In association with

Special inSightThe NeuGroup’s FX Managers’ Peer Group 2

FX Volatility outlook by Ron Leven, PhD

thomson reuters OVERALL MARKET SHARE WINNERMULTI-DEALER PLATFORMS

paul chappell | fOuNdER & cHIEf INVESTMENT OffIcER | c-view

For a long time the foreign exchange market boasted a depth of liquidity that few other asset classes could claim. Steadily rising trading volume and a resilient market structure meant regulators didn’t really need to worry about the potential for a flash crash or liquidity event in FX.

Not any more, warns Paul Chappell, founder and chief investment officer at C-View, a currency management firm that has been operating in the UK since 1996. A confluence of factors, including the increasing constraints on the ability of banks to warehouse risk and devote balance sheet to market making, means liquidity in some currency pairs can turn out to be much shallower than it used to be.

“Many banks are now almost entirely precluded from taking and managing proprietary risk of their own, which leaves the market vulnerable to a situation where there is a very limited number of price makers of last resort that will warehouse risk,” says Chappell.

Some have claimed the rise of non-bank market makers could plug the hole that might be left by banks in times of stress, but Chappell is unconvinced: “Non-banks really have less responsibility towards the market and its clients. If for a period of time it suits them to make markets, they will do so, but if volatility gets too high, they will effectively just switch off their machines.”

The reality in current market conditions, says Chappell, is that there are times when the FX market is flooded with liquidity, but at other times markets can be exceptionally

quiet. “Liquidity can and does evaporate very quickly and then takes a while to reestablish itself, which creates a challenging market environment,” he says.

In the meantime it has to be business as usual for currency managers, and for C-View that has meant largely electronic trading for many years. In some ways, a preference for trading electronically means the firm has been less affected by the cost rationalisation and scaling back of resources on the sell side, but a cut to ancillary services has become apparent.

“Core execution has not changed very much. We are seeing some slimming down of the capabilities a number of the banks have with regards to things like research and providing market colour – things that are deemed to be perhaps slightly more peripheral rather than core to their businesses,” says Chappell.

As to the execution channel itself, C-View has for some time been gravitating away from single-dealer platforms, with a preference for liquidity aggregation technology and multi-dealer platforms where prices can be sourced from several providers and best execution can be proven.

“We are making more extensive use of aggregators and multibank venues as opposed to single-bank venues for execution, because of improved net pricing and the onus of responsibility on us to show best execution. If you want to sharpen your competences, there’s no question that executing on an aggregator makes it easier to show that you dealt at the best price available at the time.”

Beware a liquidity crunch in FX

© 2014 Thomson Reuters.

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FXExchange2014

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2014: FX under the microscopeThe FX market is under the microscope like never before, as investigations into the inner workings of the industry continue and market participants prepare for the combined impact of the benchmark scandal and ongoing implementation of new regulations.

At the same time, the FX market continues to serve well the needs of the world’s real economy. In this inaugural edition of FXexchange, we focus deliberately on the experience of FX end users – banks, asset managers and corporations that need continuous access to deep liquidity to get their business done.

At Thomson Reuters, we are proud to have recently published a revised rule book for the Matching platform, which encompasses new controls to maintain a fair and orderly trading experience for all participants. It is this kind of initiative that we believe will set the standard for the future integrity of the industry.

As the evolution of the FX market continues, we hope you find the insights in FXexchange illuminating.

