Current regulatory initiatives intended to enhance stability, growth and confidence in the financial markets, are having both direct and indirect effects on the FX industry and its infrastructure. The recent publication of the European Commission’s Mifid/Mifir proposals is a case in point. While there is little to almost no reference in the text of the proposals relating specifically to the FX market infrastructure, they will impact the way FX products, deemed to be clearing eligible, will be traded.
The FX market has many unique characteristics, and various segments of the FX industry have been vocal in stating that these characteristics should be taken into consideration during the rule making process.
Furthermore, the FX market is highly liquid and truly global; currency pairs are traded between financial centres across the world 24 hours a day, seven days a week. Any discrepancies in regional regulatory regimes could therefore, potentially, have a real and disruptive impact on the operational efficiencies of FX trading. There is a great deal of consensus about the need to avoid regulatory arbitrage among both industry participants and regulators in the US and Europe.
In its current form, the European organised trading facility (OTF) regime proposed under Mifid/Mifir looks a lot like the US’s swap execution facility (SEF) regime proposed under the Dodd-Frank Act. However, what remains to be seen is the final detail on the acceptable trading methods for both platforms and whether, in the end, the two will be closely aligned. Proposals for OTFs and SEFs are very important for the FX industry and its participants. The introduction of both types of trading platforms is intended to contribute towards a more robust and efficient market structure.
On first impression, the text contained in Mifid/Mifir sets out a flexible definition of OTFs when it states that, “while regulated markets and multilateral trading facilities are characterised by non-discretionary execution of transactions, the operator of an organised trading facility should have discretion over how a transaction is to be executed.” This flexible definition, should it be approved by the European Parliament and the Council, will give trading platforms discretion over the choice of execution methods they can provide for their users.
Furthermore, this wording signals an acknowledgement by the European Commission that FX market participants have varying execution needs depending on their trading objectives. Allowing participants to choose which execution method best suits their needs should not be inhibited, since this is essential to the functioning of the FX market – and this premise is true of all trading counterparties, wherever they are located. In this flexibility, we can already see a divergence with the proposed SEF requirements. For example, the OTF definition appears to allow voice brokers while the CFTC does not.
The question is will there be something embedded in the final OTF rules similar to the CFTC's SEF requirement of providing all participants the ability to post a bid/offer to all participants that is a real limitation to a venue’s execution method? We don’t have anything yet that gives us that level of clarity on what specific trading methods will be accepted. Paragraph 2 of new Article 20 in Mifid raises such a concern. It states that, “[a] request for authorization as an OTF shall include a detailed explanation why the system does not correspond to and cannot operate as either a regulated market, MTF, or systematic internalizer.” Having to explain why a trading platform can’t be a MTF in order to be authorized as an OTF could be a significant and subjective barrier posed by regulators. There is not enough said about how this will be interpreted and used. Will this be a way for regulators to force trading platforms to be MTFs, particularly any that are electronic, and thereby remove the flexibility of trading methods for those platforms?
Whilst progress is being made on the regulatory front, we remain some way from having final decisions in place. In Europe, Mifid/Mifir will pass to the European Parliament and the Council for negotiation while the timeline for decisions in the US has already been extended until July 2012. The impact of Mifid/Mifir on the FX industry will be made clearer once another piece of legislation – European Market Infrastructure Regulation (EMIR) – has gone through the trialouge process in the EU and becomes law. Once EMIR determines which FX products are eligible for clearing, and the European Securities Markets Authority (ESMA) determines which derivatives are sufficiently liquid to be mandatorily traded on regulated venues, it will be much clearer which FX products will need to be traded on organised trading venues such as OTFs or MTFs.
It is apparent that the industry would welcome further synergies between the two legislative frameworks. Regulatory harmonisation will be key to enabling participants to trade quickly and efficiently on a global basis and, to that end, it is important that the regimes governing OTFs and SEFs are as compatible as possible.
Wayne Pestone is chief regulatory officer at FXall