A New Paradigm for the FX Industry

The impending arrival of MiFID II in January 2018 will be a watershed moment for FX markets in Europe, a time when some firms will embrace the future and succeed while others fall by the wayside, according to Christian Schoeppe, head of FX trading EMEA at Deutsche Asset Management.

​“2016 was a spectacular year,” Schoeppe told the Buy-side Perspectives.“The BIS triennial survey showed a fall in FX turnover for the first time. Markets have been normalising following the election of President Trump but geopolitical choices have clearly disappointed not only traders. Now the focus is shifting back to major upcoming elections in continental Europe, where investors are evaluating their business partners very carefully. Those that don’t support MiFID II will lose business to others that do.”

​Schoeppe is head of FX trading EMEA at DeAM, the Asset Management arm of Deutsche Bank Group, where he has been active since 2000. The FX trading desk at the firm has an interesting history. There was a time when the firm didn’t have a dedicated FX desk (see Buy-side Perspectives, Issue3 April 2016). Later, the firm began to automate FX trades arising from securities trades. These days, FX is an actively managed asset class in its own right, exceeding 750bn USD turnover p.a. for the first time last year. The key concerns for Schoeppe now are twofold: firstly that some firms may not be taking MiFID II seriously enough; and secondly that non-banks are making an increasingly significant contribution to the spot FX trading landscape as banks pull back from providing all services in that segment. The BIS survey he refers to is the Triennial survey of FX trading, which was published in December 2016. That survey details FX volume and breaks it down by country and by the method of execution. The figures suggest a fall since 2013; however, Schoeppe believes this is most likely down to structural changes on the sell side rather than the buy side.

​“Some Banks have decided that they are not interested in certain types of flow,” he said. “Non-banks offer to fill the gaps in spot FX. The banks have been neglecting that area as they feel it is not appealing for them due to the low interest rate environment. The non-banks have jumped in. They team up with research and transaction reporting providers to offer the same level of service as a bank."

If non-bank liquidity providers are gaining ground, some of the mid-tier banks may have cause to be concerned about their prospects – particularly given the far-reaching impact of the European Commission’s MiFID II legislation, as well as the impact of ISDA’s requirements on the collateralisation of non-spot FX trades starting in March. Schoeppe sees collateralisation and greater disclosure in the OTC markets as part of a push by global regulators that will define the direction of travel for the industry.

“This divergence could mean asset managers might want to make a further distinction between US and European banks, and therefore fragment the market”

As such, the market needs to prepare for a lot this year – but he is less than impressed with the approach taken by some.

“Parts of the industry are still discussing historical concepts instead of embracing the spirit of the new regulation and becoming more transparent,” he said. “They are not even looking at the new BIS framework of the Global Code of Conduct for FX, which is a very helpful document of guidance. Regulation opens new possibilities to us, for example to remove counterparties if they are not part of the MiFID II compliant future in Europe, which is all about ensuring investors get value for their money. We are constantly evaluating our vendors and counterparties under these criteria and those who don’t support the new requirements under MiFID II will lose business to others that do."

One of the major changes from a technical side under MiFID II is that the FIX protocol contains three times more required data entries than under MiFID I. Schoeppe notes that some players in the markets have stated they intend to simply keep using the old standard until the last minute – “That’s simply not good enough for this year,” he said. “If they can’t give me the data I may need to prepare myself for MiFID II, then I can’t use them.”

A further challenge of implementing the new regulation is that each counterparty has its own interpretation of MiFID II. For the buy side, it can be a major effort to go through all the CSAs held by each asset management house with each broker to determine what is and what is not eligible for collateralisation and how to proceed. That is a cost for the buy side and an earnings reduction for the sell side, which comes on top of a period when their earnings have already been decreasing. This is partly why Schoeppe believes the Code of Conduct is so important.

“The industry must take up this framework,” he said. “There is still lots to do but The global code is up to us in the industry to push.”

In terms of broker list, Schoeppe sees a consolidation from a top 100 list a few years ago to a top 15 or 20 list now. This is in part based on the improving quality of services provided by some of the larger players in the emerging markets, as well as the overall need to cut costs.

“The global houses are now almost as good as the specialists used to be a couple of years ago, so you can concentrate flow increasingly on the large value brokers,” he said. “The other thing is that the big global brokers are going to be ready for MiFID II, and that is a significant confidence factor in doing business with them.”

ISDA’s collateralisation requirements are separate to MiFID II. According to Schoeppe, the key point is that the regulators want packaged derivatives such as NDFs, options, swaps to be collateralised to reduce the risk to the industry. Next year they apply the same principle to the maturity risk of FX forwards

“This is a massive cost for us with a huge impact on our business since FX forwards are a large part of what we trade,” he said.

From a technology perspective, the regulation may also have an impact on decisions such as what sort of TCA to use. Many firms are considering specialist third-party TCA providers; the alternatives are to use a broker’s TCA or to build it in-house (see David Ketley article, page [insert page number]). One possible objection to relying on either an in-house system or one provided by the broker is that it may not be entirely objective. Schoeppe suggests that having all three might provide the best clarity and the most impartial picture of the market which would help to satisfy best execution obligations.
With EMS and OMS technologies, likewise there is a choice to be made. Deutsche Asset Management has four EMS platforms for FX and one OMS for all asset classes. Schoeppe does acknowledge that the number of EMS platforms could be reduced in the name of efficiency; at the same time, the groups’s investment into blockchain technology has taken priority over investment in developing any additional EMS platforms, so the trading desk is focused more on tweaking and fine-tuning its existing EMS platforms this year rather than looking at new ones.

“Blockchain is fantastic for digitalization efficiency,” said Schoeppe. “The industry is trying to eliminate risk. Real time clearing and settlement becomes possible with this technology. This means that a central depository is not needed, and that is a huge efficiency for the industry. All that data storage and Swift connections – the need for it is potentially eliminated. That’s attractive from a business point of view and it is a fascinating technology overall. It is like finally getting a form of secure, safe and reliable internet for financial transactions for the first time.”
“Additionally there is a lot of shift from paper and voice processes towards electronic trading. I have just 5% voice business now – it used to be multiple times higher and that cost me a lot. I need recording equipment to stay compliant and so on. It’s good having reduced that number and cut the cost. The end of print outs and the rise of digital reports is another significant efficiency especially with regards to RegTech. I have had more face time with compliance in the last three months than ever before. From a regulatory technology perspective, there is still a lot of upside.”