Phil Weisberg Global Head, FX, Thomson Reuters

INDUSTRy INSIGhT

EDITORIAL

Joel ClarkFreelance Journalist

Anne FribergSenior Director, Peer Knowledge ExchangeThe NeuGroup

Victoria HoodHead of Marketing, FX and Fixed Income Thomson Reuters, Financial & Risk

Ron LevenHead of FX Pre-Trade StrategyThomson Reuters, Financial & Risk

David WiganFreelance Journalist

DESIGN AND DEVELOPMENT

Thomson Reuters Global Creative Services

1 Beware A Liquidity Crunch in FX

2 Record Seeks Best Execution

3 Lenovo in a Hedging Conundrum

7 Technology Arms Race Accelerating

8 AXA’s Tech Fast Forward

9 Knight’s Table Laid for Clients

4 Undercurrents of Change

10 Changing Nature of Corporate FX Management Processes Due to Regulatory Change

12 In the Valley of the Vols

INDUSTRy INSIGhT

FEATURES

© 2014 Thomson Reuters 1006102/4-14

Content

Introduction

Contributions

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damian glendinning | gROup TREASuRER | lenovo

lenovo in hedging conundrum

Damian Glendinning, Singapore-based group Treasurer at PC maker Lenovo, sees two-way volatility in the renminbi (RMB) as a key hedging challenge for the company, and for the market, in the coming period.

Lenovo is a significant importer into China and sells in renminbi, while most of its costs are in dollars, and stands to gain from an appreciating Chinese currency. But as China moves to currency liberalisation, he says short term volatility will rise.

“If you are a commercial company working in a low margin business then you need to focus on short term currency volatility and the Chinese government has made clear in recent weeks it is happy to see a wider band of fluctuation for the RMB. In addition they have engineered a decline in the currency, with the clear objective of sending the message that, as they move toward liberalisation, you can expect two-way movement.”

The People’s Bank of China (PBOC) in mid-March announced that effective March 17, the exchange rate will be allowed to rise or fall 2 percent from a daily midpoint rate set each morning by the central bank. The central bank previously doubled the trading band to 1 percent from 0.5 percent in April 2012.

Lenovo prefers the forward market for hedging its currencies exposures, because it is simpler than the alternatives and less expensive than options.

“The main challenge we face is that we have the onshore and offshore markets, which don’t always trade at the same price, so you can end up with conflicts in terms of which one you trade in. To the extent you use the onshore market the existence of exchange controls makes life quite challenging.”

Under Chinese exchange controls firms must produce documentary evidence of an underlying physical import and there can be a timing mismatch.

“When you are doing hedging you are planning a future date but there may be all sorts of reasons why you won’t pay your supplier on that date.”

At the same time using the offshore market can lead to timing issues, with settlement in Hong Kong and cash still in China.

At the moment there is very little competitive bidding of FX in China. However, as currency liberalisation proceeds Glendinning expects that to change, though exchange controls must be loosened first.

“You can’t have a whole paper trail if you are likely to switch between bids, so all of these administrative challenges need to be removed. And Chinese banks are not yet accustomed to competing in this area.”

Another hedging option for Lenovo, and widely used by Asia corporates, is non-deliverable forwards (NDFs). However, with NDFs set to be traded on electronic venues under derivatives regulation, Glenndinning sees the market being severely disrupted.

“One of the issues with the NDF market is that it’s not very liquid. Now when we trade, the bank takes a position and warehouses that position. But their ability to do that is being challenged by the Volcker Rule, plus if these things are traded on an exchange there is likely to be a liquidity issue which will make it difficult to close.”

Already in Asia there are several currencies for which the fixing rates on the off-shore NDF market are no longer being published, after regulators took the view that they are too open to manipulation. In January 2013, internal reviews by banks in Singapore found evidence that traders colluded to manipulate rates in the offshore foreign exchange market.

“What all this means is that if I want to hedge the Indonesian rupiah I can jump through the hoops in Indonesia or do it in the NDF market in Singapore, where I no longer have a benchmark rate to settle against. So that means you are using the offshore rate, which is not optimal and increases your basis risk.

“What regulation means is that you take away all this flexibility and you have a market which is clear and transparent but it may be a market that no longer exists!”

James Wood-Collins, London-based CEO of Record Currency Management, says the expansion of the FX market, which hit average daily volumes of $5.3 trillion in 2013, is a boost to alpha-seeking funds. However, as dealer participation has stagnated, it has also created challenges.

