Foreign exchange debate part one: The illusion of normality?
Foreign exchange debate: Learn more about the panelists
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Executive summary
• The FX market is one of the great successes of the crisis
• Settlement risk, not counterparty risk, is the key issue and CCPs do not solve it
• More users should and will migrate to CLS
• There will be more ECNs and the market will be better for it
• Structured derivatives, while still valid, have become less popular |
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Simon Brady, Euromoney Clearly in this post-crisis world, there is much talk of regulating the OTC markets. Where are we in this process as regards FX and what needs to be done?
HE, UBS It’s a hot topic. The FX industry has been involved in detailed discussions on this both under the auspices of the Bank of England FX Joint Standing Committee and in many other forums.
In 2008 we had the Icelandic crisis, we had banks failing, and many of us were personally having to manage counterparty risk on a day-to-day basis. This was a reminder of the core of the FX business, which is transferring very large amounts of money around the world and making sure both sides of the transaction settle. Yes, credit risk is important, but the most critical part of counterparty risk in FX is settlement risk – the exchange of principal on the day of settlement. If the counterparty fails before the day of settlement, you lose your mark-to-market P&L; however losing the entire face value of a trade due to a settlement failure is a completely different order of magnitude. FX settlement risk was one of the biggest systemic risks in the financial markets, which is why we all implemented CLS. And the system worked.
Settlement risk is key
The recent regulatory focus has been upon credit risk, which is what central counterparties (CCPs) address, not settlement risk. Our message, collectively as a market, is that CCPs do take care of some risks but that there is a danger that they distract us from the much more important job addressing the remaining significant settlement risk in the FX market. This is where the regulators should focus in FX.
JWC, Record I agree. Speaking from the buy side, we are big fans and users of CLS and big users of netting agreements as you would expect. Clearly we would like to reduce residual mark-to-market credit risk through a CCP but only if we can do that without affecting spreads or liquidity or crucially the kind of flexibility that one gets in forwards on maturity date and size and so on.
SF, Threadneedle The key point is that the FX market survived. There was no major central bank intervention during that period that I am aware of to stabilize the market. That is a testament of the market’s strength.
FJ, SG Remember, we are not talking about the financial industry having to bear the cost. The people who will bear the cost of CCPs are the end users. When the regulator says, "I want a solution that minimizes risk", then we need to take into account the price – what the community and the economy is going to pay for these solutions. If regulators want a blanket solution for any type of OTC derivatives then they have to accept that such a solution will affect spreads and liquidity, and users will pay for that. These increases in costs feed through to affect trade, jobs, prices and so on. One has to consider the balance of risks and costs for the whole community.
MW, Credit Suisse CLS is a great thing. Thanks to CLS we survived the crisis and thanks to CLS the FX industry was and is able to grow; without CLS today’s daily turnover would be impossible. However, only about 50% of daily global turnover is settled through CLS; what about the other 50%? That is where the effort should be made: to make more currencies CLS eligible, to have more banks becoming clearing members or third-party clearing members and so on. The single most important thing to do to reduce risks in the FX market is to make that 50% into 80%. That is the goal we should jointly work towards.
DB, Deutsche The crisis would have been a lot worse if the banks had stopped doing FX with each other. A lot of people used FX to fund over the period of the Lehman bankruptcy. Without CLS the crisis would have been a lot, lot worse.
Instantaneous settlement?
RO, Oanda Just to be provocative, CLS is just a halfway house and doesn’t really address the issue. If we think about it, the current way of settling precludes interest rates being paid at a shorter interval than overnight. The big issue is that to halt a currency in free fall one has to hike interest rates – one-day interest rates. If we had instantaneous settlement then it would be possible to hike the second-by-second interest rate and you could get markets to clear straightaway. What we have to remember is that almost 95% of the volume is intra-day. No-one pays interest because there is no instantaneous settlement. My proposal is let’s go for instantaneous settlement, with second-by-second interest rates.
HE, UBS The consequence of that is that we would also need second-by-second cash management capability.
DB, DeutscheAnd we need the banks to be open, because there are some banks that can’t pay non-US dollar amounts on US public holidays.
RO, Oanda Yes, but the currency market is, if anything, a public service. The whole world depends on it and we cannot, because of a few hundred million dollars that have to be spent on IT technology, say we will not do it.
SB, Euromoney It is a bit utopian.
HE, UBS It sounds utopian, but it is true. FX is different from other OTC markets, like the interest-rate markets and the credit default swap (CDS) markets, because so much flow goes through the FX market, which is fundamental to the economic working of the planet. If you look at some of the other markets like interest rate swaps (IRS), it is basically a discussion among 40 or 50 people across all the institutions. The FX market has hundreds of thousands of people who use the market day after day after day. If that breaks, everything breaks. From that perspective FX market efficiency is fundamental to the entire financial system.
