The 2017 Profit & Loss Crystal Ball

Colin Lambert has retrieved the trusty Profit & Loss Crystal Ball from the dark recesses of the office, given it a wipe, and peered into the future to produce 10 predictions for 2017.

There is little doubt that as an industry foreign exchange is a more optimistic place than it was just 12 months ago – and hopefully the majority of themes in this year’s Crystal Ball reflect a more upbeat message.

Yes, the coming year will not be without the challenges of legal battles that have dogged the industry for the past three years, but if nothing else the shock factor has worn off and most people see what is happening as the continuation of a long process. This will help the FX industry present a more positive image through innovative ideas and – fingers crossed – more positive performance.

The geopolitical environment and macroeconomic outlooks are certainly likely to provide plenty of fuel for FX markets and the challenges these represent also offer opportunities.

On the subject of opportunities, we have again included the managing editor’s Trade of the Year – sadly last year only served to represent an opportunity for ridicule, but in the spirit of greater optimism this year’s trade will be a belter!

So, with the express hope that he won’t be called out on them in September at Forex Network Chicago [he will], here are Colin Lambert’s 10 predictions for 2017.

A Turn in the Right Direction

The issue of clearing in FX has been a long drawn out debate – one that has not, quite frankly, been solved to any degree.

Yes, we have mandated clearing of NDFs, but that product set represents a mere 3% of turnover and while the regulators may want to spin that as a ‘win’, it has done little to make the world a safer place.

The other FX product in the spotlight has, of course, been FX options, but Profit & Loss continues to be told privately that clearing of FX options is highly unlikely – and that is by far the most positive spin.

So we have a situation whereby clearing of FX products remains a minor sideshow – that is likely to change, and in a big way, in 2017.

If we step away from the conduct trauma of the past few years the biggest issue facing banks’ financial markets businesses – including FX – is capital charges. The Basel regime is playing a big role – bigger than its creators desired we suspect – in supressing market liquidity.

Without doubt, as we shall get to, there are liquidity issues in spot, but they are nothing compared to those likely to face FX swaps businesses. The cost of trading will soar and spreads to end users – the people the regulations are meant to be protecting of course – will widen. This is not a good outcome and represents yet another example of the law of unintended consequences – this time with customers paying for a “safer” financial system rather than the banks.

A lot of this angst can be taken out of the market with clearing of FX swaps, which is why this is my number one prediction for 2017. In what may turn out to be an ironic and salutary lesson to those in regulatory circles who would be over-prescriptive, a non-mandated product is likely to be the next big thing in clearing.

These predictions rarely – if ever – specify individual providers (competition is a wonderful thing after all), but on this occasion we will highlight LCH’s efforts to launch G10 NDFs in Q1. By providing the mechanism for banks (for the FX swaps market remains about banks at the moment at least) to clear trades, the capital burden is immediately eased.

To stress how big this could be, take a look at the BIS preliminary FX turnover data from April 2016 where 93% ofFX swap turnover was between Reporting Dealers or between this group and Other Financial Institutions. The vast majority of these two groups do not need delivery and have easy access to clearing through existing links.

Even if the impact is only felt among Reporting Dealers we are still talking about 50% of FX swap turnover and almost 25% of all FX business.

So while there may be some who look askance at clearing of FX products, seeing it as a path to an exchange-traded market, the business case would seem overwhelming. And, of course, clearing can stand alone. Yes, the exchanges that own various clearing houses want to drive business in both directions, but that does not stop other venues getting involved.

Voice broking desks, for example, have yet to really feel the pressure in terms of FX swaps market contraction and one way to potentially avert the inflow of electronic venues into this market could be to link up with a clearing house to give trades up as they are executed between certain counterparties.

Throw in the benefits of trade compression and for capital reasons alone the argument for clearing FX swaps seems unarguable. It may not have been the direction people thought it would go, but the groundswell of support suggests clearers are better off turning to FX swaps at the expense of FX options.

Where is it?

