September 12, 2014

Global FX Market Regulation — A Big Dream That Requires Even Bigger Ambition

With the majority of financial services under regulatory oversight across the globe, could now be the time when the FX market finally comes in from the cold?

The Foreign Exchange (FX) market is currently under the microscope. Regulatory agencies from Switzerland, Germany, Europe, US, UK and Australia are investigating how the FX market works in practice and whether it’s prudent to regulate it globally.

The causes for this sudden regulatory interest have been brewing for several years, although the straw that broke the camel’s back has arguably been the recently discovered cases of widespread FX manipulation at most (if not all) large banks globally. 

Calls to regulate the FX market have been bandied about for a long time and plenty of potential solutions have been supplied, including creating a banking union, introducing a single-reserve currency, creating one global regulator, or putting FX trading on exchange, giving as a few examples. The one common denominator with all possibilities provided so far is that a transformation of the FX market must happen first, before global regulation is even considered.

Not Your Average Market

The FX market differs from all other asset classes in that in its current form, it is completely unregulated, operates over-the-counter, which means there is no central marketplace ,and is by far the largest by capitalization. So as regulators ponder ways to regulate this market, they first have to quantify and ring-fence its reach.

This is incredibly difficult to do because large currency transactions can take place as part of everyday life (property investment for example) and given fluctuating currency rates, people effectively speculate on currency movements without even being aware of it. With other asset classes this doesn’t apply.

Spot FX transactions are not regulated in any country, despite the assumption that the FCA, NFA, ASIC and others regulate financial services and by extension, the FX market which is part of the financial services landscape. In fact, what is actually regulated are FX derivatives such as CFDs, Futures and Options. In the case of the Financial Conduct Authority (FCA), spot FX contracts are not qualifying investments under The Financial Services and Markets Act (FSMA) and therefore, FX dealing cannot apply to the market abuse regime under and the FCA’s Code of Market Conduct guidelines. This is likely to factor into how banks defend their actions in response to FX manipulation allegations.

International Financial Markets Regulation by Industry Segment | Source: ASIC

Muzzled but Motivated

Despite the jurisdictional quagmire, some attempts have been made to reduce market abuse and mistreatment of private retail investors. The Commodities and Futures Commission (CFTC) created a special task force in 2008 to reign in unscrupulous brokers and introduced harsh penalties in 2010 to protect retail FX traders.

One measure the CFTC was keen to implement is lowering leverage on FX trading accounts for retail clients in a bid to reduce risk taking. However, the measure made FX trading unaffordable for many traders because lower leverage meant higher margin requirements and higher initial deposits.

The knock-on effect has been for U.S traders to seek trading accounts elsewhere around the globe with lower margin requirements. Regulators seem to be creating bit-part solutions which human nature and technology find a way of avoiding before the ink is even dry on the regulatory amendment.

In the UK and Europe, regulation is limited and leverage is unrestrained with 500:1 still available depending on the broker and your trading style. Japan’s ‘Financial Services Agency’ (FSA) reduced the maximum leverage in 2011 from 50:1 to 25:1 having lowered it the year before from 100:1 to 50:1. In a similar vein, increasing numbers of Japanese traders have since looked abroad for a ‘suitable’ broker.

Quite ironic because regulators see margin FX trading as ‘unsuitable’ for many retail investors. It seems that when it comes to leverage and risk-taking, the majority of investors/traders do not want to be restricted or ‘protected’ by regulatory guidelines and rules.

All in the Same Boat

There have been several cases of market abuse that have affected both retail and institutional investors. In the U.S, “nearly 26,000 individuals lost $460 million in currency-related swindles between 2001 and 2007,” according to a Forbes article published last month.

Investigations published in 2013 by the UK’s Financial Conduct Authority (FCA) on the abuse of WM/Reuters (FX) rates, combined with the Swiss Financial Market Supervisory Authority (FINMA) investigating several Swiss firms has cast a shadow over the FX market and added weight to calls for a complete overhaul. The German regulator, BaFin, officially confirmed cases of FX manipulation in May this year.

In December 2013, UBS agreed to pay approximately 1.4 billion Swiss francs ($1.6 billion) as part of a settlement with American, British and Swiss authorities in connection with the LIBOR inquiry. Other banks including RBS, Barclays and Lloyds have also been fined for LIBOR rate manipulation.