“We have seen bank market share remain stable at around 39%, while other financial institutions such as asset managers have increased their market share,” he says. “However, profit-seeking financial institutions continue to represent a minority, which suggests that there is still a good opportunity for those with alpha-type skills.”

Increased liquidity has led to spread compression in major currency pairs to around 1 basis point, compared with 2 basis points five years ago. One of the reasons for that is the proliferation of e-trading platforms, which have been presented as a solution to issues of compliance and transparency.

“E-trading is particularly useful for spot transactions, accounting for around 64% of transactions,” says Wood-Collins. “In forwards, swaps and options e-trading it is used in about 45% to 52% of trades, and overall our e-trading volume is about 40% of our business, compared to 10% in late 2012.”

The e-trading universe can be broadly divided into three categories: single-dealer platforms, electronic communication networks (ECNs) and multi-dealer platforms.

“Single-dealer platforms, which are run on a request-for-quote basis, do not inspire confidence in terms of achieving best execution, but they can offer a quick comparison tool for other prices offered,” Wood-Collins says. “ECNs meanwhile offer streaming pricing from multiple sources, and are most useful for spot markets. But for hedging we use forwards and banks are understandably less willing to offer streaming prices on forwards because of the credit risk involved.”

Multi-dealer platforms offer and compare both spot and forward prices from multiple banks, and usually operate on a request for quote basis.

“A multi-dealer platform is the most comprehensive option, and almost 40% of our transaction volume is executed on this basis, a little bit below the average for non-bank financial institutions. The percentage is not subject to a hard and fast rule but is the outcome of our trading team seeking the best execution venue for each and every trade, and the proportion tends to vary over time.“

The introduction of swaps functionality on e-trading platforms over the past two years was the direct cause of Record’s increased use of the platforms, Wood- Collins says.

Still, he says e-trading is not the be all and end all and there are plenty of scenarios in which alternatives are a better bet, and when Record went through a period of growth in its passive hedging business it turned to the swaps space.

“As passive hedging grew, we relied more on FX swaps, with two linked transactions closing out a spot transaction and opening up a forward. It’s critical that you link those transactions so that effectively the spot price embedded in the forward contract, the far leg, is exactly the same as the spot price at which you are doing the near leg, because we don’t want to be paying a spot spread. So there are two linked transactions and up until quite recently the platform we were using could not accommodate that.”

There are additional reasons why e-trading would not be the optimal solution, Wood-Collins says.

“The best price for large transactions will often be found by dealing on the phone. Also many of our clients expect us to manage their credit risk actively and therefore we often need to tailor the allocation of transactions to fit their parameters, and you can only get a limited amount of banks to quote at the same time on an RFQ platform, which is a constraint.

“Perhaps most importantly, currency market conditions vary from day to day and therefore it is essential if you want the best possible price to maintain both e-trading and phone dealing infrastructure.“

james wood-collins | cEO | RecoRd cuRRency manaGemenT

record seeks Best eXecution

INDUSTRy INSIGhTINDUSTRy INSIGhT

UNDERCURRENTS OF CHANGE

The foreign exchange market has been through some fairly seismic structural shifts in its time, from the birth of the European single currency to the advent of electronic trading platforms. The exact nature of the next shift cannot be known with any certainty, but the market faces some strong regulatory and technological headwinds in 2014 that will ultimately cause fundamental changes to the way currencies are traded.

A high-profile investigation into market manipula-tion has heralded increased scrutiny of FX trading practices and could see major changes to the way the industry operates. But scratch below the surface and the tide may be turning towards a healthier market structure, writes Joel Clark

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Up until recently, the market appeared to have survived the financial crisis in fairly good shape. Having sailed through the upheaval of 2008 without missing so much as a heartbeat – largely thanks to the resilience of the industry’s infrastructure – it consequently escaped the most punitive elements of post-crisis regulations, with an exemption from mandatory central clearing and electronic trading for FX spot, swaps and forwards in the US.

