In addition, while declining in the aggregate, hedge fund and principal trading firm (PTF) activity has been shifting towards Asian financial centres, partly reflecting greater liquidity of Asian currencies and hence inducing co-location to their main trading venues. For instance, FX trading by hedge funds and PTFs in London and New York dropped by 50% and 10%, respectively, but rose by 88% in Hong Kong SAR, more than doubled in Singapore and tripled in Tokyo. Combined, Asian financial centres now account for 4% of trading by hedge funds and PTFs, compared with 1% in 2013.
FX Market Participants
The structure of FX markets may be moving from anonymous trading towards a more relationship-based form of activity. The number of dealer banks willing to warehouse risks has fallen, while non-bank electronic market-makers have gained greater prominence as liquidity providers. Yet, the resilience of voice trading suggests that market participants at times prefer to avoid primary electronic venues due to concerns about price impact and information leakage.
- Dealer banks have been adjusting their business models to their reduced capacity to warehouse risk and tighter limits on proprietary trading. A few top-tier banks have consolidated their position as liquidity providers, attracting further customer flows, including from other banks. They have also have maintained their position as large flow internalisers ( the process whereby dealers seek to match staggered offsetting client flows on their own books instead of immediately hedging them in the interdealer market) and price-makers. The largest dealer banks include JP Morgan Chase, Citigroup, UBS and Deutsche Bank. By contrast, many other banks are increasingly acting as agents or conduits, sourcing liquidity from the largest dealers and passing it on to their clients. Dealer banks appear to be focused on retaining a relationship-driven market structure, where bilateral over-the-counter (OTC) transactions dominate. Bilateral trading takes place primarily via proprietary single-bank trading platforms operated by the FX dealing banks, or electronic price streams via application programming interface (API) connectivity. Single bank platforms include Citi Velocity, JPMorgan’s Morgan Markets, UBS Neo and Deutsche Bank’s Autobahn.
- Electronic non-bank market participants have gained prominence as market-makers and liquidity providers due to new technologies. While previously focused on high frequency trading (HFT) strategies, they are becoming some of the largest liquidity providers on primary trading venues and have been making inroads in direct etrading with customers. Non-bank electronic market-makers includes XTX Markets, Virtu Financial, Citadel Securities, GTS and Jump Trading. Their trades are prime-brokered by a dealer bank. They are active on multilateral trading platforms, where they provide prices to banks’ e-trading desks, retail aggregators, hedge funds and institutional clients. Typical daily volume for each firm is estimated to be about $10 billion with the highest concentration in spot trading.
- Multilateral trading venues, such as EBS and Reuters Matching have suffered a fall in trading volumes due to the emergence of relationship-driven electronic platforms and also because they rely on centralised limit order books (CLOBs) as their primary trading protocol. They have responded by providing alternatives facilities to allow direct e-trading. For example, Thomson Reuters bought FXall, a multibank trading platform based on the request-for-quote (RFQ) trading protocol. Nevertheless, traditional multilateral (or inter-dealer) electronic trading venues continue to be vital to the FX market: they play a major role in price discovery, and they offer crucial backstop when FX market conditions worsen by allowing dealers to hedge their inventory risk anonymously.
- Multi-dealer electronic communication networks (ECNs), allow customers to trade directly with a range of dealers, using a suite of trading protocols, such as price streams from individual dealers or requests for quotes, and direct (or bilateral) trading between a dealer and a counterparty.
- High Frequency Trader activity has levelled off as a result of tighter FX market access from the decline in prime brokerage as well as from various measures, such as “speed bumps” to curb HFT activity which were put in place by major FX trading venues beginning in mid-2013.
- Institutional investors and corporate treasuries have increased their participation, notably for hedging purposes.
FX Market Regulation
The dichotomy between a principles-based and rules-based regime for the global FX markets has been discussed and examined by many experts, and the conclusion was that former is likely to be more effective. Arguably, however, implicit in the message of the FX Global Code is a warning that if market practice comes up short of its recommendations and standards, then the heavy hand of regulation will be administered. The consequences on industry participants would be costly, time-consuming and add a considerable administrative burden.
However, regulation does not need to be wholesale. An alternative is to apply global regulation to particular areas that are susceptible to manipulation and malpractice due to ambiguity (for instance “last look”) or where transparency can be achieved. Private initiatives have an important role too, especially if they meet the demands of customers.
An example, is a consolidated tape. In September 2017, FastMatch, part of Euronext, announced the launch of a consolidated FX Tape for the spot market. It will publish real-time post-trade information collected from market participants in aggregated and delayed fashion to minimize market impact. The idea is that it will serve as a central reference point for spot FX transacted prices helping market participants evaluate best execution performance, and improve post-trade transparency. (6)
Other initiatives are likely to be launched too, and for similar commercial reasons. If they are adopted by market participants at a critical mass, then they are likely to be normalised and hence easier to formalise in regulation.
Therefore, if there is momentum towards regulation of the FX markets, it is important for the discussion to identify the scope of that regulation: whether it should be all-encompassing or selective.
Recommendation
National regulators and market participants should maintain a constant dialogue about the advantages and disadvantages of global regulation, and where and how it can best be applied. The new Code is all-embracing, and it should be possible to identify some of the 55 principles that can be formalised as rules. The implementation of MiFID II across the European investment services industry and its compatibility with other regional jurisdictions can help point to future difficulties as well as opportunities.
The dialogue can be maintained through existing industry bodies such as FIX Trading Community (FICC Committees and Working Groups) globally and any new initiatives that have the purpose of exploring and examining best practice regulation. They should:
- Help coordinate the agenda by identifying key issues, working with all stake holders
- Support submission of whitepapers and consultative documents about FX markets regulation in general and specific problem areas of the markets
- Help coordinate and plan ‘best practice’ implementation strategies
- Promote discussion of the issues in industry media outlets
This paper is intended to form part of a continuing discussion within the FX industry about market regulation, supervision and surveillance.
Sources:
- Financial Times, 25 May 2017
- FX Global Code, May 2017
- Guy Debelle, FX Code Press Conference, London, 25 May 2017
- Bloomberg, 25 September 2017
- “Downsized FX markets: cause and implications”, Michael Moore, Andreas Schrimpf and Vladyslav Sushko, BIS
- Mondovisione, 25 September 2017
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