LONDON, May 21 (IFR) - Foreign exchange dealers are preparing to overhaul business models to keep up with the largest changes the industry has undergone in more than two decades.
The sector breathed a collective sigh of relief when the US Treasury proposed a clearing exemption for FX swaps and forwards on April 29, but it is far from business as usual for dealers.
As well as forthcoming regulation on options and non-deliverable forwards, electronic trading is growing across all products at a dizzying pace. The FX derivatives market is evolving into an entirely different animal -- and fast.
While keeping pace with the increasingly larger volumes being executed on electronic platforms, FX dealers will be forced to divide their business between products that will be cleared through central counterparties and executed on swap execution facilities (notably FX options and non-deliverable forwards), and those that won't.
"We're going to see a bifurcation of the FX business model," said Kevin Rodgers, global head of FX derivatives, spot and e-trading at Deutsche Bank in London.
"Certain products in certain jurisdictions with certain clients will go to an exchange, similar to the equities world. And big portions of the market -- spot, swaps and forwards but also parts of the derivatives market will be done bilaterally, like the old model."
E-MIGRATION GRABBING ATTENTION
Normally, regulation of this magnitude would be the main focus for dealers. But this regulatory push comes at a time when much of the market has been migrating on to e-platforms of its own accord. Computer power has boosted dealers' abilities to offer execution on e-platforms, as well as managing risk in a more automated fashion.
Deutsche Bank estimates that 20-30 percent of its total options flow is now executed on its e-platform Autobahn compared with scarcely anything in 2008. Meanwhile, about 80-90 percent of its spot volumes and 60 percent of its swaps and forwards volumes are executed electronically. It is hardly surprising then that dealers are throwing cash at their e-platforms by the bucket-load.
"We're still investing heavily in our e-commerce platform Morgan Direct, both on the technology and the people side," said Kayhan Mirza, global head of FX options trading at JP Morgan in London. "An increasing amount of our business is priced, executed and risk-managed on that platform. We believe that continued investment makes a lot of sense, regardless of the ultimate definition of an SEF."
Part of the problem, therefore, is that dealers must second-guess the final shape of regulation. Participants are confident that the US clearing exemption for swaps and forwards is in the bag, but will not find out for certain until the end of the month.
Meanwhile, the SEC and the CFTC currently have different definitions of a SEF, although it seems likely banks' own e-commerce platforms will be ruled out for executing clearable trades -- magnifying the significance of clearing exemptions for products that are already heavily e-traded. On top of this uncertainty, Europe has yet to pronounce on FX clearing.
"There is still uncertainty, but if the Treasury exempts swaps and forwards, we'd expect Europe to follow suit," said David Clark, chairman of the Wholesale Markets Brokers' Association in London. "However, we can't exclude the fact that Europe may not include options and NDFs in MiFID II. A further potential difference may be the position that Europe takes on single-dealer platforms, because there appears to be little appetite to ban them."
In any case, e-commerce platforms will still add value regardless of the final SEF definition, said Vincent Craignou, head of FX and precious metals derivatives at HSBC in London. For example, single-dealer platforms can be used to root to SEFs, he said, and clients should still be able to glean value from the platform's execution and risk management capabilities.
This means that dealers are still piling money into their e-platforms and systems despite the uncertainty, looking to attract clients as well as shouldering the costs of connecting to multiple CCPs and SEFs.
But while the FX derivatives market is evolving, some things should stay the same. Rodgers at Deutsche Bank signalled that electronic execution of vanilla options would continue to work on a request for quote basis rather than shifting to a central limit order book, as clients value flexibility in strikes and tenors too much.
Likewise, dealers concurred that clients would still execute the largest options tickets through voice broking rather than clicking and trading, out of comfort if nothing else.
The impact of clearing and SEFs on options liquidity is a hazier subject. Proposed reporting requirements for cleared trades have led dealers to fear that they may not be able to warehouse risk as effectively as before, leading to rises in prices to compensate.
"For short-dated options on liquid currencies, this transparency should help market liquidity," said Craignou at HSBC. "But there is a risk that longer-dated contracts for block trades, and potentially for minor currencies, will become more illiquid as banks will have to widen prices to mitigate the effect of increased disclosure."
Another looming question is how effective e-trading platforms can perform in stressed market environments. FX is notoriously sensitive to market shocks and can swing violently in short periods of time.
Perhaps not surprisingly then, there are anecdotal reports of various e-platforms temporarily pulling options prices on days like the flash crash or the Japanese earthquake.
"It can be very difficult," admitted Craignou. "My temptation in such a scenario would be to switch off streaming and rely on good old-fashioned traders to generate prices."
Nevertheless, continued investment in systems and advances in technology will mean automated risk management will only grow in prominence in the future.
"More and more price making and risk management tasks will be handled by computers, as we've already seen in the spot market," said Rodgers. "That's not to say that human traders will become redundant, though. Trading is a bit like flying a plane. You can put it on autopilot a lot of the time, but ultimately you need human beings who can understand the risk and make the right judgements.
(This article originally appeared in the May 21 issue of the International Financing Review, a Thomson Reuters publication: here)
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