By Brad Bailey, Research Director, Celent
The wave of legislation governing global securities markets has raised expectations for greater regulation and better surveillance of the foreign exchange industry.
The markets in financial instruments directive (MiFID) II and the market abuse regulation have set new standards in the European Union that will increasingly influence the behaviour of global sell- and buy-side firms. MiFID II, in particular, sets standards on the pursuit of best execution, requiring that all sufficient steps must be taken to obtain the best possible result for clients. It has driven a focus on transaction-cost analysis (TCA) technology for best execution, portfolio analytics, and pre- and post-trade analysis across the financial markets.
MiFID II has also been the impetus for operational, logistical and technology changes as firms prepared for how they will be trading FX products. They are forcing firms to remap workflows, build more robust connectivity, find personal information for trade tickets, and consider the geographical implications of all their counterparties.
Meanwhile, in the US, the Securities and Exchange Commission and the Financial Industry Regulatory Authority, and CFTC are also strengthening oversight. The CFTC has spoken about the fragmentation of liquidity in FX.
Several cases of misconduct have tightened scrutiny, and in part led to the publication of the FX Global Code of Conduct in May 2017. Arguably, this principals-based (rather than rules-based) code will struggle to prevent future market abuses because it lacks punitive remedies. National jurisdictions do possess legal powers of varying scope and severity, but there is still a heavy reliance on self-regulation within the industry.
FX market evolution
However, the future of regulation of the FX market must be discussed within the context of the evolution of electronic trading and the growth of new platforms and channels for sourcing liquidity and executing transactions.
Since the launch of the first electronic platform, EBS in 1992, the spot market has gone from 100% voice to 80% electronic. The FX technology space has seen considerable changes as a broad range of participants, from private individuals to central banks, continues to increase their electronic presence.
Yet, different market participants have diverse priorities, determined by the client base they serve. A firm that primarily transacts cross-currency payments for a corporate treasury department has a different perspective than one that is acting for a global fund manager making geographical asset re-allocations and from a firm competing with fast-trading dedicated FX funds.
Similarly, there is no single model for FX trading. Instead, participants can choose between order- and quote-driven models, single- and multi-dealer platforms, banks and non-banks: all are part of an increasingly fragmented ecosystem that offers alternative venues and trade strategies. As trading volumes are being dispersed, so there is a need for better and easier connectivity, aggregation, and access to co-location.
The market is faced with further technology demands as trading fragments and adapts to new obligations prompted by regulatory pressures on industry conduct. These trends are generating an ecosystem characterised by strong growth in data collection and analysis, and in new ways of measuring, transacting and accessing liquidity, as well pressures to reduce complexity and costs in middle and back office operations. It is essential to have analytics to understand exactly how counterparties are providing liquidity, their fill rates, time to fill, their risk positioning policies and its impact. Expectations on fair costs for execution and services and the type of markets expected by market makers remain a crucial theme for examination.
In addition, firms are looking at their technology choices in innovative ways. They are merging historically separate liquidity, protocols, and functionality, which should create opportunities for cross-FX product leverage and the merging of liquidity sources. And if the explosive growth in FX trading of the past two decades continues, then the market is likely to create new efficiencies to spot, forwards, options, and swaps, and drive better executions and cross-margining, while reducing costs along the operational cycle.
Moreover, as the FX market structure develops and the share of liquidity provision continues to be divided up between banks and nonbanks, greater intelligence is required by type of currency, time of day, and the fluctuations in workflows.
Liquidity constraints and fragmentation, combined with regulation in FX, are driving more firms to use TCA in order to determine which liquidity providers have risk-taking capacity and provide quality execution. We are seeing innovation in the delivery methods as well as the move from check-the-box compliance to real, actionable insights on trading performances for both internal staff and external counterparties. Best execution, and its demonstration, is the biggest driver of TCA.
Moreover, the legal ramifications from past scandals has altered communication methods within the FX market and is one of the factors driving a new wave of tools such as secure messaging, compliance-friendly instant messaging platforms, and voice capture systems. The legacy will continue to drive investment in more sophisticated and third generation surveillance. In fact, firms already conduct surveillance across multiple channels, incorporating rapid electronic trading with human voice transactions within a structured, disciplined process. Firms want to know how their traders are interacting with clients, and avoid liability for misbehaviour. That means prevention and, if that fails, catching transgressions quickly.
Individual FX trading firms are solving many of the problems, such as front-running, price fixing and “last look” exploitation, both internally and in partnership with third-party technology vendors.
Banks have traditionally focused surveillance efforts on executed trades in liquid instruments. But the evolution of algorithmic trading and high frequency trading has revealed that significant information on
potential misconduct can be found in order level data – for example, layering, spoofing, quote stuffing, multi-legged orders, high order to execution ratio. With the proliferation of order types and trading strategies in all asset classes, including FX, banks also have to understand how these can be used to identify and prevent misconduct.
However, few banks have adequate policy and governance structure in place to handle the scale and complexities of the challenge. This is because surveillance operations are often driven by how trading desks, asset-class based operation, or lines of business have already been organized in the front office; these are often siloed with each having its own systems and processes.
Artificial intelligence, machine learning and robotic process automation technology provide opportunities to significantly bolster surveillance operations by offering new insights through advanced analytics, as well as by improving costs and efficiency through automating parts of the alert investigation process. The cloud, with its low-cost storage and flexible computing capabilities, can be another potent tool for helping in surveillance.
The real revolution is likely to come in communication surveillance. Developed solutions in electronic communication have already emerged, and the next frontier of innovation will involve analysing voice. More advanced firms are moving toward a holistic approach, overlaying trade information on top of communication data and even other data that gives them a better view of employee behaviour and understanding of intent.
It seems clear that the FX industry is making significant efforts to improve standards of internal surveillance and self-regulation. The threat of legal sanctions within individual jurisdictions for misconduct is costly not only in terms of monetary loss, but also on reputations. Most of all, client expectations, reinforced by the availability of new technologies, are forcing FX firms to curtail opportunities for misconduct, increase transparency and ensure best execution.
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