Will a regulatory shake-up see market quality improve?

Richard Elston, head of CMC Institutional, talks to FX Week about how regulatory change is manifesting itself in 2020 and why this will leave the entire industry in a stronger position for the future.

The regulatory landscape is constantly changing, but for many institutional FX providers the pace of change in recent years has been unusually brisk. Although creative thinking by some players has resulted in a degree of regulatory arbitrage, the latest changes now being effected have the potential to sound a death knell for such activity – at least across the most respected jurisdictions.

 

What regulatory changes have occurred so far?

Richard Elston: Two years ago, we saw the roll-out of the revised Markets in Financial Instruments Directive (Mifid II) – a piece of regulation with wide-reaching impact across the entire financial sector. In terms of FX, however, it precipitated a series of moves by some market participants looking to maximise the opportunities available to them. Principally, this was done by repapering institutional clients, for example introducing brokers through alternative jurisdictions – more commonly known as offshoring. Regulatory hurdles were less strict and while this arguably went against the spirit of the legislation, it enabled those counterparties to be remunerated on legacy terms. Leverage changes implemented by the European Securities and Markets Authority (Esma) further drove the popularity of offshore venues, allowing retail clients to continue to trade on the same terms, as long as they were happy with new regulatory structures. 

These shifts, combined with changes in the underlying prime brokerage market, helped drive further growth among prime-of-prime providers ready to service this new work. However, owing to their weaker relationships with Tier 1 liquidity providers, the liquidity on offer was often recycled – which added to costs and did little to help market quality for end-users. As the top regulators globally are now working to remove these arbitrage opportunities, it seems inevitable that  offshore operators with access to better liquidity will find themselves manoeuvred back into the most established regulatory structures. 

 

What has been the catalyst for change?

Richard Elston: Again, this is a situation driven by a number of simultaneous factors, rather than it all stemming from a single initiative. At the highest level we have growing adaptation of the FX Global Code, in what is really a self-regulation bid to improve market quality among the large institutions that dominate the spot market. Elsewhere, however, we are seeing a raft of regulatory enhancements that seem set to shut down workarounds, potentially increasing cost but ultimately raising the quality of the market. One aspect the offshore exodus has exposed is how this created an inherent disadvantage for a number of the biggest firms, many of which are publicly listed. This cohort – including CMC – have historically been held to high standards by investor demands and the accompanying internal governance protocols. The regulators are now adding their influence here, with the Australian Securities and Investments Commission (Asic) particularly vocal in criticising Australian brokers who have ventured offshore, but ultimately these moves will instil best practice across the board. Clearly this comes with a series of obligations that may be cumbersome for smaller operators to implement, but ultimately it helps deliver a more professional and consistent service all round.

 

You mention the quality of the market – can you expand on this?

Richard Elston: We are looking at a series of events – rather than one item in isolation – which stands to improve aspects such as execution and consistency of pricing, as well as delivering proper regulatory oversight. Ultimately, however, a number of the moves observed off the back of Mifid II and Esma that drove business offshore added more parties to each transaction. Each step incurs extra cost, introduces an extra step in the chain and – if smaller liquidity providers are being used – can present issues with the ability to fill orders at agreed prices, especially in fast-moving markets. Where this latest round of changes results in price increases as brokers return to onshore jurisdictions, the current expectation is that intermediaries or introducing brokers will be left to absorb the majority of this uplift. Conversely, however, it does mean some of the price advantage that has been harnessed by smaller operators to thrive offshore may now be removed. This in itself has the potential to reduce the reliance on liquidity recycling and again feed back into producing higher-quality market conditions.

“With this phase of regulatory change seemingly close to concluding, it’s now down to market participants to ensure they’re properly aligned to service the work that will be the core of their business going forward”

Richard Elston, CMC Institutional

 

Does this favour the legacy players?

Richard Elston: Yes – I think that’s right. Those with the better Tier 1 liquidity relationships will find themselves with a proverbial head start, but the raft of regulatory change we’re seeing will provide further advantages. We have just seen the roll-out of the Financial Conduct Authority’s Senior Managers and Certification Regime, which replaces the existing approved persons regime. This formalises requirements to ensure sufficient structure and cover is present in regulated firms of all sizes to guarantee continuity. It arguably already exists for big listed firms through their own risk and governance structures and will be good news for counterparties not wanting to be hit by unexpected disruption owing to events well beyond their control. Conversely, it adds to the management burden at regulated brokerages – and it has the potential to hit the smallest entities harder. What’s more, the accompanying reporting obligations will need to be maintained for the long term, and the office culture required to support this can often be easier to establish in a bigger business. If there’s one point that’s clear from all this, it’s that the latest evolutions won’t favour the smaller, deft, edgy brokerages in the future – but the benefit is likely to be a better quality trading experience all round.

 

What do you expect to happen next?

Richard Elston: With this phase of regulatory change seemingly close to concluding, it’s now down to market participants to ensure they’re properly aligned to service the work that will be the core of their business going forward. Asic has demanded greater price transparency in a move that has parallels with the ethos of Mifid II, while they’re also making pointed calls in terms of ensuring local brokers aren’t pushing clients offshore. Similarly, the Monetary Authority of Singapore has recently clamped down on leverage in a move that mirrors what was seen in Europe with Esma’s stance. While the impact here is predominantly focused at the retail end of the spectrum, again it results in a review across the sector of how smaller brokerages move forward from here. What this points back to, however, is the idea that a number of premium regulators worldwide are now working to the same agenda at a far more granular level. From here it seems the brokers who have looked for short cuts in recent years to take advantage of regulatory arbitrage will be left with two choices: either lift business back to the high standard that respects both the letter and the spirit of top-tier regulators, or risk becoming marginalised in terms of who they can work with. 

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