FINMA said it was investigating several Swiss banks but was reluctant to name them. The agency also said it was cooperating with authorities in other countries and that banks outside the country were also suspected. In a statement FINMA said it is “currently conducting investigations into several Swiss financial institutions in connection with possible manipulation of foreign exchange markets. FINMA is coordinating closely with authorities in other countries as multiple banks around the world are potentially implicated.”

In June 2014, the FCA said it was examining claims that traders at large banks manipulated some foreign exchange benchmark rates and that it might start an official investigation. It was not immediately clear if that preliminary inquiry was related to the Swiss investigation.

Questions for a Regulator

A uniformed approach to FX market standards amongst the world’s most prominent regulatory authorities does not exist and moreover, is not being sought.

Is it cynical to ask whether the 5%-10% market share occupied by the retail FX industry has any bearing on regulators’ priorities? With so many other financial market practices under scrutiny, do regulators have the resources to regulate the FX market as well? If they’re struggling to keep up with the current workload without FX, how does adding FX to their coverage help anyone aside from stretching existing resources further?

For the time being, the two biggest selling points of a global regulatory regime in the FX market is that this would curb FX manipulation amongst the largest market players and protect smaller investors using retail brokers to speculate on the FX market.
But would additional regulation be able to achieve that?

— Part 2 —

In the second part of our article looking at FX regulation, we analyze the current status of global FX market regulation and what the implications are for various market participants.

Top-tier banks have demonstrated an insatiable urge to circumvent legislation and anti-competitive safeguards including regulatory oversight in a variety of ways, including manipulating prices in most major asset classes.

The assumption that additional regulation in the form of a ‘co-ordinated global FX policy’ will therefore stop collusion amongst the largest FX market participants is probably wishful thinking.

The ‘MiFID II’ directives introduced in 2011 and updated in April this year attempt to deal with OTC markets, but there is no specific mention of spot FX. In any case, MiFID II is more so about aligning organizational requirements rather than policing the FX market.

The European Market Infrastructure Regulation (EMIR) is another scheme designed to standardize reporting and clearing in the FX market. However, both MiFID and EMIR focus on larger firms, which means smaller firms can continue offering trading services without being fully compliant with the new regulations.

Unless an authority of some description stipulates that all FX brokers must meet EMIR/MiFID standards or be prevented from operating, the new rules will only add a layer of bureaucracy, fail to necessarily stop collusion, not necessarily make the FX market more transparent and not necessarily protect retail customers. The only likely effect is tougher conditions for smaller brokers to obtain a perceived ‘stamp of authenticity’ and encourage consolidation within the FX industry.

Undesired Effects

Global regulation of the FX market could reduce the 80% market share top-tier banks hold in terms of FX volumes, but fundamentally, those that transact the most FX business (banks) will always have an opportunity to ‘fix’ benchmark prices from which other financial instruments are derived because they are the de-facto market makers. Regulation cannot stop market abuse but only redistribute its source.

The LIBOR, ISDAfix and FX (amongst many other) manipulation cases demonstrate that given enough market share, large firms tend to form cartels and ‘oligopolise’ amongst themselves, because this reduces operational costs, raises revenues and keeps barriers to market entry high for new participants.

The root of the problem is incentives rather than opportunity i.e. regulation will never take away people’s ability to cheat, it may only take away the incentive to do so. 

Given the lack of criminal proceedings relating to any given market abuse inquiry, it seems the incentive not to manipulate a particular market is outweighed by the incentive to do so – this would explain why almost all asset classes have experienced multiple cases of market manipulation emanating from banks. If the only penalties are relatively small fines and individual bans, banks are more inclined to continue manipulative practices seeing as the rewards are incredibly lucrative.

Forex Magnates’ research shows the Financial Conduct Authority (FCA) is close to a financial settlement with several banks, including Barclays, Citigroup, JPMorgan Chase, UBS, RBS and HSBC regarding FX market manipulation – the settlement could set a precedent for other regulatory authorities to follow and would underline the toothless nature of regulatory regimes around the world. Asking for the same regulatory structure to on-board FX into its scope is a recipe for disaster.

Banking Union

The Banking Union project was launched in 2012, with legislative proposals for the creation of a Single Supervisory Mechanism (SSM).

Political agreement on the establishment of the SSM was reached in early 2013 and the legislative text was formally adopted by the European Council and the European Parliament later in the year. The new SSM system is due to enter into force in early November 2014, unless the ECB requests that the entry into operation be further delayed.

