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As a global market, foreign exchange trading is subject to as many rulesets as there are tradeable currencies.

While specifics can vary widely, there is some commonality in the broad aims emanating from Washington and Brussels.

“The disposition of the regulators right now is about eliminating pockets of opacity, wherever they can find it,” said John Adam, global head of product strategy at trading-technology provider Portware, a FactSet company. “They want the market as transparent, audited, and externalized as possible.”  

“Many of our clients’ goals are about increased levels of audit transparency and retrievability of data,” Adam told Markets Media. “It really comes down to two questions: One, why did you trade with this counterparty? And two, why did you trade at this price, or why did you give up this other good price?”

The massive FX market, which trades an estimated $5.3 trillion per day, was historically a lightly regulated market conducted over the counter, i.e. via private telephone negotiations. In the wake of the 2008-2009 global financial crisis that exposed a lack of transparency in some areas of financial markets — as well as several well-publicized FX trading scandals — regulators are getting more involved.

In the U.S., the Securities and Exchange Commission and the Commodity Futures Trading Commission “have mandated that swaps trading for interest rates, FX, and FX non-deliverable forwards must be conducted on a swap execution facility,” Adam said. “That’s regulators sending a message of ‘We don’t like the capacity for risk in this market, so we want mandate trading on an execution platform that’s going to enable us to keep a better eye on what’s going on’.”

The first SEFs went live in October 2013, and while the trading venues have gained baseline acceptance, broad uptake has yet to occur. Clarification on some specific rules pertaining to trade reporting and other aspects of the SEF user experience are likely to move the needle on that this year, according to Robert Savage, chief executive officer of quantitative hedge fund CCTrack Solutions.  

Another item under regulatory review is ‘last look’ liquidity, which allows FX market makers to reject or delay an order before it is filled. The protocol is meant to deepen liquidity, but it can be problematic for an electronic trader who’s unclear about whether an order will be filled.

“This is something that needs to be addressed in that the market-making function in foreign exchange has been shifting from major banks to high-frequency traders,” Savage said. “Last look has been used by some of the larger FX bank traders, and some high-frequency traders, to enhance profitability. I think any regulations that move out from that may well affect market liquidity, but it’s not clear how it would play out.”  

As the main U.S. post-crisis financial regulation, Dodd-Frank didn’t target the FX market specifically, but the impact of its risk-damping objectives continue to be felt. One unintended consequence is that it’s considerably more difficult for an FX manager to open up shop.

“It’s a world of difference,” said Philip Simotas, portfolio manager at $400 million global macro manager ROW Asset Management. “Because of regulation, it has become more expensive for the banks to take on new clients, and they have become much more finicky and much more stringent about who they will accept as a customer.”

“You’re not profitable to a bank until you get to a certain level, which is in the hundreds of millions” of dollars in assets under management, Simotas said. “Even then, there are questions about their willingness to work with you in terms of finding the right solutions in terms of margin, trading venues, cost, access to the market, everything. It’s just a lot more difficult.”

Another unintended consequence of regulation pertains to the light being shone on the FX market, which presents a mixed bag for the end user.

“Transparency gives me more information and helps me be smarter about my risk,” said Savage. “That said, transparency does not beget liquidity. Some of the push for transparency has actually hurt liquidity. At the end of the day, the information that I garner from a more transparent market doesn’t necessarily compensate for the fact that it’s a less liquid one.”

“I’m not convinced that the steps that the regulators have put in for transparency have made markets that much less liquid, but it has made clear just how illiquid they can be at certain times,” Savage continued. “The real threat in the foreign exchange market is that we’re going to have ‘flash crash’-type scenarios pop up across currencies. No amount of regulation is going to get rid of those.”

Featured image by lovebeer/Dollar Photo Club