Shadow of MiFID II is falling on FX trading transparency

The evolution of spot foreign-exchange trading to an agency model and electronic trading is accelerating as a result of MiFID II — even though the regulatory regime's transparency and disclosure rules don't apply.

Sources said money managers preparing for unbundling of research and execution costs and increased disclosure in securities trading under the new regulations are asking the question: If we need transparency in equity and fixed-income trading, why not in FX? (The Markets in Financial Instruments Directive II goes into effect Jan. 3.)

And that push for disclosure is dovetailing with requirements implemented in the FX Code of Conduct in May for more transparency in execution quality among market participants. It also coincides with an overall industry-driven increase in use of the agency model, which uses algorithms to find liquidity and price discovery from multiple venues, as opposed to the traditional single-platform process that had been used by banks.

The growth of agency FX services, from both banks and non-bank third-party providers, "has dovetailed in the last six months, with managers feeling under the gun with regulations and FX remaining this opaque area," said Alex Dunegan, CEO and founder of money manager Lumint Currency Management, Boston. "If I'm a money manager and agency brokers can solve this transparency problem, I'd move in that direction ... There's an ever-growing focus on accounting for cost. With more regulations and more business applying technology to this, agency FX is growing."

Added Oliver Jerome, co-founder and director of BestX, a London-based FX analytics provider, MiFID II "absolutely" has had a direct impact on spot FX trading. "With the disclosures that are required with equity and fixed-income trades, investors want that disclosure in FX as well," Mr. Jerome said. "And although spot FX isn't specifically under MiFID II, associated spot deals involving a regulated securities transaction are under MIFID II. That's driving more electronic FX trading to provide the analytics required under MiFID II."

Mr. Jerome said the only way to get that data on spot FX trading — an exchange of currencies between counterparties executed at a specific time — is through electronic trading. "The overall demand for data is a key piece," he said. "That demand will force people to increasingly use electronic trading. We're seeing that already with managers converting more FX to electronic execution."

Radi Khasawneh, senior analyst for fixed income at TABB Group LLC, London, said, "There's a clear lesson from what MiFID II is presenting. With its implications as well as the code of conduct, FX is going more toward the agency model with the eventual move to as full automated trading as possible."

The transparency is in how FX market participants are trading, said Tod Van Name, global head of FX electronic trading, Bloomberg LP, New York. "And for managers, what matters is how and where my trade is being executed. In the past, these FX trades were done by custody banks. But the technology that has since been developed gives fund managers a tremendous amount of insight into how FX trades are sourced. Managers want that transparency of the trade."

Lumint's Mr. Dunegan said agency FX "is the type of business that is a stepping stone as FX becomes more electronically traded. Banks are seeing shrinking margin on deal flow in FX due to scandals (and) the increased use of transaction cost analysis, and the growth in electronic FX trading has pushed on banks' FX margins."

Banks' moves away from single-platform offerings for FX trades to the agency model "is a way to improve changes to get better execution," said James Singleton, founder, chairman and CEO, Curex Group Holdings LLC, a New York-based FX execution services and data analytics provider. "Note that it's not best execution; that's an ongoing process. But these (algorithms) are better than single platform. The buy side getting the opportunity to move to algorithms is a massive step forward, whether that's market driven or regulatory driven."

Some sources said the shift to an agency model was an attempt to apply an equity-like market structure to spot FX trading. "The reality is that in 2015 and 2016, the FX market became obsessed with the idea of agency brokers because of the transparency they provide, that would create a sort of equity-like FX market," said Mr. Jerome of BestX. "Things like the WM/Reuters fixing scandal, the manipulation by banks of the spot FX markets and indexes, and the charges of custodial overcharging all had been driving the discussion.

"With the agency model, best execution was using an agent to source as many prices as possible and then the client would be charged for that search for prices. The agent has no principal risk. That was supposed to lead to a level playing field among all market participants. The problem was that the market didn't do it as fast as it could have. People want the equitization of the FX market. The problem is that the equity market is exchange-traded, but FX is total over-the-counter. That's a big difference."

That discussion on equity-like structures for spot FX has been discussed among market participants for 10 years, said James McGeehan, co-founder and CEO of FX Transparency LLC, a Framingham, Mass.-based FX transaction cost analysis provider.

"But the case to actually do it is becoming more accepted," Mr. McGeehan said. "The extreme focus on the cost in the money management industry, inclusive of implementation costs, has made its way down to currency markets."

However, Mr. McGeehan said, the transition has been slow. "The reality is, like everything else in FX, things change by evolution, not revolution," Mr. McGeehan said. "The FX market today still relies on bilateral credit, and that helps keep people married to the banks in a sense. The banks are still the key source of liquidity… If it was so easy to replicate the equity exchange model, it would have happened already, but for now FX is still a principal-based market. Banks have done a very good job in creating more transparency while the credit and booking model of FX is still the same."

While managers are asking for more transparency and better execution in the spot FX market, TABB's Mr. Khasawneh said in the short term, getting that information as well as working to comply with MiFID II requirements in other securities will take them out of their comfort zone.

"It's adding to their burgeoning to-do list," Mr. Khasawneh said. "But no one's going to complain about it. More data ultimately leads to more information. It's more of an implementation burden. It won't put the brakes on any changes in market structure."