PLAYING BY THE RULES
By Mr Odoni, CEO And President Ipocampus Holding Odoni Partners
Many dyed-in-the-wool foreign exchange traders lament the regulatory changes sweeping the industry more than six years after the global financial crisis. The market has become too boring for them. In the US, the Volcker Rule has caused banks to shut down their proprietary trading desks, while provisions of the Dodd-Frank Act are causing big FX banks to stop making markets in currencies and to act simply as agents for their customers.
The worldwide probe of the FX market is also causing traders to pull in their horns. Trading platforms are becoming ever more sophisticated and equipped to monitor users, while banks have lost their appetite for taking risk.
Slowing economic growth in many parts of the world, particularly in China and other emerging markets, has dampened demand for commodities and the need for some trade-related FX transactions. This has sparked a debate about how much of the current malaise in the industry is cyclical and how much is structural. The optimistic traders say the FX market always snaps back from periods of low volatility, while the pessimists say the market (at least in the US) has been completely ruined by overregulation.
Backers of swap execution facilities, regulated platforms for swap trading, are in the optimist camp. They say Dodd-Frank is great, and regulators should move more quickly to implement the new regulations. SEFs are new venues with centralized clearing and reporting obligations for FX swaps in nondeliverable forwards, contracts common in many emerging markets. Supporters say SEFs provide enhanced transparency and efficiency.
Some FX traders are migrating to London—long the center of the FX world—to avoid US regulation. Britain does not regard FX forwards as derivatives subject to new regulations. However, the European Securities and Markets Authority says forwards are derivatives. Mandatory trading and clearing of FX derivatives could be introduced in Europe as soon as 2016, if member states can agree on common definitions of spot, or cash, FX trades, and forward contracts.
The low volatility in the FX markets this year has lulled many corporations into a false sense of security when it comes to FX risk exposure. The recent decline in the euro shows that volatility could return to the markets, catching corporate risk managers off guard. The more prudent ones will utilize available tools to manage currency risk exposure and increase potential profits.
Meanwhile, financial centers worldwide are elbowing one another to become leading offshore renminbi trading hubs. Apart from Hong Kong, with its built-in advantages, London has taken an early lead. The Chinese currency still has a long way to go, however, before it seriously challenges the dollar as the leading currency for international trade.
Will regulation repair forex’s damaged reputation—and are banks ready for the culture change?
Banks and other FX providers are adapting to an increasingly regulated environment: The foreign exchange landscape is indeed changing. Many big banks have shut down proprietary trading desks, and some have lost star traders to hedge funds. Regulatory changes and increased scrutiny are shifting FX trading volume away from the interbank market and toward electronic platforms. Margins have narrowed as the system becomes more commoditized. Telephone trading and chat rooms have gone quiet.
Although the FX market remained vibrant and liquid throughout the financial crisis, the recent extended period of record-low volatility is raising concern that the changing regulatory mix is depressing interbank volumes, says George Saravelos, currencies analyst at Deutsche Bank. The lower transaction costs from electronic trading may also be reducing volatility, he says.
Deutsche Bank shut down its proprietary FX trading desk in London in December 2012. Early this year, Kevin Rodgers, the bank’s London-based global head of FX, let it be known that he would retire in June to focus on academic and musical/theatrical interests. As of early October, a replacement had not yet been named.
Citi, another one of the world’s largest FX banks, lost its two top FX officials this year. London-based Anil Prasad, global head of FX and local markets, left to form his own hedge fund, to be replaced by Nadir Mahmud, who was head of global markets for Asia-Pacific. And Jeff Feig, managing director and global head of G10 FX at Citi, left the bank in June to join Fortress Investment Group, a New York–based global investment manager, where he is co-head of the liquid-markets business, which includes the firm’s macro funds.
Though none of these personnel changes has been linked to the widening investigation into alleged manipulation of the FX market, more than 30 traders at leading FX banks have been fired or suspended in the past 12 months. This purge has cast a pall over the market.
