With MiFID II regulations now in play, a new set of characteristics is emerging for FX markets in 2018.
MiFID II rules are combining with other industry dynamics to shift the way FX markets function in 2018. New regulated trading venues, best execution requirements and a relentless push for automation will significantly impact the role of buy and sell-side FX professionals.
In 2018, the expansion of new MiFID II-regulated trading venues in the European Economic Area (EEA), such as Multilateral Trading Facilities (MTFs), continues a trend of regulatory-driven FX liquidity fragmentation.
This began in 2013 with the launch of Swap Execution Facilities in the United States. Once a global, primarily over-the-counter (OTC) and unregulated market, FX liquidity now varies by geographic location and instrument.
In the EEA, if a participant chooses to trade FX derivatives on a venue, that venue must be regulated. This includes FX swaps, non-deliverable forwards (NDFs) and options.
In the U.S., venue trading in NDFs and options must be regulated. The rest of the world, however, can trade where they choose.
FX trading venues
Participants across the buy and sell-side must now make decisions about where they source and provide FX liquidity.
For some, the benefits of trading on a regulated venue, such as increased transparency, will be attractive. Others will perceive regulation contributing to higher costs.
While most buy-side institutions are expected to continue trading in the same jurisdiction, some could look to move their FX trading operations to circumvent regulation.
Banks, ultimately, will do what is necessary to provide liquidity to their clients. For many, this includes offering liquidity across multiple venues.
Choice of derivatives
Although new regulated trading venues will undoubtedly influence where specific participants trade FX in 2018, trends in what derivatives people choose are likely to remain the same.
Look for continued growth in both traditional OTC FX instruments, such as swaps and forwards, and exchange-traded FX futures.
The unique qualities that have made these instruments attractive, such as broken dates in OTC and clearing for futures, will continue to be attractive irrespective of the new regulation.
Transaction cost analysis
Also in 2018, new best execution requirements and adoption of the new voluntary FX Global Code will introduce substantial changes to trading workflows.
Many firms will be required (by regulations), or will elect (due to the FX Global Code) to establish best execution practices, and the buy-side will increasingly be held accountable for justifying liquidity decisions.
To meet these obligations, institutions will require transaction cost analysis tools and quality market data.
It is reasonable to assume that part of a bank’s service in providing FX liquidity could expand to include transparent reporting tools that demonstrate how a price was formed for a particular client.
Furthermore, as buy-side firms look more closely at their trading process, they will need to examine counterparty relationships and selection criteria.
It could very well be that under increased scrutiny a firm with few counterparties expands to trade with more, or a firm with many counterparties consolidates to drive efficiency.
FX technology solutions
These new regulations further support a relentless drive for automation across trading workflows. Increased transparency requirements will cut into the small portion of FX still traded over the phone.
And with intense cost pressure across the industry, institutions will rely heavily on technology solutions to drive efficiency in accessing and distributing FX liquidity.
Platforms that allow users to seamlessly access both regulated and off-venue liquidity pools via a single interface will be crucial for many participants.
Data and analytics tools will be needed for both making trade decisions and evaluating their effectiveness.
Gradually over time, trade decisions will become more and more automated with increased use of execution algorithms. The role of traders will also evolve as they learn to optimize and monitor automated transaction flow.
Ready for change
And finally, although 2018 brings unprecedented amount of change, markets have seen periods of new regulation before and adjusted accordingly.
FX markets will not decrease in size or importance as participants adapt to the new characteristics.