Then in 2013, details began to emerge of a regulatory probe into alleged manipulation of benchmark exchange rates. Dealers, it was claimed, had shared confidential client information in online chat rooms and colluded to trade large orders in such a way as to influence a popular and widely traded benchmark known as the WM/Reuters 4pm fix. By April 2014, numerous regulators had announced they were investigating the allegations, well over 20 traders had been suspended or dismissed from banks, and the Bank of England had been caught right at the centre of the scandal amid allegations its officials may have ignored or even condoned market manipulation.

Very little is known about exactly what market malfeasance has so far been unearthed, and it could still be months or even years before the full ramifications are known. But however serious or trivial it all turns out to be, some believe the increased scrutiny will inevitably mean a clamp-down on certain parts of the market that had not previously been subject to stringent oversight.

“There are unwritten mechanics of how the FX market works, and certain practices that are legal but may not look very sensible when

you put them under the microscope,” says Phil Weisberg, global head of foreign exchange at Thomson Reuters. “That will have to change and FX will gravitate towards being a more operations and technology oriented business, with clear rules of engagement and more explicit fees for individual services.”

The role and sophistication of technology in foreign exchange has evolved at a rapid pace in recent years, to the extent that retaining

a lead as a market maker now requires substantial investment in risk management and price distribution technology, as well as single-dealer portals and algorithmic execution tools.

But in an environment in which banks are required to hold much more capital and devote far greater resources to compliance costs, technology budgets are under pressure, and many expect concentration on the sell side as a decreasing number of banks have the resources to dominate the market in the way they once did.

“The biggest disruption in FX at the moment is the changing role of the sell side and the ability of banks to act as market makers,” says Rupert Bull, managing partner of Expand Research, a subsidiary of the Boston Consulting Group. “Relatively few banks in the future will be able to be all things to all people and the focus will shift from market share to profitability.”

The way in which banks trade currencies for clients is also likely to change, and a well-documented shift from traditional risk-taking to an execution model where banks act as agents rather than principals is continuing to play out in the FX market. As banks’ use of balance sheet comes under pressure, the agency model offers a way for them to remain active in the market while taking less proprietary risk.

The shift to agency is largely a response to regulatory constraints but it could ultimately make banks more profitable in the FX market as they could theoretically take on larger client orders than if they were warehousing the risk on their own books. For corporations and asset managers, it should also mean more transparency on how the bank is trading its orders.

“There weren’t very clear lines in the past to delineate where banks were principals and where they were agents, but those lines will have to be drawn in future. While it will still be possible for banks to be both, they will have to be much more explicit with the client about how they are trading their orders,” says Phil Weisberg.

The nature of bank liquidity provision may be changing, but the rise of non-bank market makers, including high-frequency traders (HFTs), has also been a recurring theme in

“There weren’t very clear lines in the past to delineate where banks were principals and where they were agents, but those lines will have to be drawn in future.”

— Phil weisberg, Global Head, FX, Thomson Reuters

FEATURE

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INDUSTRy INSIGhT

richard anthony | gLObAL HEAd Of fX ELEcTRONIc RISK | Hsbc

Progressive investment in trading technology over the past decade has pitched banks aggressively against one another in an intensifying arms race to offer the best access to FX liquidity. It’s a race that shows no sign of abating any time soon.

“Anyone who participates in this market has to participate in the technology arms race to some degree, and there is clearly a cost associated with that,” says Richard Anthony, global head of FX electronic risk at HSBC. “I do think that if spreads continue to become more compressed and volume continues to decline, not least because of lower volatility, we may see a reduction in the number of market makers.”

That reduction could be good news for the likes of HSBC, which has long been one of the largest banks in the FX market, with a vast global footprint. But like all banks, HSBC faces its own challenges in navigating the increasing complexity of the market structure. A rising number of trading venues and execution channels means provision of liquidity is becoming a far more costly and resource-intensive business in which to compete.

“One of the biggest risks for a market maker is not having access to liquidity, so as liquidity becomes more fragmented and more and more trading venues appear, we need to connect to those venues. Connectivity is an expensive process to set up and maintain,” says Anthony.

