Annie Walsh of CameronTec spoke to FX users to better understand the topical issues and challenges facing the OTC Foreign Exchange market and the central role FIX can play in addressing these challenges.
Undoubtedly the capital markets in 2011 will be remembered for many history-making moments including some of the largest currency moves the market can remember. We have witnessed the global foreign exchange market — the most liquid financial market in the world with an average daily turnover in the vicinity of USD4 trillion — bear the brunt of one political crisis after another, causing widespread volatility and difficult to pick currency moves.
Currency friction in Europe and between the US Administration and China will no doubt remain a prominent feature of the global economy for at least the next 1 – 2 years. On top of this remains uncertainty of government, particularly in Europe, and the implications for continuity of fiscal and monetary policy.
Many investment banks too in their search for alpha have been left wondering ”where did the black box get it wrong?” following lack lustre P&L performance, almost industry-wide over recent months.
Without a formal open or close, the FX market presents a true ‘follow the sun’ global market, with inherent levels of opportunity and risk.
Against this uncertain backdrop, the FIX Protocol has great potential to centrally feature in what is undoubtedly the single greatest threat (opportunity, if you prefer) facing the global OTC FX market. That is of structural uncertainty compounded by impending regulatory change to be ushered in, courtesy of Dodd Frank, and MIFID II and III.
With no unified or centrally cleared market for the majority of trades, and little cross-border regulation, due to the over-thecounter (OTC) nature of currency markets, these are rather a number of interconnected marketplaces, where different currencies’ instruments are traded. Inevitably OTC FX will move, however grudgingly, away from its long-standing (self-serving) model of self-regulation, toward greater levels of transparency, regulatory oversight (either directly or indirectly) and centralised clearing.
A Two Speed FX Market
As currently drafted, spot, outrightsand swaps are to be exempt from Dodd Frank’s requirement to be traded via Swap Execution Facilities (SEFs) and be centrally cleared; FX options, Cross Currency (CCY) swaps and Non-deliverable Forwards (ND Fs), however, are not. A perhaps unintended consequence of this two speed approach is the potential for jurisdictional arbitrage, product/financial re-engineering and further fragmentation of execution venues and liquidity.
In the short term, it also means that the sell-side needs to fundamentally reconsider strategies for design, development and deployment of Single Dealer Platforms (SDPs). Multi asset class SDPs will now necessarily evolve to become simultaneously both an execution venue as a destination and a gateway to a SEF, depending on the instrument traded.
Jay Hurley, FPL Global Foreign Exchange Committee Co-Chair and Vice President, Morgan Stanley Fixed Income, unravels FIX’s role in FX and argues for FX to be integrated into equities algo trading.
Adoption of FIX in FX
Adoption of FIX in FX for the core functions, such as streaming prices, orders and executions, has done well. Evolving from a situation where few ECN’s and banks used FIX for FX to one where the last ECN not using FIX will be FIX compatible in January of 2011. While adoption at the ECN level is almost 100%, for banks it is probably around 70%, up from 15% 5 years ago.
I would say FIX sold itself. It just naturally happens that when you get enough critical mass, after that tipping point, outliers start to look unusual. From there, it becomes more important for FIX to address more than just core functions. For instance, nondeliverable forwards (NDFs), which include most of the Asian currencies that cannot be freely traded, have some of their own specific features that need to be incorporated into the protocol.
New Developments in FIX for FX
The FIX Protocol for FX has provided an opportunity for rapid product development and deployment, and in doing so has increased competition in the market space. FIX provides the flexibility necessary for a platform provider to work with potential users to provide product enhancements. If a product doesn’t meet the needs of the market participants, it will fail quickly; but other times a new product will fill a gap and become the new force in FX trading. This process does not need regulatory oversight for it to happen - it happens by innovation.
Currently, the GFXC is working on OTC options as well. FX specific issues for options revolve around the fact that often at the end of the day, traders receive deliverable cash, so questions like ‘What is the currency of your option?’ are not as obvious. In a currency option, you have several currencies: the currency of the option, the currency that it is against and the currency of the payment, which can be a third currency.
The FPL Global Foreign Exchange Committee (GFXC) has also worked on FIX for allocations, which has some quirks for FX that are not present in equities. For example, if a fund manager has 50 sub-funds, often they will do a single FX trade, representing the net exposure of all of the funds. Rather than buying and selling some all day, they aggregate it. As a result, a single trade of ‘buy 1 million Euros, sell US Dollars,’ turns into an allocation of sell 50 million Euros, buy 150, sell 100, etc. Also, the net trade cannot be zero; otherwise, you cannot settle the trade. This issue caused a lot of consternation, but because there is still a need for a way to do the allocations in a trade where the net is very small, it was decided to have a one cent minimum.
Other factors FIX has to address include delivery and settlement dates, and NDFs cannot actually be delivered, so they are cash settled - normally in US Dollars. There are also questions regarding what fixing rate to use, because FX is an OTC market and there can be several semi-official prices to choose from.