Possibly the most often asked question of 2016 in foreign exchange circles was “where’s the market?” It was certainly an event-driven world and things were not helped by the somewhat unexpected outcomes. Generally speaking, however, the foreign exchange markets handled the events well and customers were able to get a price (it may not have been pretty at times, but it was a price) in good time.

Looking ahead to 2017, I suspect that a lot of people will be reading up on the electoral processes of France, Germany, Netherlands and, possibly, Italy, as the first three at least face general elections.

Again, most expect the market to handle the actual events well, however there remain fears of sharp market moves at other times. There was some surprise in certain circles over the lack of market reaction to the often outrageous statements made by US president-elect Donald Trump during the presidential campaign, but to a degree any reaction was dampened by the majority view that he had no chance of winning!

Financial markets are not going to be fooled twice, though, and this leaves them vulnerable to shock statements from politicians seeking office, whose pronouncements just months ago, we would have ignored. Can the market afford to ignore a comment from a far-right European candidate? Recent history will suggest not.

Throw in the uncertainty over the market structure and the impact of regulation and we have conditions ripe for flash moves – and we think we will see more of them in 2017, although they may not be as extreme as Cable’s rampage on October 7, 2016.

Another ingredient helping to drive flash moves is the lifting of the veil around liquidity. When markets aren’t moving aggressively there are countless market makers happy to quote and make a turn. When things start moving they stand in for so long, but have the unfortunate habit of all stepping out around the same time (normally because they are all using the same analytics).

Attracting resting orders and non-directional flow are two ways to help alleviate these liquidity gaps, as is taking a decision that it has moved too far and stepping in with a bid or offer that may slow or halt the move. All of these could be seen as “genuine liquidity” and pretty much all are rare in today’s market.

There is likely to be quite a debate over what “genuine liquidity” actually means and it will involve one of the great bugbears of P&L’s managing editor – last look.

As a concept, last look is not going away – that has been made clear by those responsible for developing the Global Code of Conduct – but it is to be hoped that the bare minimum demanded by the Code is total transparency over how last look is used.

A good starting point for measuring “genuine liquidity” could be to start with removing all pricing that is subject to last look.

This is not a panacea because price cancellations are just as prevalent in a no-last look environment, but it could possibly help people understand market dynamics.

Is this debate likely to be resolved in 2017?

Absolutely not, which is why we will continue to see flash moves and liquidity gaps.

Incentivise Me

On the subject of unblocking markets, May will see the complete Global Code of Conduct unveiled, something that many hope will help free participants up by taking away grey areas around conduct.

While there is no doubt that the Code of Conduct is a vitally important piece of work, the implementation and enforcement of its principles is much more important – and that is where the quandary lies.

Senior management within institutions have already pointed out that their own conduct rules are much stricter than the Code’s and several seem to be struggling with the challenge of backing the Code whilst at the same time not being seen to dilute their own institution’s values.

One of the easier aspects of the final Code will be adoption – some framework for attestation will be put in place and people can sign up. The challenge is what gets done if (sadly this should probably say “when”) someone transgresses? This will be a topic of debate throughout the year and several ideas are likely to be discussed before the industry naturally gyrates towards one.

The general idea that is likely to find most favour – and into the bargain represent a serious deterrent to would be miscreants – is for some sort of register of offenders, or at the very least for firms that have had to dismiss or discipline employees for breaches of the Code to be mandated to have to reveal that fact in references.

Another serious challenge for the Code will be overcoming the fear factor that permeates too many foreign exchange businesses. Repeatedly over the past 12 months we have heard the question, “What’s my upside? Where’s the incentive for me to take this risk?” from senior dealers in both the ‘e’ and voice space and this mindset is helping to perpetuate flash moves.

It is a valid question on the part of an employee. If they are to take risk in the markets by making prices, what’s in it for them? Where is their risk/reward? Heavily biased in favour of risk sadly. Make money in a market event? You stand accused of exploiting clients. Lose money in a market event? You stand accused of being incompetent for not knowing something was going to happen.