But given the number of new trading venues that have sought to enter the FX market in recent years, banks have had to be discerning about whether there is sufficient

unique liquidity to justify the connectivity costs. HSBC is no exception, having so far backed some new ventures but kept a watching brief on others.

“If a new venue has exactly the same participants and architecture as an existing platform, the chances of success are fairly low. What attracts us to support a venue is if the rules of engagement or policing are slightly different or the proposed participants of that venue are different, thereby giving access to genuine liquidity that doesn’t exist elsewhere,” Anthony explains.

But it is not all about external liquidity, and banks have invested increasingly in their own technology in recent years, including single-dealer platforms and algorithmic execution, which is an area Anthony believes is poised for growth in the coming years.

Internalisation of flow is also an increasingly attractive way for banks to match buyers and sellers without having to take an order to the broader market, thereby offering better execution to the client. As HSBC has invested in its risk management and pricing models, and market volatility has declined over the past two years, meaning there is less urgency to clear risk in real time, the bank’s internalisation ratios have increased substantially.

“Matching off client flows internally is the most efficient way of managing the risk. This has always happened, but with automated risk management processes and the electronic distribution of prices, we can now manage the internalisation process more efficiently. That’s positive for clients because they get tighter spreads,” says Anthony.

technology arms race accelerating

recent years. Such firms may provide valuable liquidity, but questions have been raised about whether their commitment to the market would endure during times of stress.

Meanwhile the proliferation of trading venues in recent years – many of which have still to show signs of gaining real traction – has been predicated on a move to answer the needs of an increasingly diverse market ecology. For example, it was a collision of cultures between banks and HFTs on primary platforms that led to the creation of new venues such as ParFX, which brought fresh rules and functionality to the market to discourage disruptive behaviour.

“A lot of the innovation in FX is focused on client segmentation, and trying to deliver functionality that appeals to particular groups of customers. Many venues have segmented their pools to attract different types of participants and protect users that may not want to interact with certain types of flow,” observes Sang Lee, managing partner at Aite Group, a research and advisory firm.

For the buy side, the increasing complexity of the market structure and the growing number of execution options that are available from both banks and third parties means the priority in the coming years will be to more explicitly measure and prove best execution.

Sophisticated use of transaction cost analysis (TCA) technology has developed in the equity market over a period of many years, and FX traders are increasingly now also looking to TCA as a means of benchmarking execution quality. But TCA is more complex in FX, largely due to the higher volume of trades and lack of central data sources.

“FX is a fragmented over-the-counter market and trying to aggregate separate data feeds to create a holistic view of the market is exceptionally difficult. TCA has been one of the biggest drivers of investment from an IT and research perspective and I expect it to be a major focus in the next few years,” says Sang Lee.

The FX market will clearly face some big challenges in the years to come, but there are also some bright spots

on the horizon. Foreign exchange remains, for the most part, a deep and liquid market, which will be less affected by onerous regulations than other OTC asset classes.

There will also be major growth opportunities in emerging markets. The Mexican peso and Chinese renminbi, for example, are now the eighth and ninth most actively traded currencies, according to the 2013 triennial turnover survey by the Bank for International Settlements. As the renminbi continues its path towards full convertibility and greater offshore trading, many market participants are positioning themselves to benefit from its growth.

And some believe even the potentially more damaging developments could turn out to be positive in the long term. “Whenever people fundamentally re-examine their business, good things happen,” says Phil Weisberg. “We may not necessarily be spending time on the most important problems first, but when people know and understand better the cost of doing business and the way FX is traded, that can only be a good thing.”

“FX is a fragmented over-the-counter market and trying to aggregate separate data feeds to create a holistic view of the market is exceptionally difficult.”

— sang lee, managing partner, aite Group

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INDUSTRy INSIGhT INDUSTRy INSIGhT

In seeking the most efficient route to market, Axa Investment Managers has made the decision to focus on new trading protocols on an execution management system (EMS).

