQA) to FXall market participants.
EQA reports help buy-side customers analyze a rich array of their trading activity over a specified time period to assess the effectiveness of execution strategies and to help them manage risk and achieve best execution.
Use of FX options and hedging
The NeuGroup survey found that 54% of members currently trade FX options, with 30% of these firms trading FX options electronically.
50% cited hedging strategy as one of the three biggest areas of change in their FX trading practices over the last two years.
In addition, many respondents expressed their desire to better explain the costs of emerging market hedging to their management.
An evolving client-bank relationship
The client-bank relationship remains multifaceted and complex. In the survey, FXMPG members were asked to choose the factors that influence their choice of FX counterparties.
More than half (54%) said that their allocations are based on several factors including service, credit and overall relationship. 41% said they allocate business based on best price.
Regarding the impact of market scandals on corporate perception of banks, the essential level of trust corporate treasury clients place in their banks remains relatively healthy.
Only a small sample have chosen to temporarily limit trading with certain banks, curtailing specific activities and placing greater emphasis on competitive bidding.
Preparing for MiFID II and the FX Global Code of Conduct
MiFID II introduces a broad range of changes to the market.
Extensive new pre-and post-trade transparency requirements will result from MiFID II. Corporate treasurers will specifically be impacted by increased transaction reporting requirements.
MiFID II implementations timings are tight, with the law slated to become effective in January 2018.
Although a certain degree of uncertainty needs to be accepted until the final rules are decided, firms need to begin considering several questions now. counterparties will change.
FX Global Code
On 26 May 2016, the Bank of International Settlements (BIS) FX Working Group published phase 1 sections of the global code of conduct (Global Code).
The main purpose of publicly publishing the Global Code is to raise broad awareness of this prompt all market participants, including corporate treasurers, to consider how they can best embed the Global Code in their practices once the final text is released in 2017.
Looking ahead, the FX market will see more structural and regulatory change, requiring ongoing adaption and innovation.
With further regulatory scrutiny and the continued shift in how banks view their market-making vs. agency roles, the potential for reduced liquidity will remain a concern for corporate treasurers.