Senior management, especially within the banks, needs to understand that by maintaining this atmosphere of fear they are not only letting their staff down, but also their clients, who are getting worse service because staffers are handcuffed.

The hope is then, that the Code of Conduct removes at least a healthy degree of this fear factor. Sadly – and this is a rare period of gloom in what is generally an upbeat set of predictions – we don’t see many banks’ management being brave enough or strong enough to free their staff up.

Most people know how big the stick is that they will be beaten with if they step out of line thanks to the Code – what we need now is a set of incentives for those people that actually behave, do the right thing, look after their customers, and innovate.

It’s All About the Food

Life is full of challenges and the foreign exchange industry is no different. In recent years we have seen the banking industry squeezed by a combination of regulation and competition – the latter from the burgeoning non-bank market making sector.

The result of this competition has been twofold. On one hand the major banks have become much better at quoting (which is good), more efficient (which is also good), and much quicker at offloading risk (which is bad).

The easy prediction to make here would be that the line between banks and non-banks in FX will blur to the point of invisibility, however in reality that has already happened. Both segments quote in a similar ways, face the same challenges, manage risk in similar fashions and are inter-dependent to a large degree.

So I am shying away from that and instead suggesting that the ranks of the non-bank players will thin out very much as they have in the banking industry. There will be players who are committed to FX and remain with it, there are others who will reduce their commitment and may even pull out.

Why will they do this? Simply put – competition. This may not come from the banks – although we suspect that one or two bigger players will find a way to put the squeeze on some smaller non-bank market makers – but more likely it will come from within the non-bank segment’s own ranks.

Years ago, FXMarketSpace was famously referred to as a “shark tank” because it was viewed as a playground for high frequency, fast traders. Today’s broader FX market has a “shark tank” feel to it in spite of the push to balance the playing field and neuter the advantages of speed.

In the real world, multiple sharks exist in tanks because they are adequately fed. In foreign exchange terms, the food supply is drying up. The really valuable business remains out of the reach of the non-bank segments, which leaves a large number chasing scraps – and there isn’t enough to go round.

One look at the financials from a firm like Virtu Financial shows the extent of the potential problem. There were events in 2016 and generally the FX market seemed busier than 2015,but year-on-year revenues in the first three quarters were lower.

Why? Partly because volumes were down – and again this comes back to the amount of “food” on offer, but also because competition from rival firms – XTX Markets springs to mind – started to impact.

The non-bank segment is not about being a first mover, it is about being smarter, quicker and nimble. Just because you were good last year does not mean this year, or the next, will be as good.

In some respects, the non-bank segment has permeated the FX market almost as far as it can – from here there is nothing but fiercely protected and valuable end user business that is likely to remain with banks, and the more toxic flow from large, smart players (the type of flow no market maker wants to see, but some banks have to).

As the food on the table becomes scarce, naturally the nonbank firms will turn on each other and start to eat each others’ lunch. This means the survival of the fittest, which in this case means a blend of strong models, the right balance in terms of a firm’s profile (being too big can become an issue), and effective control on costs.

Sound familiar? It should because countless banks have gone through the same process over the past three years, which only goes to highlight how similar the two supposedly combative segments are.

Empire Builders

Given how slow such things develop in this industry, this next prediction comes with the rider “could take several years”, indeed it may well be reprinted, word for word, in next year’s Crystal Ball feature.

Notwithstanding that, everything has to start somewhere and we suspect 2017 will see the start of a structural shift in the platform world which could end up in a flurry of deals and a very siloed structure.

This shift may have already started with the purchases of Hotspot by Bats and 360T by Deutsche Borse, but we suspect it will really get into its stride over the next 12-24 months.

The catalyst could be Nex Group, the offspring of the TullettIcap hybrid brokerage and information services deal, which closed at the end of 2016. Nex is, by any measure, an attractive proposition for an exchange/clearing group.

