Winners and losers emerge from fragmented FX swap rules
By Paul Golden
The International Swaps and Derivatives Association has frequently warned that market fragmentation will continue and market transparency will be damaged as US and European regulators fail to reconcile their FX rule sets.
Disharmony is most evident in relation to SEFs. The US SEF trade mandate does not include FX, although footnote 88 of the final CFTC SEF rules compels all-to-all electronic platforms for FX to register as SEFs.
"So if you trade FX, you are not mandated to trade on an SEF, but if you operate an all-to-all FX trading platform it must be registered as an SEF," explains Mark Brennan, head of business development Americas at ITRS.
Peter Best, chief operating officer of the Icap SEF, says the rules that apply in the US have forced his company to split its EBS non-deliverable forward (NDF) platform and in effect create two offerings – one for US persons and a second for London, EMEA and the rest of the world.
"Therein you can see an advantage for Europe in that London-based entities get to straddle two liquidity pools," says Best, who expects the implementation of Mifid II to broadly create regulatory equivalency that will help with increased cross-border activity as more participants will be prepared to trade with US persons.
Liquidity on the platforms will generally beget more liquidity, so, to a degree, if the FX SEF market matures there would naturally be more trading in the US, adds Brennan at ITRS.
"But the FX market has been electronic for a long time, so simply having FX SEFs in the US won’t necessarily change the profile of the global market," he says. "We would need to see FX products become so-called 'required transactions’ under CFTC rules – that is, mandated for SEF trading – before we see a big shift."
Brennan describes this as a work in progress as far as the CFTC is concerned, adding: "There was discussion about an FX clearing proposal coming out some time this year, but the CFTC seems a little distracted with other issues.
"A trade execution mandate won’t happen until after options and NDFs move to clearing, so my guess is we are looking at a two-year horizon." Stéphane Malrait, chair of the ACI’s (Financial Markets Association) FX committee, refers to a sense that regulators are more focused on clearing and trading of instruments other than FX.
"Agreement on clearing of FX options is likely to take another 12 to 18 months to resolve," he says. "There is a suggestion that there will be greater clarity around clearing of NDFs when the Basel III requirements start to take effect, but this might not happen until 2019."
Jodi Burns, head of regulation and post-trade networks at Thomson Reuters, agrees that European counterparties want to avoid being caught up in US regulatory requirements, but is confident that regulatory alignment would encourage a return to previous levels of cross-border trading.
She is also relaxed about the impact of fragmentation, suggesting that it inhibits liquidity for individual counterparties rather than the overall market.
"The CFTC has signalled that an NDF clearing mandate isn’t on its radar in 2015," says Burns. "As for clearing FX options, industry participants including clearing houses and major banks are discussing how this would work.
"But for now there is no clear indication when a solution will be identified."
Should the US and European rules prove irreconcilable this would create a further fracturing of liquidity from two pools (US v rest of the world, with a UK bridge) to three or more (US, Europe and the rest of the world), according to Icap’s Best.
"Not only is it important for liquidity that the rules are aligned, but the closer the rules look, the easier they will be to implement for platforms and participants who have had SEF experience, thus reducing confusion and friction when the Mifid rules hit," he says.
"I believe that there is a lot of support for rule alignment."
Best also observes that the threat of mandatory clearing and made-available-to-trade determinations – which would impose SEF transaction-level requirements on FX – appear to have subsided, with the US working to stay aligned with Europe.
"We would like to see one liquidity pool, a single platform where participants can freely trade with each other," he concludes. "It is less important to us whether this is a US or EMEA platform."