The factors that influence FX network connectivity are diverse. Regulations govern the culture of trading in FX as they do other asset classes; technology provides the tools while market participants and infrastructure providers all play their part in the tapestry that is the global FX network. They all have one thing in common - they are all in a state of ongoing development as the nature of the institutional FX trading environment is never exactly the same year on year. This presents challenges to buyside FX traders, who can’t afford to fall behind in a competitive market where underperformance will lead to loss of investor confidence and where a lack of attention to detail could mean falling foul of the regulator.
To properly understand how FX traders and other market participants can stay ahead of the changing trading landscape and ensure they have the right connections to keep them trading into the future, let’s dive into the challenges they face in today’s landscape.
Everyone in the FX world can name the main trading hubs: New York, London, Hong Kong, Tokyo and Singapore, the last of which has seen substantial growth in recent years. Singapore’s rapid expansion as an FX trading hub has been driven by the strong economic growth of Asia, and a larger share of the global investment flowing into the region. Now, the Indian city of Mumbai is catching these leaders up, boasting the world’s tenth and eleventh largest stock exchanges by volume and where global stocks are traded, FX follows to provide liquidity to facilitate other derivatives trading.
Global reach, local touch
The FX market makes up the largest single capital market in the world, with a daily turnover often over $3 trillion, so it’s unsurprising that so many players want to get in on the action, each looking to carve out their own niche. The result is market fragmentation.
FX is traded around the clock so if there is a variation in rate between one location and another, traders will be looking to take advantage of these arbitrage opportunities wherever possible. This plays to the strengths of those liquidity providers who are global, but some participants are solely based in one region - perhaps just in Asia or Europe. In each trading hub, FX is being traded in a variety of different ways, such as spot trading, FX futures, options and NDFs and by a variety of different providers.
FX trading entities can include buyside traders, speculators, and those corporates big enough to have their own FX broking operations. Derivatives traders who need to hedge their trades also need FX - for example, a commodities trader who buys Indonesian rice might need to do so in Indonesian Rupiah.
Specialist market players
Specialist providers have emerged, who offer expertise in a very targeted area. One example is R5 FX, an electronic liquidity pool, which specialises in the fast-growing transaction volumes in BRICS and emerging economy currencies and aims to provide a faster, more efficient, regulatory alternative for anyone wanting to benefit from FX trading in these emerging markets.
Companies trading assets in foreign jurisdictions often find that their counterparts want to do business in their local currency and that the counterpart will charge an extra premium on top of the price for exchanging currency at their end. This is where firms like R5FX come into their own with proven links into those markets.
There are single bank trading platforms, each controlled by a bank, and multibank and independent platforms like Currenex, or CBOE FX (formerly Hotspot). Size matters in FX and the big institutional traders can take advantage of services like EBS and Reuters matching, which is only available to those trading in the millions of dollars, using their volume to achieve the best aggregated liquidity. The advantage of a multibank platform is that it allows buyside traders to get the best rate across a number of banks, via just one portal.
Connectivity is key
All these factors contribute to market fragmentation, providing buyside traders with a plethora of options. The first thing they must do to is analyse and plan comprehensively which options are right for their business, based on the many factors and methods outlined.
Connectivity is key here; when it’s impossible to be on every exchange and platform simultaneously, traders need to access liquidity in the different sections of the FX global ecosystem to achieve the best fills for their clients. The way to do that is by colocating in a data centre with the right level of liquidity and connectivity. For most trading firms, the cost of having their own hardware like servers in the locations where there is liquidity is prohibitive and colocation with a managed service provider is the only solution. Partnering in this way allows them focus on the business of trading.
Traders need to make sure that they are also getting the right level of latency for their needs - they should be looking for speeds of under 160 milliseconds between Tokyo and London, to take advantage of market movements quicker than their competitors. Having the right relationships is essential and buyside firms need to make sure that they have a capable partner to provide them with the services they require.
MiFID II and the rise of regtech
Providing best execution for a client, isn’t just good business practice, it’s the law. In the EU, this is set out under the MiFID II rules, which came into force on 3 Jan 2018. Under the new rules, buyside firms can no longer rely on their broker for regulatory compliance but must adhere to new rules on Trade and Transaction Reporting and Transaction Cost Analysis. Spot FX trading, which involves trading live FX rates, does not need to be reported, but FX Derivatives trades have to be reported in near real time and transactions must be reported at T+1. Information on the trade includes unique identifiers which would enable audit teams to trace back the details of the trade if any market abuse was suspected.