From EBS, in its many forms, and Brokertec, providing trade flow and data, through Traiana’s connectivity, to TriOptima which can be bolted onto the end of the clearing house, this group has a lot going for it in the eyes of an exchange.

Perhaps a year ago this would not have been a problem for the exchanges – there would have been a battle for the group, won by the highest bidder (unless Nex Group can, and wants to, withstand the pressure), and the loser would have gone away to lick their wounds and hope (secretly probably) that they had undermined their rival by making them pay too much.

Now the situation is different, which is why we could have a rush of deals. It is hard to think of a platform that isn’t for sale. Excluding Hotspot and 360T as recent deals, one hears rumours on just about everyone else almost on a weekly basis.

Currenex, FastMatch, FXall, GTX, Nex Group are all frequent headliners on the rumour mill with even Thomson Reuters’ trading businesses making an occasional appearance.

So how does this play out? Well if there is indeed going to be a play for Nex it will likely be between CME Group, long rumoured to want an OTC venue; ICE, a fierce rival never above making a big splash; and Nasdaq, the current favourite given recent hires at the firm and its repeated – and so far futile – attempts to build a foreign exchange franchise.

If we accept that FX markets are not going to support multiple futures models and that OTC will remain king, three into one does not go and therefore two losing competitors are going to look elsewhere. And unlike a short while ago, there seems to be rich pickings.

This means that in two years’ time we could be looking at three or four siloes in foreign exchange – each with an exchange/clearing group at the top and one, maybe two OTC venues below it. How it plays out is harder to predict, but play out it most probably will.

Dark Will Win…Or Will it?

The quietest success story of the past couple of years in the foreign exchange platform industry has probably been BGC’s MidFX. The firm is tight-lipped on how much it handles, and MidFX very much lives up to its description of a Dark Pool – it’s not even mentioned in the firm’s annual report.

Anecdotal evidence from banks, however, suggests things are going very well indeed and that if we want to look at where so much of the volume from the major platforms has gone, there is no better place to start.

Generally speaking, as with the exchanges and FX futures, it is hard to see the need for multiple models when it comes to a dark mid-book matching service, and the evidence to date is that BGC’s would-be rivals have largely fallen by the wayside and see minimal, if any, volume.

Two things could change this, however. Firstly, there is growing discontent among non-bank players that MidFX is only open to banks. This is, generally speaking, BGC keeping its core client base happy no doubt, but one senses that at some stage a rival will make their own offering all-to-all.

The second possible route for competition is actually where we expect it to emerge from – the forward FX swaps market.

For years the industry has struggled with the conundrum of how to transfer FX swaps – half of all average daily volume in FX lest we forget – to a fully electronic environment. The reason most often put forward for the success of the voice (at a push hybrid) model is the negotiating aspect of a trade.

Generally speaking, FX swaps are priced off other products which means they naturally come with a spread. Getting inside that spread is the job of the forward traders, helped, to a large degree, by the voice broker. This involves negotiation, cajoling and (this is very much tongue in cheek), threats.

Sad though it may seem, however, this remains an expensive and less than transparent way of doing business, which doesn’t sit well with the authorities in the current day and age. One solution could be for participants to use a dark mechanism where they input orders with a degree of discretion. If two discretionary orders meet, they trade – very simple.

Equally, traders could submit orders to be traded at midbook, although this will be less popular in the FX swaps market with the aforementioned wider spreads (which could get wider as interest rate differentials and volatility starts to bite).

There is a credit issue with this model, after all limits are precious in the forwards, but if, for example, a mid or dark model was connected to a clearing house (see prediction one in this feature), that could be taken out of the equation. The possibilities are limitless it would seem.

Back in the spot market we also suspect the mid-book mechanism will continue to grow in popularity as the focus on market impact, signalling risk and slippage continues to grow.

So much of this business is not about ticking the right boxes that a dark or mid-book mechanism fits very nicely into the new view of the world.

More….and Better?

