Banks and institutional investors are still trying to figure out their roles as new rules shape market behaviors and structure.
As regulators push for increased due diligence from buy-side investors and shine a light on the issue of market conduct and enforcement, the structure of the market itself is becoming more complex. In reaction, banks are asking themselves if it still pays to be a principal in the FX market or if an agency role suits them better, as buy-side firms seek to gain more direct access to primary markets.
The result of the structural change has been reduced liquidity and decreased risk appetite among market participants, both of which are affecting participant behavior. This sentiment was supported by a Q1 2016 survey of FX managers participating in The NeuGroup’s FX Managers’ Peer Group Summit, sponsored and hosted by Thomson Reuters.
Members of the groups were asked about their preferences and priorities with regard to FX execution and holistic risk management. The survey found that changes in the market have indeed created concerns around liquidity and the growing need for the buy-side to take a closer look at their execution strategies and methods.
Other findings from the survey include the need for increased electronic trading, new execution strategies, along with ways to measure the performance of those strategies, including the use of FX derivatives.
INCREASE IN ELECTRONIC TRADING
Electronic trading increases efficiency, particularly when electronic liquidity access and execution capabilities are provided in the context of a firm’s workflow, including post-trade. Increasingly, firms are seeking to adopt electronic trading to leverage the efficiency benefits it can bring to the entire trade lifecycle.
Although all survey participants already use electronic methods to execute at least a portion of their FX transactions, 15% cited (increased) electronic execution as one of the three biggest areas of change in their FX practices over the last two years, and 20% said that improving technology is their top project/priority for 2016.
While all respondents already trade electronically, when asked to choose the statement that most closely matched their perspective on bank service levels, 39% said that their focus for trading electronically is to get tight pricing; a further 28% said they intentionally perform some of their FX trades over the phone to maintain good relationships with their banks (to counteract, in some cases, slimmer margins on electronic trades with “grid pricing,” but also to gain market insights and maintain personal connections). A third of respondents said they felt service levels from their banks remain the same, whether they trade electronically or over the phone.
IN SEARCH OF NEW EXECUTION STRATEGIES
Because of the structural changes and heightened scrutiny in the market, the need to achieve, evaluate, and demonstrate best execution is more important than ever.
At the same time, there’s recognition among the buy-side that regulation is constraining banks’ ability to provide liquidity.
In an effort to adapt to this changing environment, corporates are seeking additional execution strategies. The use of bank algorithms and benchmark orders are two alternate methods that are making inroads with corporates. Twenty percent of members polled in the survey use bank algorithms, with 37.5% of those saying that their frequency of algo use has increased over the last two years. The top two drivers of algo usage are size of deal and efficiency, according to the survey.
Reinforcing this trend on a broader level, a recent review of trading activity on Thomson Reuters’ FXall dealer-to-client platform showed a strong and steady increase in the use of algos over the last 18 months. The use of algos that enable FXall clients to auto-execute FX orders, especially, has been especially on the rise.
PERFORMANCE MEASUREMENT ENABLES BEST EXECUTION
Institutions are increasingly being asked to justify how they transact their FX business and to prove best execution.
Firms that perform best execution analysis on their FX transactions can evaluate performance based on actual trade data and identify improvement strategies accordingly.
To assist clients in evaluating execution quality, Thomson Reuters offers Execution Quality Analysis reports (EQA) to FXall market participants.
EQA reports help buy-side customers analyze a rich array of their trading activity over a specified time period to assess the effectiveness of execution strategies and to help them manage risk and achieve best execution. Reports include a summary as well as detailed analysis of:
- Currency pairs traded
- Trade size and time of execution
- Counterparty activity
- Spreads
- Response times received
EQA also offers the ability to compare trading activity to the entire market’s highs and lows of the day, as well as to reference rates. By leveraging insights from EQA reports, institutions can efficiently maximize their execution performance and demonstrate best practice.
USE OF FX OPTIONS & HEDGING
The NeuGroup survey found that 54% of members currently trade FX options, with 30% of these firms trading FX options electronically.