Buyside traders must make sure they are connected to the right reporting mechanisms, independently of their broker. The MiFID II rules make it clear that the liability for compliance sits with the buyside firm who initiates the trade. As the risk has moved away from the proprietary tradingat investment banks and to the buyside, and proprietary trading firms the focus for technology solutions providers has shifted in the same direction, looking to fulfill the new requirements of the buyside firms.
Regulations like MiFID II have initiated a surge in the development of regulatory technology - regtech - to help trading firms deal with the extra compliance burden. In FX trading, the reporting mechanisms are provided by the likes of the Deutsche Borse Regulatory Reporting hub and Euronext APA and ARM, whose systems aim to ensure traders comply with the evolving regulatory requirements, reduce the time and resource spent on reporting, identify and correct anomalies in their workflows and give them guidance on changes in the pipeline.
There has been some M&A activity in the regtech space. CME acquired NEX Group including its Regulatory Reporting platform, which NEX acquired when they bought Abide Financial in 2016, back when NEX was still ICAP. Firms looking at procuring this sort of system would do well to check for this sort of technology pedigree, behind the current brand. Exchanges and brokers will often have this regulatory reporting technology built in to their systems, but the buyside trading firms need to confirm that it fits their workflow.
MiFID II requirements for clock-synchronization
MiFID II sets exacting new standards of transactions as they move through financial networks to provide market clarity. According to the requirements set out in Commission Delegated Regulation (EU) 2017/574, commonly known as RTS 25; time stamping accuracy must be within 1 millisecond for standard electronic trades, while high-frequency trades need accuracy within 100 microseconds, synchronised with and traceable to Coordinated Universal Time (UTC). The National Physics Laboratory (NPL) offer a single source directly traceable to UTC, that is MiFID II compliant, with accurate time stamping, for a secure and resilient connection eliminating risks of non-compliance.
Across the trading landscape, firms have made major efforts to keep pace with the task of remaining compliant and have invested in new systems to assist them. Continued investment like this will remain critical for companies to satisfy the current demands of the regulator and to be able to cope with future regulations. Meanwhile, service providers to whom much of the technology provision is outsourced, will want to keep partnering with fintech and regtech firms, often set up by former traders and market practitioners, which are focused on solving specific regulatory challenges. In a competitive market, buyside firms are looking for service providers who can connect them to a full suite of regulatory and other technologies.
Regulation by the Securities and Exchange Board of India (Sebi) who regulate the National Stock Exchange of India’s Index (The NIFTY 50) has encouraged equity traders based offshore, principally in Singapore, to trade onshore, principally in the busy trading hub of Mumbai.
India has been a major global player in commodities trading for years, with large amounts ofcommodities traded and a long standing interest in the the trading of gold, which itself has a close relationship to the US Dollar and traded on the Metropolitan Stock Exchange (MSE) in India.
Where these other asset classes are liquid, so FX trading will too find liquidity. Companies trading in India must execute via a broker with offices in the country, such as Edelweiss. To maintain access to the liquidity of a market like India, traders must make sure they have the connectivity to such a local broker.
The Fundamental Review of the Trading Book (FRTB), which is an initiative from the Basel Committee on Banking Supervision to overhaul trading book capital rules, mandates a standard of minimum capital for market risk, meaning that trading firms must hold greater cash reserves in order to trade illiquid instruments, like illiquid traded currency pairs and derivatives. So traders need to make sure they can meet the modelability requirements via access to cloud based analytic platforms provided by companies like TickSmith and have access to brokers who can offer liquidity for that trade and thereby speed up the transaction so the cash doesn’t have to be held for too long on the trading firms balance sheet.
Connecting the global FX ecosystem
Away from regtech, technology investment can pay big dividends for traders. The latest trading systems have made buyside-to-buyside trading easier, either via a matching platform or via a broker. This means that sellside banks have to offer value added services to remain competitive. Those platforms and brokerages which can build the best community will be able to offer the best liquidity.
In a huge fragmented global FX market, it’s clear that few trading firms can go it alone. Partnerships are key - finding the right brokers and services providers will mean traders can take advantage of the shifting pools of FX liquidity. Connectivity plays a central role in forming these partnerships. Ongoing technology investment will allow market participants to future proof their FX connectivity needs and maintain their place in a successful global FX ecosystem.