The $2 trillion-a-day foreign exchange spot market underpins a huge array of basic economic activity, from going on holiday, to cross-border trade and investment. This vast market has also given rise to more than $10 billion in fines for banks that had rigged it against their customers – and it has largely escaped direct oversight.
In Europe, that may be about to change. Regulators in the European Union are now weighing whether to bring spot FX into the scope of Mifid II, the bloc’s far-reaching markets and transparency regime.
“I think spot FX is the one market regulators haven’t got sight over,” says a regulatory specialist at a trade processing platform. Extending rules that exist for other asset classes could be seen as a “natural next step”, he argues.
Adding spot FX into Mifid II could open up the asset class to the same rules that currently apply in equities and fixed income, including trade reporting and best execution requirements. Meanwhile, the 70-odd trading platforms and aggregators that currently operate unregulated in the spot FX markets may have to register as multilateral trading facilities, with all the regulatory trimmings that brings.
Many in the industry had hoped – and are still hoping – to avoid that outcome. One of their principal defences is the FX Global Code, developed in conjunction with regulators following the market’s rigging scandals and published in its initial form in 2017. It now has more than 1,000 signatories, but it remains voluntary, raising concerns over levels of adherence.
Some see a clear direction of travel.
“[Spot FX] was initially considered to be part of Mifid II, but then prior to implementation it was taken out. So, when you take the set of global principles of good practice we have in the FX code of conduct on the one hand, adding on the other hand the central clearing of currently bilaterally executed business, then one could imagine that a regulation like Mifid could also become applicable for FX spot at one stage,” says Christoph Hock, head of multi-asset trading at Union Investment.
Industry opponents argue having a global FX code alongside regulation would be confusing. In the UK, supervisors can enforce the code indirectly via rules on accountability – the Senior Managers and Certification Regime – negating the need for stand-alone regulation, some argue.
Other critics warn regulation would be economically damaging: if the EU moves on its own to regulate the market, trading will simply move out of the region and its local market participants face being cut off from global liquidity pools. In addition, complying with the various transparency and record-keeping requirements in Mifid II is not cheap, say dealers. In a business already struggling to stay profitable, some dealers might decide to avoid trading with EU clients.
Politics makes the issue more complex. The UK is negotiating a trade deal with the EU as it prepares to leave the single market at the end of 2020. That will leave the world’s biggest FX trading centre – London – just outside the EU’s perimeter, and there are suggestions that European regulators want to be able to monitor FX trading, post-Brexit.
But not everyone in the industry is against tighter regulation. The European Venues and Intermediaries Association (Evia), which represents interdealer brokers that operate regulated platforms in other asset classes, says that while it doesn't agree spot should be in Mifid II, including it in the market abuse regime could level the playing field between its members and the unregulated venues that have sprung up in recent years.
Today, spot FX is not defined as a financial instrument by Mifid II, and therefore falls outside the regime's scope. Recent consultations by European regulators have questioned the status quo.
In October last year, the European Securities and Markets Authority canvassed the industry for comments on the potential introduction of spot FX into the Market Abuse Regulation, which tackles insider trading, market manipulation and other illegal practices. The consultation is part of an obligatory review of Mar by the European Commission.
Mar sets its scope by referring to the financial instruments definitions in Mifid II. So, one way of applying Mar to spot FX would be to add spot FX to that list.
The topic arose again in February when the Commission published a consultation on Mifid II and its accompanying regulation Mifir. The document asked stakeholders if the regulatory provisions were “adequately calibrated to prevent misbehaviours in the area of spot foreign exchange transactions”.
You’re going to have conflict because it’s the governing bodies who created the [global FX] code versus the regulator who is going to enforce regulation
Head of market structure at a European bank
The Commission said it had heard concerns from stakeholders and competent authorities regarding a “regulatory gap”.
Regulators went beyond these kind of questions in March when the Commission told Risk.net it was looking at whether an Australian-style approach could be a model for the regulation of spot FX in Europe. Australian market participants need a licence to trade FX, granted by the regulator (see box: The Australian way).
It’s unclear what a licence regime would look like in the EU, and whether this would still require spot FX to be brought within the perimeter of Mifid II.
But the idea of bringing spot FX into Mar and Mifid II has already triggered a flood of protest and criticism. One of the most popular arguments is that the industry already has a set of standards in the form of the FX Global Code, which was created to guide the market after the rigging scandals of recent years.