The shrinking number of dedicated interbank participants and a growing herd mentality could lead to sudden, unexpected shifts in exchange rates. David Rodriguez, quantitative strategist at DailyFX, a news and analysis portal owned by FXCM, says: “The dollar tumbled and the Japanese yen surged [on August 6] as an aggressive wave of selling led the dollar to its worst single-day loss against the yen in four months. The dollar’s exchange rate fell sharply in the typically quiet period after the European market close. Traders initially suspected a ‘fat finger trade’ was to blame—someone had mistakenly placed an especially large sell order. But it turned out to be simply panic selling which forced many nervous speculators to exit their leveraged positions.” The unexpected volatility underlines the risks below the surface, as FX markets’ overall volatility falls to near-record lows, Rodriguez says. “Clearly, many traders fear the next major move is just around the corner, and any especially crowded trades seem at risk, as speculators will flee at the first sign of danger,” he says.
SEISMIC SHIFTS UPEND THE FX BUSINESS
According to a recent report by Stamford, Connecticut–based Greenwich Associates, the slump in FX trading volume has all the features of a cyclical decline, as hedge funds and central banks have slowed their FX trading. But, the report continues, in reality the slump could reflect a major shift in the FX business model. “Greenwich Associates believes there are FX-specific factors at play that signal a secular shift as well,” the report says. “Regulatory concerns and tightening budgets could lead to most FX trading being done on an agency basis and executed via exchange. Dealers who invest in their electronic platforms will benefit from this potential shift to agency-style trading.
”In general, only the biggest banks can afford the cost of building these big platforms. Financial institutions as a whole increased the share of their trading volumes executed electronically by three percentage points to 77% last year, Greenwich Associates says. Nearly three-quarters of global FX trading was electronic last year, up from 71% in 2012.
“Electronic FX volumes are also getting at least a minor boost from currency options, which are often traded through single-dealer platforms that allow for a maximum level of customization,” Greenwich says. However, its Market Structure and Technology practice recently released research showing that regulatory burdens set to take effect in the coming years could severely slow the growth in FX options trading.
Until now the FX industry has been largely unregulated. In the wake of allegations that the 4 p.m. London fix for benchmarks was being rigged, however, further regulation is likely. The UK Treasury said in June that it was working with the international Financial Stability Board to clean up the market. A task force set up by the FSB recently proposed a series of 15 reforms, including extending the time for the London fix from one minute to five minutes. It also wants banks to separate their fixing orders from the rest of their FX business and to take other steps to minimize conflicts of interest. The FSB, however, did not go so far as to recommend a global utility to match fixing orders. The London fix is used to create a benchmark to value trillions of dollars in investments.
More regulation, more compliance costs and more technology replacing human traders will continue to change the market. The new way of doing business could make it harder for most banks to make a profit from FX trading.
EFFORTS UNDER WAY TO RESTORE TRUST
The benchmarking scandal in the FX market has shaken faith in the system of trading currencies that enabled a dozen or so major banks to allegedly manipulate the world’s largest market. The global investigations may be settled soon, but the damage to the market’s reputation could be lasting. Recognizing the need to restore a sense of fairness, transparency and liquidity to the global currency market makes changes inevitable. Many market participants have welcomed the Financial Stability Board’s recommendations for reform, particularly those relating to the 4 p.m. London fixing. James Kemp, managing director of the Global Foreign Exchange division of the Global Financial Markets Association, which represents many of the dealers in the market, says: “As the report highlights, there may well be challenges and costs in implementing the changes, but enhancing confidence in the market is crucial, and the industry will adapt to embrace these recommendations.”
If the industry does not act quickly to ensure appropriate behavior and implement the FSB report’s recommendations, the authorities may conclude that further regulatory reforms are necessary, the FSB has warned.
The Foreign Exchange Professionals Association (FXPA), a new Washington, DC–based trade association representing a wide range of interests in the FX market, was formed in September to provide advocacy for the industry. “This is a watershed moment for FX, as we redefine who we are as an industry and where we’re going,” says Derek Sammann, global head of commodity and options products at CME Group and vice chair of the FXPA. The group includes buyside institutions, exchanges, clearing houses, trading platforms, multilateral trading facilities, technology companies, banks and nonbank market participants.
In June, Thomson Reuters revised its FX trading rules and updated is Rule Book. “We want to make sure people are using the platform for its intended purposes—genuine commercial interest in trading—and ensure that’s the kind of liquidity we’re getting,” says Phil Weisberg, global head of FX at Thomson Reuters.
RENEWED VOLATILITY TESTS TREASURERS
The recent surge in foreign exchange volatility may be catching some corporate treasurers by surprise after the currency market’s prolonged lull.
