The Last Look…

Very quietly the next big change on the regulatory horizon is approaching in stage 6 of the Uncleared Margin Rules (UMR), which lowers the threshold for being in scope to $8 billion from $50 billion in Average Aggregate Notional Amount (AANA), but will it, as some believe, really change the fabric of the FX industry?

We have faced these moments before when great change was predicted, but if you look back over the past 20 years it has hardly been a revolution, more an evolution as my friend James Sinclair would term it. Doomsayers have had their day, and most of the time been proven wrong. I suppose technically it would count, but I am struggling to think of how a regulatory decision actually triggered significant change outside of the SNB’s debacle in January 2015.

So will the new threshold of UMR be any different? Are SA-CCR and G-SIB finally going to impact the industry? There are many out there who believe that the last 10 years-plus have been building towards the moment in September when the new changes come in and, in their eyes, change the industry for ever. Whilst respecting their views, and having no evidence to contradict them (but when has that ever stopped me?) the weight of history is against them because enforcing change in FX markets has historically been very difficult and has taken either an outstanding (and sometimes obvious) idea, as well as the support of the most important players in the industry – the banks.

Reuters Direct Dealing and Reuters Matching either side of 1990 were important developments that changed the industry, the creation of EBS by the major banks in 1992/93 then reinforced this, sealing the effective end of the voice broker in major spot markets. The Hotspot, Currenex, FXall development period then changed matters again and, to a degree, the growth in prime brokerage and EBS’ decision to allow prime clients onto its platform provided another instance of change. Not only were none of those driven by regulation, since then, you could argue, there has hardly been a change in how the market operates.

I would argue this lack of change (there have been dramatic improvements in technological performance and a few other nuances of course) is because the FX market works – it does what it is supposed to, which is service the global economy. It is here that I believe the biggest challenge lies for those promoting, for example, clearing – the majority of “real economy” clients don’t want it. I absolutely understand a lot of financial clients do, but they are rarely valuable enough to a major bank to drive a change in attitude to what remains a more expensive process.

The focal point for the post-September FX market will be FX swaps – what will happen there? There is already chatter about conditions in the market and how spreads are widening out and liquidity thinning, but is this the result of regulation or due to a new phenomenon for many traders in the market – interest rate volatility and divergence? There is no doubt that some banks eye their G-SIB rating nervously at quarter ends, and the BIS paper from 2020 demonstrated how some of the bigger banks pull back at quarter ends in FX swap markets, but that is already happening, will it be any different, or more so, in September?

FX Link’s inability to grow exponentially over the past two years just highlights how difficult it can be to gain a foothold in the FX market structure

To drive change I believe it will need more than regulators, it will need the banks and their clients to embrace the need for clearing. If that can be achieved then indeed great change may be upon us. The challenge for those in the clearing space is that many bankers on the trading side especially, see clearing as a threat in that it would open up FX swaps to non-bank players, who have, until now, been clients rather than liquidity providers in this space. Look at CME’s FX Link – it’s a really good product that manifests a really good idea, but volumes are relatively steady (they are up over 40% year-to-date on 2021, but the highest monthly ADV thus far in 2022 is $2.2 billion, which is not too far off where it was in 2020). I suspect activity is steady because the client base for the product – at this stage – is not growing.

I happen to believe it will grow because of the idea behind it, but FX Link’s inability to grow exponentially over the past two years just highlights how difficult it can be to gain a foothold in the FX market structure. Will clearing be any different?

There is also the question of compression and novation, which seems to be the preferred path of the banks. Talk to people at Capitolis, Osttra and Quantile and there is a sense of optimism, business seems good, but it is not due to clearing, it is down to the basic capital optimisation services available. This, it seems, is keeping the regulatory wolf from the door.

Of course, these firms like the idea of clearing, it could supercharge their business, but if pushing clearing potentially disenfranchises, or even worse, angers, their clients, are they going to pursue it?

There will be no “big bang” in September, so it will take a few months for the impact of the next set of changes to work through, and as such we will not have an answer to the question “will regulation change the FX industry” for some time. My sense is that the industry has been, and will continue to be, sufficiently innovative to circumvent the need for clearing on a grand scale. The banks will support those initiatives that help them manage their capital as efficiently as possible without great infrastructure change.

The key to the question undoubtedly lies with the banks. Don’t be fooled by industry surveys that suggest non-bank firms are close to domination in FX, they’re not – even in spot. The vast majority of business still goes through banks, so that is where the change has to start. The real question is then, “is there appetite for it?”

colin@thefullfx.com

@colinlambertFX