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November 2008 Chicago's wind of change

Felix Shipkevich

Change seems to be a common theme in Chicago this year. On Election Day, the new President-elect from the windy city showed he has successfully convinced the American public he can foster the rebuilding of the recently handicapped domestic financial markets. Similarly, several weeks ago, a hurricane of regulatory proposals spun out of Chicago, aimed at building additional regulation in the retail foreign exchange market.

The wind of change towards greater regulation in the US began to pick up at the end of last year. Last winter, anticipating the legislative approval of the Commodities Futures Trading Commission Reauthorisation, the National Futures Association (NFA) sent a team of analysts to study business operations at foreign exchange firms. The aim of these educational visits was to better understand the effects of trading in retail FX from a customer's point of view. After regulating the exchange-based futures industry for more than two decades, the NFA wanted to better understand the dealing practices of over-the-counter forex transactions. This was the first time US-based FX firms saw a proactive step towards regulation beyond promotional practices and financial requirements.

The resulting set of proposals covers a number of topics, including requotes, limit orders, discretionary trading, the hedging feature, customer statements and independent systems testing. Arguably, these proposals reflect the start of the major regulatory overhaul that whirled out of the Reauthorisation. The US regulators appear to be concerned about the lack of uniform regulations between retail FX and the commodities and futures markets, which are primarily exchange-based industries. That is why the premise of these proposals largely echoes exchange-type rules. While similarities exist between the exchange-based futures and OTC forex, the business models available in the foreign exchange industry do not resemble that of their exchange-based cousins.

To efficiently regulate the forex market, it is important to understand the disparities between exchange and OTC business operational models. Without properly addressing the various types of OTC models, regulations cannot adequately provide safeguards for retail customers. For instance, one of the proposed rules requires firms to requote in two directions, both in favour and against the client. Generally, forex firms might requote a client depending on the size of the order and volatility of the market, particularly when the market moves in the opposite direction of an order.

However, not all forex firms requote. Some either execute an order at the new available price (thus slipping the client) or alternatively reject an order entirely. The merit of either type of model is not an issue in these proposals. The regulators are concerned that, by requoting in one direction, forex firms might not allow clients the ability to enter the market at a better price. The practice of requoting is a legitimate one used by forex firms both in the US and abroad, and generally only occurs in response to fast market conditions or due to market-depth considerations on large orders.

Requoting is also one of the many tools some forex firms can use to control their counterparty risk. While a one-sided requote might not appear to be advantageous to a client, its purpose is to fill a client's order at the same rate that the firm gets from a counterparty.

Another proposed rule requires execution of a limit order when an order is better than the requested price, particularly when the market gaps. Banks that are counterparties to forex firms, however, will not generally execute a limit order at a better price than requested. For an FX firm to offset its risk on market gaps and limit orders, it must do the same with its own counterparty or bank. The firm will usually place an equivalent transaction to be executed with the bank. The bank will execute the order at the requested price and not at the prevailing gapped price. If FX firms fill client orders at prices better than those they receive from a bank, their capitalisation could potentially be at risk. Even following the higher capital requirements introduced during Reauthorisation, we must be mindful that multiple instances of such examples might ultimately result in undercapitalisation.

Forex firms had two weeks to respond to these proposals, a period that seemed short to some of them. However, firms are even more concerned about being given the necessary time in which to implement any requirements that might be enacted into law. The proposed rules encompass a wide variety of aspects of the forex business that are highly dependent on the current technical infrastructure, trading specifications, and supporting platforms and trading systems used. Any changes to the existing requirements would require substantial modifications to the trading systems and business models in use. Somehow, in the past few weeks, the wind of change has quickly turned into a small twister, one that many hope will blow itself out in this rapidly growing industry.

Previously published in FX Week

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