The thinking behind the move was to create greater flexibility, says Lee Sanders, Axa IM’s London-based head of FX/MM and UK and Asia fixed income trading.

“In FX we decided to move away from the established ECN market to an EMS, which gives a lot more access to innovation and versatility in the market,” Sanders says. “It means we can hook into the same system and take prices from any of the 15 banks with which we want to deal, which is better from our perspective than the request for quote protocol that dominated previously.”

The difference between OMS and EMS is that the latter enables direct market access, as opposed to facilitating trades through an intermediary, and while OMS excels at portfolio accounting, analytics, and compliance, EMS offers higher levels of granularity in execution control. An example is in algo trading, Sanders says.

“We can use the EMS to connect to anyone’s algo, releasing it from the staging area on the EMS straight to a bank’s algo suite, rather than releasing via the OMS. I can send an RFQ order, resting order, fixed order or limit order; so I get all of that versatility, depending on the counterparties’ API.”

AXA IM will be looking at tailor-making its trading algos, working with banks, Sanders says.

The firm executes around 75% of its tickets electronically, and the rest by voice. However, voice still accounts for 40% of volumes, as bigger tickets are more often executed on the phone.

Still, EMS brings with it some key advantages, Sanders says, including its anonymity and its ability to select execution venues, including algos.

“We can use the algo to execute in a way that reflects the particular investment driver,” Sanders says. “If we want to be aggressive we can keep lifting the offers until we are done, or we can be more selective and passive and sit back and be the offer or the bid, which may potentially give us a better fill. On the other hand if it’s one minute before non-farm payrolls you can go all out with a big order and while you might get some slippage you should be able to get it done.

“The other thing we like about our EMS use is as a clearer and in providing better transaction cost analysis. This is not just a box-ticking exercise for us; it’s a post-trade functionality that goes a long way to help us gain more efficiency and has proved useful for our pre trade analysis.”

AXA IM uses TCA to evaluate its trading performance against three benchmarks: the WM/Reuters foreign exchange fixing, creation time and execution time.

“Those are what we use to analyse where we are adding value. For example would it be better doing everything at the (WM) fix, or are we losing value in the time it takes to get from the fund manager’s request to executing in the market, or at execution are we getting the best price possible?”

Use of TCA functionality has had real impacts on the AXA IM business.

“We run through all the currency pairs and see if there is anything we can do better, and we analyse all the funds and the trades that have been executed on their behalf. We look to identify weakness caused by order creation time, lack of documentation and risk constraints, executing away from prime liquidity points and lack of liquidity through restricted execution venues.

AXA IM also uses TCA to evaluate counterparties, creating peer groups and calculating average levels of ‘added value’ before pinpointing where each counterparty’s strengths or weaknesses lie.

lee sanders | TSf HEAd Of EXEcuTION fX/MM, uK & ASIA fI | aXa invesTmenT manaGeRs

aXa’s tech Fast Forward

knight’s taBle laid For clients

As the platform revolution sweeps through the foreign exchange markets, some banks have taken a contrarian view of the implications. Chris Knight, head of e-FX trading at Standard Chartered, says that while electronic execution has become a vital market cog, client relations remain paramount.

“When e-commerce came in people started hiding behind their machines and it became all about best price being hit,” he says. “The best price still gets hit but people are coming back to relationship banking.”

If banks focus solely on price, they miss out on understanding the wider picture of what the client needs, and the part that FX may play in other client- related activities.

“What is equally as important as price is building a long-term relationship. But from a client point of view it is not just about having numerous price makers and from the bank point of view there is much more you can do than simply provide execution. So more counterparties are not necessarily better.”

Standard Chartered has seen some clients rationalise their bank panels and use favoured bank platforms to cater to all of their needs, sometimes through partnerships if the bank does not retain a particular specialty in-house.

“If a client wants to invest in Asia, Africa or the Middle East we would want to own that and to be everything to that person, but we may reach out to partners for some aspects of other projects.”