EU Banking Union Intentions | Source: EU Commission

The new supervisory system will initially apply to the 17 Eurozone countries and all other EU countries have the possibility to join the system if they wish to do so. The ECB will be entrusted with direct supervision over ‘significant’ institutions within the Eurozone and the SSM system will comprise of the ECB and national supervisory authorities.

Earlier this year, European legislators established the Single Resolution Mechanism (SRM) which will activate on January 1st, 2015, and Single Resolution Fund (SRF) due to start operations in 2016, with an 8-year build up period.
Jean-Claude Juncker, EU Commission President

Plans for a banking union in Europe are going ahead on schedule as evidenced by the recent EU Commission restructuring being led by Jean-Claude Juncker, a staunch federalist who is very likely to support any plans that centralize decision-making. If a banking union goes ahead, regulation over the whole of Europe will fall under one regulatory agency and could potentially pave the way for a single currency, as first thought by John Maynard Keynes when he proposed such plans at Bretton Woods in 1944.

Times have changed but love of Keynesian motifs has not. Judging by the gravitation towards Keynesian policy by all major economies in the G20 and their respective central banks, we may see a fresh attempt to introduce a Clearing Union backed by a single currency in the foreseeable future.


Different depths and scopes of regulation around the world hamper standardization. Having a single global regulator for a market that has multiple national jurisdictions is difficult enough, but when nations have different sized markets and also have different legislation in terms of how various financial instruments apply to different entities, this means that global FX regulation is likely to be undermined by national legislation and jurisdictional wrangles for years into the future.

One clear example of this is the self-regulatory model of financial regulation. Some countries may not be suitable for self-regulation because of specific factors such as high corruption rates or incompatible political stance of the ruling government. Therefore, a self-regulatory model cannot apply to all regions. Also, countries differ on how they see and define various financial market entities such as SPVs, holding companies, trading venues and brokerages. Having the same definitions across the globe require all financial markets to be similarly matched in terms of sophistication – but that is simply not the case.

The Timeline

First and foremost, most market participants want to see the outcome of FX market manipulation inquiries ongoing around the globe. If referring to past cases of market manipulation, rather speedy settlements are likely to be reached.

The G20 Summit in Brisbane scheduled for November 15th-16th, 2014, could provide developments, but any specific FX market legislation or re-classification is only likely to take place after lengthy consultations and other factors play out.

Over the next few years, if regulators attract the attention of politicians building momentum for an election push, there may well be wholesale changes as to how financial markets and their specific ‘asset classes’ are regulated.

The Here and Now

Mifid II is expected to be implemented next year and a European Banking Union is earmarked for 2015/2016 – subject to market developments of course. Regulators continue to struggle to even define their jurisdiction/scope while market participants invent ever more ingenious ways to become undefinable.

Does the benefit of becoming OTFs or MTFs under Mifid II (higher trust level, higher volume) outweigh the higher costs (higher capital requirement)? For the time being, some brokers with enough order flow to afford Mifid II, will go ahead and implement the necessary requirements and possibly become better run businesses as a result. However, brokers who are starting up or operating on a relatively smaller size, simply cannot afford to implement costly solutions to problems they don’t have.

Mifid II, EMIR and their own respective national rules make global financial market regulation a patchwork at best. Making the whole exercise more difficult is the technology factor that allows business to be conducted remotely and with no geographical restrictions.
The FX market has enough trouble regulating itself on a national level. 

For the FX market to be globally regulated is simply unfathomable at this stage. In the meantime, central banks such as the Bank of England and ECB are taking an increasingly influential role in supervising financial markets with special powers to intervene or assist significant institutions – the same institutions that happen to be the largest providers and intermediaries of FX liquidity. The role played by central banks is often underestimated when it comes to regulatory matters, but that could all change as their market influence grows.

Worst Case Scenario

If markets falter and financial firms go on the brink again, this time bailouts will probably not suffice simply because central bank balance sheets are overblown and this time its sovereign nations will need bailing out, not just banks. 

A repeat of the financial market turbulence first seen in 2008 would be a lot harder to mitigate and more expensive. 

In financial markets’ history, the most influential and market impacting legislation tends to be implemented in the midst of an emergency or following a significant market event that shocks market participants into a state of emergency.

It may just require something of that magnitude for global regulation of the FX market to even be attempted, let alone become a reality.

First published by Finance Magnates
Written by George Tchetvertakov