FX options were also cited as one of the top ten FX priorities and projects for FX managers in H1 2016. Fifty percent cited hedging strategy as one of the three biggest areas of change in their FX trading practices over the last two years. In addition, many respondents expressed their desire to better explain the costs of emerging market hedging to their management.
EVOLUTION OF THE CLIENT-BANK RELATIONSHIP
The client-bank relationship remains multifaceted and complex. In a survey question about their view on allocating business among their FX counterparties, FXMPG members from both groups were asked to choose from multiple factors: best price, credit, service, provision of credit, overall relationship or other internal guidelines.
More than half (54%) said that their allocations are based on several factors including service, credit and overall relationship. Forty-one percent said they allocate business based on best price.
Regarding the impact of market scandals on corporate perception of the banks, the essential level of trust corporate treasury clients place in their banks remains relatively healthy: in spite of the fact that 70% of respondents feel slightly to moderately concerned about FX market conduct scandals in recent years, a full 83% said they haven’t changed how they engage with banks due to the scandals, and 26% of members aren’t at all concerned.
Only a small sample have chosen to temporarily limit trading with certain banks, curtailing specific activities such as using fixing rates, and placing greater emphasis on competitive bidding.
These strong statistics indicate the high levels of good will that corporates and their banks have built up over time.
LOOKING AHEAD: MiFID II AND THE FX GLOBAL CODE OF CONDUCT
MiFID II
MiFID II introduces a broad range of changes to the market across regulation and liquidity, technology and trading venues, economics and risk and data reporting.
Extensive new pre-and post-trade transparency requirements will result from MiFID II. Corporate Treasurers will specifically be impacted by increased transaction reporting requirements.
MiFID II implementations timings are tight, with the law slated to become effective in January 2018. Although a certain degree of uncertainty needs to be accepted until the final rules are decided, firms need to begin considering several questions now: whether they are authorized under MiFID; how they will comply with transaction reporting rules; how they will transact on trading venues; and how relationships with trading counterparties will change.
From Q3 2016, Thomson Reuters will support FX Corporate Treasury clients with a series of webinars about MiFID to help them understand the impact of regulations on their transaction reporting requirements and more.
FX Global Code
On 26 May 2016 the Bank of International Settlements (BIS) FX Working Group published phase 1 sections of the global code of conduct (Global Code), outlining principles of ethics, information sharing, certain elements of order handling and trade execution, and confirmation and settlement.
The main purpose of publicly publishing the Global Code is to raise broad awareness of the Global Code and prompt all market participants, including corporate treasurers, to consider how they can best embed the Global Code in their practices once the final text is released in 2017.
As a member of the BIS Market Participants Group that helped develop the Global Code, Thomson Reuters intends to adhere to the completed Global Code by incorporating the relevant portions within its processes. Thomson Reuters is also committed to promoting the Global Code amongst its customers, and intend to facilitate and encourage adherence in the interests of the integrity and effectiveness of the FX market.
To help buy-side customers understand the Global Code and its practical implications, Thomson Reuters has published a Perspective Paper on the topic.
To complement the release of the buy-side Perspective Paper Thomson Reuters will launch a webinar hosted by Jodi Burns, Head of Regulation and Post-Trade. More information about the webinar is available alongside the Perspective Paper.
Queries related to the Global Code and related Thomson Reuters solutions may also be submitted to Thomson Reuters via [email protected].
OUTLOOK
Looking ahead, the FX market will see more structural and regulatory change and all market participants will continue to be affected. With further regulatory scrutiny and the continued shift in how banks view their market-making vs. agency roles, the potential for reduced liquidity will remain a concern for corporate treasurers.
In addition, volatility, a strong dollar and the cost of hedging will continue toput pressure on FX risk management programs to deliver on their objectives. As The NeuGroup survey results demonstrate, corporate treasurers have already undertaken a reevaluation of the strategies, tools and FX execution methods they employ to transact and manage risk. Ongoing adaptation and innovation will ensure that they will be prepared for the challenges now and in the future.
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