FX Supplement 2014 | Introduction

Many dyed-in-the-wool foreign exchange traders lament the regulatory changes sweeping the industry more than six years after the global financial crisis. The market has become too boring for them. In the US, the Volcker Rule has caused banks to shut down their proprietary trading desks, while provisions of the Dodd-Frank Act are causing big FX banks to stop making markets in currencies and to act simply as agents for their customers.

The worldwide probe of the FX market is also causing traders to pull in their horns. Trading platforms are becoming ever more sophisticated and equipped to monitor users, while banks have lost their appetite for taking risk.

Slowing economic growth in many parts of the world, particularly in China and other emerging markets, has dampened demand for commodities and the need for some trade-related FX transactions. This has sparked a debate about how much of the current malaise in the industry is cyclical and how much is structural. The optimistic traders say the FX market always snaps back from periods of low volatility, while the pessimists say the market (at least in the US) has been completely ruined by overregulation.

Backers of swap execution facilities, regulated platforms for swap trading, are in the optimist camp. They say Dodd-Frank is great, and regulators should move more quickly to implement the new regulations. SEFs are new venues with centralized clearing and reporting obligations for FX swaps in nondeliverable forwards, contracts common in many emerging markets. Supporters say SEFs provide enhanced transparency and efficiency.

Some FX traders are migrating to London—long the center of the FX world—to avoid US regulation. Britain does not regard FX forwards as derivatives subject to new regulations. However, the European Securities and Markets Authority says forwards are derivatives. Mandatory trading and clearing of FX derivatives could be introduced in Europe as soon as 2016, if member states can agree on common definitions of spot, or cash, FX trades, and forward contracts.

The low volatility in the FX markets this year has lulled many corporations into a false sense of security when it comes to FX risk exposure. The recent decline in the euro shows that volatility could return to the markets, catching corporate risk managers off guard. The more prudent ones will utilize available tools to manage currency risk exposure and increase potential profits.

Meanwhile, financial centers worldwide are elbowing one another to become leading offshore renminbi trading hubs. Apart from Hong Kong, with its built-in advantages, London has taken an early lead. The Chinese currency still has a long way to go, however, before it seriously challenges the dollar as the leading currency for international trade.