“Over the last year and a half, volatility has returned [to the foreign exchange markets],” notes Karl Schamotta, director of FX strategy and structured products at Cambridge Mercantile Group. “We’ve seen the emerging markets run into troubles, and now the majors are adjusting quite dramatically, as well.”
Schamotta links the currency moves to “a rebalancing in the global economy,” as growth in China slows while economic activity in the developed world, particularly in the United States, picks up steam. “What we’re seeing is central bank policies, economic growth and simply the flow of capital—the expectations of those things are shifting in different directions right now.”
A lot of corporate treasuries were relatively unprotected as they headed into the renewed volatility, Schamotta says, citing the low implied volatility on options on major currency pairs earlier this year. “Buying insurance on currency movements was relatively cheap,” he says. “That really reflected that there wasn’t a lot of demand, there weren’t a lot of people looking to protect themselves. Many corporates simply said, ‘Let’s focus on the underlying business and leave the currency markets to do what they will.’”
Whether companies cut back on FX hedging while volatility was subdued likely depended on each company’s policy, says Krishnan Iyengar, a vice president at treasury and risk management solutions provider Reval. Iyengar says that some companies give hedging managers the latitude to modify the amount of exposure they hedge. “A very common approach companies use is, they allow their risk managers a policy band to hedge within, depending on external market factors,” he says.
Nevertheless, any complacency among companies has now evaporated. “People have become well aware that the house is on fire again,” Schamotta says. “Treasurers are looking at putting trades in place. Unfortunately, the reality for many is that they’re reacting too late.” He adds that some people with large euro and yen receivables who had thought they were “sitting in the sweet spot” have taken substantial losses, while others are looking to lock in the gains they’ve achieved using forward contracts.
TURNING TO OPTIONS
Although corporate treasuries have traditionally employed products like forwards, spots and swaps to hedge their foreign exchange exposure, Iyengar notes an increasing interest in options. “We are seeing a pickup in companies trying to get budget for option products in the last couple of quarters,” he says.
Options “are primarily used from an insurance perspective on extreme moves in the market at some time in the future,” says Iyengar, explaining that there is increasing interest in option structures because companies view them as cheap, based on historical comparisons, while sensing a future rise in volatility.
Schamotta also cites increased use of currency options. In particular, he says, companies worried about extreme market moves in the wake of the 2008 financial crisis are using options to implement currency collars, a structure in which a company buys a put option while selling a call option. A collar limits the company’s gain if the market goes in its favor and limits its loss if the market goes against it. “If the markets go really crazy, you are protected,” says Schamotta.
Iyengar says that companies using a collar “would typically be buying insurance on rates moving in one direction and financing that premium by selling the counterparty an option that, if rates went below a certain point, the company would pay the counterparty.”
“The company wouldn’t care if rates went down because they would pay their suppliers less,” he adds. “The benefit they would gain by paying their suppliers less would make up for the payment to the counterparty.”
Companies are also starting to employ a portfolio approach to forex hedging, according to Iyengar. “Rather than looking at each currency pair discretely, they’re looking at their entire exposure on a portfolio basis, looking at which currencies are highly correlated or inversely correlated, and isolating the net risk on a portfolio basis,” he says, explaining that the approach involves the use of more sophisticated models. “Once they’ve isolated their risk, they can then make certain decisions on how to hedge that risk.”
Increased volatility makes hedging more expensive, but it shouldn’t alter the effectiveness of a company’s hedging program, says Luis Montiel, assistant treasurer at Jabil Circuit, a contract manufacturing company based in St. Petersburg, Florida.
The keys to hedging effectively are understanding the company’s business and the data associated with its business flows, Montiel says, adding that knowing the business relates to understanding how the cost of goods sold moves through the supply chain: “If you don’t understand what you’re hedging, it becomes extremely difficult to say you’re effective at it.”
Companies also need to have a clear handle on the information flows associated with transactions. “If you were to sell in euros today and wait three to four days to book that into your enterprise resource planning system, that lag of time doesn’t allow you to have the real-time data to say, ‘I just sold X amount in euros that needs to be hedged,’” says Montiel. “That is the type of data visibility that companies need to have an efficient program.”
