Trading foreign exchange has been lucrative for the major international banks that dominate it. The asset class continues to grow, now experiencing $5.3 trillion of average daily turnover, according to the Bank for International Settlements.
Until recently this was unregulated, but that is now changing. Although the size of the FX market will probably keep expanding, particularly if the renminbi becomes more easily tradable, increased regulatory costs combined with technological innovation threaten banks’ profits.
Broadly speaking, regulators value transparency. That is why they are pushing for derivatives to clear centrally, taking them out of the over-the-counter market and putting trading on multilateral platforms. This is meant to be achieved through technology, although new regulation can have the opposite effect, dispersing trading activity and making it harder to track — causing damage to volumes in the meantime, although tighter spreads ultimately benefit investors and clients such as corporate treasurers.
In the FX world, both technology and regulation are now having a major effect on trading, but while tech was the driver in equities, it is regulation that is in the vanguard for FX.
FX has traditionally been regulated by central banks as part of national monetary policies, which in many countries focuses on currency stability. However the global financial crisis led authorities around the world to look at making financial markets safe. They focused initially on regulating credit markets, but have extended that to FX. Specifically, regulators want to introduce requirements regarding liquidity, clearing, execution, margin, capital reserves and even bonuses.
Efforts to regulate FX mystify some traders. Settlement risk was addressed with the 2002 launch of the continuous linked settlement platform, a bank-owned utility that allows members to settle cash and spot FX. “This makes trading FX operationally risk-free,” said Shankar Hari, head of fixed income structuring and FX at JP Morgan in Singapore.
While there is no exchange body, FX markets are the most liquid in the world. Competition is so fierce that pricing is very tight and transparent — so far better for customers than, say, a broker’s dark pool trading equities.
And FX is global, so who is responsible for regulating a dollar-yen trade; and why should anyone be given that power anyway?
The problem is that some people think the system is in need of reform. FX prices are subject to manipulation. Regulators in Europe right now are investigating banks’ price-setting practices. As with Libor (London interbank offered rates, for credit), benchmark FX levels in London and other major trading centres are determined by anachronistic and arbitrary pools of quotes for FX pairs from multiple banks. These are done at particular times of the day, such as the 4pm London “fix” or the Tokyo “cut”.
And while only a fraction of spot FX prices are actually set this way, these provide a reference point for the entire market. And just as banks have confessed to manipulating Libor prices to cheat clients, banks are under scrutiny for similarly sharp practices in FX.
Traders puzzled by threats of regulation miss the bigger political point about the role FX markets, and financial markets in general, should play. This does not mean the end to big players or big profits, as the equities world attests, but it will further drive automation — for reasons of compliance as much as for competition.
For most players, this creeping change is not yet very visible. Some traders say there has been little to no effect on their business, other than on non-deliverable forwards (NDFs), which have been subject to reporting and regulation since October. The question is whether NDFs are an exception, or the beginning of a trend.
The more thoughtful traders say it would be foolish to assume that, five years from now, FX trading remains over the counter.