One product for which Standard Chartered has seen increasing demand is its central treasury centre offering, a centralised solution through which a corporate can manage its FX exposure, probably based in its home market but servicing jurisdictions around the globe. The centralisation process creates efficiencies and saves costs, says Knight.

“Through technology they can literally tick a box and deal through their regional offices, and we have worked hard to help clients set these up, including different legal agreements covering each country.

“It makes sense to have a group of specialists in head office be able to log in, monitor and trade on behalf of their regional entities.”

The key driver for Standard Chartered’s increased focus on harmonised services is client convenience.

“If a client can see his cash flow that makes it easier for him to make decisions on FX,” Knight says. “People want that level of service, though of course they are still pretty price sensitive.”

In addition clients can trade more currency pairs by coming direct, Knight says.

“We have over 130 currencies electronically tradeable 24 hours; that kind of depth is unusual in the multi-dealer environment.”

Following a period of low volatility, business still remains tough and banks are looking for efficiencies wherever they can find them.

One area of focus for Standard Chartered in the recent period is proof of underlying reason to trade. Many Asia markets, for example, require that FX transactions must be directly tied to real-world sales or purchases, and the bank has worked with regulators and local authorities to service that need electronically.

“We have designed our system to be tailored to the environment in each country so that the client can easily pick an underlying reason for the trade, simply by clicking on an option. We have spent a lot of time on that. So it’s still very technology-focused, to cut costs and build scale and efficiencies.”

chris knight | HEAd Of E-fX TRAdINg | sTandaRd cHaRTeRed

In a survey leading up to this year’s FX Managers’ Peer Group 2 meeting, The NeuGroup asked its members how their internal processes for trading in FX markets have changed since the advent of increased regulation (in line with the Thomson Reuters euromoney poll). About 93 percent of their members said that trading processes had become at least slightly more onerous, with 27 percent saying much more onerous — and this is before the bulk of new regulations has kicked in. For example, MNCs that conduct FX trading outside of the EU, e.g., Switzerland, still did not know what rules they will need to follow.

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Indeed, the extent of new regulation and its impact on corporate FX management was cited as the number one area of uncertainty causing FX managers concern (60 percent cited it as a top concern), topping market concerns like emerging market political uncertainty and its resulting volatility (20 percent) and pricing/liquidity (13 percent).

More than one member also tied the regulatory impact to pricing/liquidity concerns, noting “between Basel III and other ‘Credit Charges’ we are seeing huge price differentials on trades out beyond a year.” Accordingly, one of the takeaways for the FX sell side is that their customers might seek more tangible explanations for the pricing discrepancies they see across derivatives trading partners on longer-dated transactions. This will be all the more true as collateral, margining and clearinghouses are understood to harmonize credit/counterparty risk.

The trend toward e-trading will continue, even if the transition, for those concerned, to fully functioning, compliant SEFs has created some hiccups. Among these hiccups are the new challenges for trading options and NDFs on electronic platforms and the clarifications needed between details in corporate ISDA agreements with banks and SEF rules, which have left some major FX banks on the SEF sidelines, initially. The number one driver of e-trading is that it is just more efficient with the limited treasury headcount available to most corporates (and some members report being asked to cut staff further).

In response, more corporates will increase spending on IT/systems. Regulations only help justify it: 80 percent expect to increase IT spending due to regulation in the coming year. End-user exemption or not, credit charges and collateralization coupled with market liquidity moving to SEF

venues should prompt corporates to prepare to manage the growing range of contracts “made available for trade” on a SEF along with reporting and other compliance burdens imposed by Dodd-Frank, EMIR and the rest of the G20 rules to follow.

However, looking at the bigger picture, MNCs also undertake spend on IT/systems to gain a better understanding of their exposures so that they might cut back on hedge contracts that regulators are making more onerous to trade. MNCs with FX hedging programs that rely heavily on options, in particular, are taking a more strategic view on both their cash flow and balance sheet exposures. Accordingly, efforts are underway to find natural offsets, reduce notional amounts hedged, fine-tune tenor and strike selection and generally become more efficient with regulated hedge contracts.