VOLATILITY VERSUS REGULATORS
James Lockyer, director of development at the Association of Corporate Treasurers, argues that regulatory change poses a far greater challenge to corporate FX hedging than market volatility.
“The biggest driver in hedging foreign exchange risk at the moment is actually regulation,” Lockyer says. He cites new reporting requirements related to Dodd-Frank in the US and the European Market Infrastructure Regulation in Europe, as well as new bank capital requirements.
The capital adequacy and liquidity requirements that are part of Basel III are resulting in banks’ charging more for long-term hedges, because they have to hold more capital against them, and are affecting “the maturity of trades which corporations can enter into with banks,” he says.
Montiel describes the regulatory environment as “quite a large burden” and says that, from Jabil’s perspective as an end user of derivatives, it’s often “not transparent and extremely clear what we are supposed to be doing” to comply with regulations. But he adds that compliance with regulations is just another one of the risks that companies have to deal with in their hedging programs, as is market volatility: “There’s not a risk that we don’t address on a continuous basis.”
A LONG WAY OFF - RISE OF THE RENMINBI
Despite media hype, the renminbi still has some way to go before challenging the dollar as a major currency for international trade.
China’s renminbi, or redback, won’t be displacing the greenback anytime soon on the global stage. The surge in the renminbi’s share of global trade settlement in recent years still leaves it as a marginal player, even as the country’s economy is on the verge of becoming the largest in the world. China will need to liberalize its capital account and ease restrictions on capital outflows before its currency can begin to displace the dollar, analysts say.
The renminbi’s share of global payments in September 2014 was 1.64%, up from 1.55% in June, according to SWIFT. “To call this a rapid displacement is an exaggeration that distorts the facts beyond recognition,” says Marc Chandler, global head of currency strategy at Brown Brothers Harriman in New York.
Nonetheless, renminbi payments worldwide nearly tripled in value over the past two years, according to SWIFT, which is clearly a big rise. The Chinese currency in September ranked seventh as a world payments currency, just behind the Canadian dollar and ahead of the Swiss franc.
China is, of course, seeking to establish the renminbi as a major currency for international trade. However, the recent rise in the use of the currency is not so much a symbol of the internationalization of the renminbi as a financial arbitrage play, according to Chandler. Citing a recent study by the Peterson Institute for International Economics, he says that when the offshore renminbi trades at a premium to onshore renminbi, Chinese importers have an incentive to pay for imports in the offshore market. The magnitude of the premium seems to drive the rise in the supply of offshore renminbi.
The renminbi is not yet an international currency, although it is headed in that direction, according to the Peterson Institute. “It cannot become a true international currency until Chinese authorities drop the strict limits that remain on capital flows (that is, transactions in financial assets) between China and the rest of the world,” the institute notes.
Meanwhile, the growth of the Chinese economy appears to be slowing, in part owing to the country’s anti-corruption and anti-pollution campaigns, according to Chandler. “The risk is that a further slowing could convince the Chinese authorities to sacrifice reforms and concentrate on stimulating the economy,” he adds, emphasizing that this scenario is a risk rather than a forecast.
The Bank for International Settlements’ latest triennial survey last year found that global foreign exchange trading averaged $5.3 trillion daily. The renminbi had the ninth-largest share overall, but at $120 billion this was still a drop in the bucket, says Chandler. The renminbi’s share of total trading rose to 2.2% from less than 1% in 2010, whereas the dollar’s share increased from 85% to more than 87%.
At the same time, China’s capital controls have resulted in an imbalance between the country’s economic size and its financial integration, according to a report by Mitul Kotecha and Hamish Pepper, currency strategists at Barclays in Singapore. “A relaxation of capital controls is likely to precipitate an outflow of capital by residents and place stress on the domestic banking system, which in turn could lead to a financial crisis,” the report says, pointing out that deposits in China’s banking system are equal to 200% of GDP.
The Barclays strategists observe that interest rate liberalization, particularly for deposit rates, is an important prerequisite for convertibility of the renminbi. China took the first steps toward capital account convertibility 20 years ago when the multiple exchange rates for the renminbi were unified, they say, but there is still a long way to go. The Barclays strategists add that if the capital account were opened before caps on interest rates were removed, there would likely be a significant outflow from the Chinese banking system.
By Mr Odoni, CEO And President Ipocampus Holding Odoni Partners