The code was published in 2017 by the Global Foreign Exchange Committee, an industry body of regulators and practitioners, and is due for a mandatory three-year review this year. The industry argues any concerns over behaviour in spot markets could be addressed as part of the review.
However, Guy Debelle, chair of the GFXC and deputy governor of the Reserve Bank of Australia, says the review has had to move at a slower pace due to the disruption caused by Covid-19.
Another issue is that the code is voluntary. The UK’s Financial Conduct Authority has stressed that although it recognises the code, it won’t directly supervise or sanction companies against the standards set out in the code. London is the main hub of FX trading, with a 43% share of all FX activity by volume, according to latest data from the Bank for International Settlements.
In its response to the Mar review, Evia said it considered the limited reach of the code and of the UK financial regime “to be insufficient in respect of the size and nature of the spot FX markets”.
The group also noted that platforms “would find it more difficult to monitor and police a principles-defined code of conduct than we would for a legal statute and concomitant national rules”.
Speaking in March, Debelle said it was not inconsistent for the code and regulation to co-exist, and that compliance with the code could be enhanced if it was “backed up” by national regulators.
But there are worries a twin approach would leave firms uncertain over which document to comply with.
“You’re going to have conflict because it’s the governing bodies who created the code, but the regulator who is going to enforce regulation. And if they are not 100% aligned, it’s going to be difficult for market participants to choose which one they should adopt,” says the head of market structure at the European bank.
If spot FX became a regulated financial instrument under Mar and Mifid II, market participants warn of the financial burden, technology development, and complexity that would accompany such a change.
Bid/offer spreads for spot FX trading leave little room for extra costs. John Estrada, global co-head of spot FX at Credit Suisse, estimates the industry-wide cost of complying with Mifid II in 2018 was £2 billion–£3 billion, with annual running costs of not much less than £1 billion per year.
An Australian-type approach could be considerably cheaper for participants. But if all jurisdictions adopted a licencing regime, the resulting costs might force banks to choose which countries they wanted to be active in, Estrada says.
“It would probably create a two-tier market where banks would have to be involved with some key countries like the US, or UK,” he says.
Vikas Srivastava, chief revenue officer at cloud-based e-trading platform, Integral, says that for trading platforms that already operate multilateral trading facilities or swap execution facilities in other asset classes, updating their infrastructure to include spot FX should be relatively straightforward. Evia in its Mar response also noted that broker platforms already apply the same level of market monitoring, storing and reporting of transactions in spot FX as they are required by regulation to apply to asset classes already in scope of Mifid II.
Problems may arise, however, for liquidity providers that deal exclusively with spot FX.
“They might have to build their own infrastructure completely from scratch, whereas for buy-side and sell-side firms involved across asset classes it would just be one additional asset class to be added,” says Union Investments’ Hock.
Regulatory reporting can also be costly, with the infrastructure, people and processes that are required to implement it. The head of product management at one Mifid data reporting repository, says the increase in workload could affect liquidity in the market.
“It'll just be a high-volume increase for us and for the firms that trade it in order to get the mechanisms in place to get us those transaction reports on time,” the head says.
Given the low latency and high frequency nature of spot FX, the European bank’s head of market structure says opening up the market to regulations and monitoring activities could overwhelm regulators’ databases, which weren’t designed for that type of volume.
Christoph Hock of Union Investment downplays this concern, saying the systems used by regulators should be able to handle the increase in volumes of data.
A sudden hike in Mifid II-related costs might prompt firms to avoid trading in jurisdictions where these rules apply, insiders warn. Alex McDonald, chief executive of Evia, says the global nature of the spot FX industry means regulatory co-ordination is needed – particularly with the US, given many trades are denominated and settled in US dollars. These trades could theoretically be rerouted to the US to avoid the EU’s requirements.
The association believes that while Mar should apply to all FX instruments, some should be carved out of the Mifid II framework altogether, like spot FX. Some products should also be regulated instead as payments or securities financing transactions – for example, FX forwards up to 12 months.
Similarly, when speaking to Risk.net in April, German MEP and the rapporteur for Mifid II, Markus Ferber said a low-impact solution was necessary, but the Australian regime went beyond that remit.
