Mifid rules could force FX swaps onto OTFs

The foreign exchange market could face severe disruption in Europe if the scope of forthcoming rules on organised trading facilities (OTFs), which broadly mirror US Dodd-Frank rules for swap execution facilities (Sefs), include FX swaps.

OTFs will be introduced as part of the review of the Markets in Financial Instruments Directive (Mifid II), which is in the ‘trialogue' phase of negotiations, in which the European Parliament, European Commission and Council of the European Union must agree on an identical text. If FX swaps are designated as derivatives and mandated for trading on OTFs, as options and non-deliverable forwards (NDFs) are for Sefs in the US, participants fear that the use of the instrument could decline.

"The clear response we are getting from the buy side is that if FX swaps are defined as derivatives in Europe, they will not use them as hedging instruments. They are not saying they will scale down their use of swaps; they are saying they will stop using them completely. They will internalise risk on a greater scale, and reduce exposures to negate the need for large hedging programmes," says Stephane Malrait, global head of fixed income and currencies e-commerce at Société Générale Corporate and Investment Banking in London.

"This impact is not in line with the original intention of the over-the-counter market reforms," he adds. "Regulators wanted a stronger, more transparent market, not a market where no hedging takes place at all. As an industry, it's not what we wanted to happen."

The trialogue negotiations on Mifid II are expected to produce a result by the end of February, and market participants are anxiously awaiting the outcome. Swaps make up a much greater portion of the over-the-counter FX market than either options or non-deliverable forwards, and it is feared that trading them on OTFs could add a significant layer of cost for the buy side.

The clear response we are getting from the buy side is that if FX swaps are defined as derivatives in Europe, they will not use them as hedging instruments

"If swaps are placed within the OTF framework, it would be a disaster," says the head of FX execution at one European asset management firm. "Ninety per cent of our derivatives business is done via swaps, so adding an extra cost to that is not a road we want to go down. A lot of people on the buy side will be in the same boat as us. If regulations are too costly and cumbersome in the OTC space, people will alter their risk-taking. At present, it is hard to find alternatives to OTC hedging in FX because the exchanges have been very slow in coming up with new trading ideas."

In the US, Sefs opened for business under the Dodd-Frank Act on October 2, but liquidity in NDFs is understood to have taken a hit in the weeks following the deadline as some users opted to revert to voice trading or single-dealer platforms to avoid the regulations.

"The introduction of Sef trading for US participants initially reduced liquidity in the NDF market alone by around 30%. Two months on, we are almost back to normal, perhaps to around 5% below pre-Sef liquidity levels," says Rob Lane, head of Asian interest rates and FX for London and New York at BNP Paribas.