Thomson Reuters participated in a meeting of US multi- national corporate FX managers March 2014, facilitated by The NeuGroup, a leader in peer knowledge exchange for treasury and finance professionals. One of the goals was to get a read on just how regulatory change in FX markets was impacting corporate FX management processes.

ChANGING NATuRE OF CORPORATE FX MANAGEMENT PROCESSES DuE TO REGuLATORy ChANGE

For 20 years, The NeuGroup has been a trusted thought leader and respected advocate for global finance and treasury professionals. The NeuGroup leads the way in peer knowledge exchange through the peer groups of The NeuGroup Network and in intelligence for treasurers through the publication iTreasurer. For more information please visit us on: neugroup.com

FEATURE

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Ron Leven, Phd, Head of FX Pre-Trade strategy, offers thoughts on the trends in vols and their effects

uSd implied vols nearing all-time lows: The second half of the last decade saw an almost unremitting downtrend in broad currency volatility. Figure 1 shows this was broadly true for the USD with vols for both the EUR and JPY hitting record lows on the eve of the financial crisis. Along with other markets, volatility for currencies surged during the crisis but the downtrend since reemerged. EUR vols are nearing the 2007 lows; JPY vols have been slower to decline reflecting the seachange in BoJ monetary policy. While we are not of the view that reaching the 2007 lows bodes that another crisis is looming we do believe vols are not apt to go much lower and the seeds of a fundamental turn are germinating.

The decline in USD volatility (figure 2) – the average of EUR and JPY vol – has not been in isolation but closely tracked vol trends in fixed-income and equities. We would posit that it is the decline in vols in these major asset classes that has been a major source of lower volatility in the USD market. We would also posit that the broad decline in asset market volatility is tied to low rate targets and quantitative ease by the major central banks. Indeed, QE is inherently bearish for bond volatility; while early redemptions associated with declining rates can firm vols, ultimately, volatility will be compressed as rates become trapped in a narrowing range defined by central bank imposed cap and the zero boundary.

Quantitative ease is also weighing on implied volatility in the equity markets. A primary avenue for QE to stimulate the economy is via asset appreciation so, by intent, it is supportive for equity prices. As shown in figure 3, there is a strong directional link between equities and the VIX – specifically, a rally equity market is negative for implied volatility.

The Fed’s decision to taper is perceived as the beginning of the end for quantitative ease. Indeed, 10 year Treasury rates are roughly 25 basis points higher than last October and a full percentage point above last year’s low. As long as the tapering continues and ultimately leads to higher rates we believe volatility will firm across asset markets.

diverging central banks are another plus for fX vols. As shown in figure 4, the aggressive ease by central banks pushed rates towards zero largely eliminating interest rate spreads. The alignment of macroeconomic policy across borders has been another reason that currency volatility has been depressed. But the Fed move toward tapering is not being mirrored abroad. Indeed, the Bank of Japan is still aggressively easing while the ECB is sending mixed signals on its policy intent. We believe divergent trends in central bank policy should gradually be reflected in widening yield spreads and a pickup in exchange rate volatility.

The Fed is still early in the process of reversing course and may yet switch back to an easing bias if US economic growth falters. If this were to occur then the low volatility environment is apt to persist. But if, as we expect, the economy continues to improve and the Fed gradually tightens then a more volatile world is likely ahead.

thomson reuters

In the valley of the vols

3-MoNTH IMPLIED VoLATILITy Figure 1

3-MoNTH IMPLIED VoLATILITy Figure 2

THE SPX AND THE VIX Figure 3

source: Thomson Reuters eikon

2-yEAR GoVERNMENT BoND RATES Figure 4

THE EFFECTS oF VoLATILITy oN LIqUIDITy IN FX AND FIXED INCoME

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