“If there really is a problem, a dedicated chapter for spot FX contracts in the Market Abuse Regulation could achieve the same objective without creating any collateral damage,” he said.
He warned that over-regulation of the spot FX market could push participants beyond the bloc’s borders, stating that the Commission will have to make a convincing case to demonstrate that the status quo isn’t working when it comes to market integrity.
Politics and data
Greater transparency may be a contributing factor for financial authorities to pursue regulation of the market. The head of product management at the data reporting repository says the move is part of a wider push by regulators to move trading activity on to regulated venues in an attempt to have greater insight into the market.
“It’s only once [regulators] have the data, they can start having a look and try to understand the kind of the dynamics of the market and how the business activity happened from what venues, in which areas, through which processes,” he says.
The global head of market structure at the European bank suggests there might be a political element at play, considering London’s central role in spot FX markets in Europe and the closing of the Brexit transition period in December.
“I don’t think the goal is to move the trading activity out of the UK to mainland Europe, like we may see in other asset classes, but it was more as a starting point to be able to measure the activity and to say, how much is done in Europe? That fragment is very hard for EU regulators to know because most of the activity is done in London.”
What the market would not like to see is spot FX brought under an investment-type regulatory framework, because you never know where that’s going to end up
David Clark, Evia
Consultations of spot FX regulation are ongoing, and it is understood that if any changes are made by European legislators to Mifid II or Mar they would come into force after the Brexit transition period. This, sources warn, could result in a divide between spot FX markets in mainland Europe and London.
The head of product management at the data reporting repository points to the breakdown in diplomatic relations between Switzerland and the European Union in June last year which saw the EU unwilling to extend stock market equivalence to Switzerland, which then retaliated by banning trading of Swiss equities on exchanges in the EU.
“[EU regulators] could say, ‘we don’t like the supervisory regimes globally, you can only trade FX spot in Europe’, which for a 24-hour global market would probably be more impactful than the impact on Swiss equity trading,” he says.
But with Covid-19 still causing significant disruption in Europe it’s unclear when regulators will have an opportunity to revisit this topic.
The head of market structure at the European bank says the EC has bigger issues to deal with at the moment than regulation of spot FX.
Others suggest that the impact of including spot FX in Mifid II would have such far-reaching consequences for the market that it should be enough of a deterrent to cease any further investigation.
In the case the European legislators do move forward on this, David Clark, chairman of Evia, says the choice between a similar regulation to the Australian licencing regime and introducing spot FX into Mifid II will be an easy one.
“The market will probably shrug its shoulders and say, ‘okay, we’ll go for the licence to deal’,” says Clark.
“What the market would not like to see is spot FX brought under an investment-type regulatory framework, because you never know where that’s going to end up.”
The Australian way
In Australia, spot FX is defined as a financial product. Those who advise, deal or make a market in spot FX in Australia are required to hold a licence. Firms that carry out FX services must have an Australian Financial Services Licence, while exchanges and platforms must have an Australian Market Licence.
“Once an AFSL is granted, the licensee must comply with ongoing obligations, such as to do all things necessary to provide the financial services covered by their licence efficiently, honestly and fairly, have adequate financial resources, and to comply with the financial services laws which include laws prohibiting market misconduct,” says Steven Rice, special counsel at law firm Herbert Smith Freehills.
As part of ongoing compliance, firms must conduct regulatory reporting. Spot FX firms fall under a number of reporting requirements, including breach reporting and, in the case of forwards and options, derivatives trade reporting, says Paul Derham, partner at law firm Holley Nethercote.
The Australian Securities and Investments Commission announced on March 30 it would be receiving breach reports through its online regulatory portal, doing away with older methods of logging reports.
Foreign financial service providers were previously able to take advantage of certain exemptions to the rules if their home jurisdiction was approved as sufficiently equivalent.
But following recent reforms, all overseas firms operating in Australia – even those from regulatory equivalent jurisdictions – are required to hold a foreign AFSL. These licences allow the holders to be exempt from some provisions outlined in chapter seven of the Corporations Act 2001.
Firms that relied on the previous exemptions may be able to benefit from a transitional period under the sufficient equivalence relief until March 31, 2022.
Editing by Alex Krohn
Update, May 12: This article was updated to clarify Evia’s view that spot FX should not be treated as a financial instrument under Mifid II.
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