Somehow market data has managed to creep its way into this feature – a first if ever there was one. This is a lucrative business in the current box-ticking and model-driven world and as such it is inevitable that the foreign exchange industry seeks to eke out a larger slice of the cake.

So much of what happens now seems to be about justification – you may not have done the best you could have, but at least you can prove you did it in the expected way.

Whether this makes things better is for another debate, but notwithstanding doubts over the rectitude of such an environment, data helps people go about their daily lives.

Which brings us to what will be one of the more interesting developments of 2017 – and we are confident that it will go ahead in spite of what seems to have been slower than expected progress – the Tape.

The brainchild of the people at FastMatch, the Tape has garnered enough support to make it a reality we are told and as such, will go live. But will it be any good? Clearly it will not be universal in terms of contributors, nor will it carry every transaction from those participating, which all suggests it’s something of a folly.

That suggestion would be wrong, however, for even if it is partial, it will still – in its consolidated form – offer a larger amount of data than is currently available to most users. As such, there is value in the Tape, which would also help inform better pricing.

This is not to say the data will be different to a lot of offerings already live, just that there will be more of it – and as we have found out repeatedly over the years in foreign exchange, size often wins.

If nothing else – and the relative providers will argue this is not the case of course – the Tape has helped drive other data providers to better, more frequent, distribution models. So if it does nothing else, the Tape will be the driver of what we confidently expect to be a better market data environment as 2017 progresses.

Equities is So 1990s

It seems that ever since the foreign exchange market started trading electronically, there has been a school of thought that the market structure is heading towards an equities model.

Indeed there remains a sizeable minority in FX who still see that as the end game and promote the totally transparent, all-to-all, equities model at every opportunity.

Chances are though, the FX industry will not see this model because it, and this is not a new argument, conveniently ignores the differences between the two markets, specifically, the people they serve. As long as the real economy needs foreign exchange, the market will not transfer to a totally transparent equities model.

Putting aside the need for delivery of cash to oil the wheels of global trade, or that “uninformed” (this is not an insult it just refers to their lack of care over the timing of the transaction) customers do not want their order to be free for all to see, there is the matter of speed.

Generally speaking, in the totally transparent model, speed rules – just look at the debate that has been taking place in equity markets for the past two years. Speed is clearly a problem for some – and they are, it seems, pretty influential.

So in 2017 we expect to see less of foreign exchange taking ideas and models from equity markets, rather we expect to see wider adoption of FX models in equity markets. A growing percentage of equities volume seems to be done in a “dark” or at least “opaque” environment, that is foreign exchange 101, and we are hearing more about the need for speed bumps – step forward Campbell Adams and the team at what is now ParFX for introducing that model in FX some years back.

That there are flaws in the equities model seems pretty clear given the heated debate in the US in particular over that market’s structural future. In 2017 I expect that debate to intensify – and into the bargain, the voices in the FX industry promoting that model to quieten down a little.

You Mean These Numbers Are Actually Telling Me Something?

We have already referred to the “box-ticking” environment in which we exist and one thing to emerge from this is greater demand for best execution.

What is actually being demanded – and provided – of course is actually just a run of data that “proves”, within the criteria required, that the executing party did the appropriate job.

I shall put aside the argument over whether this is “best” execution, that is best left to an op-ed, however there does seem to be a growing awareness that so much more can be done with the data provided. It is significant, I believe, that one of the higher profile start ups (sorry FinTechs!) that seemed to gain traction quicker than other fields, was that of BestX, which does exactly what is says on the tin – provide best execution analysis.

This satisfies the demand for independent verification of execution quality but it doesn’t, and shouldn’t, stop there. We see more and more customers seeking the tools to actually inform future executions using data from previous transactions.

The data is there and currently it is used to justify something (generally that the performance has been “average” it has to be said!) but it can, and will be, used for so much more.

What we are really talking about here is serious growth in pre-trade analytics from what remains a low base, but we think we are also talking about new strategies being built by, or for, customers, based upon previous experience.

Best execution should be about so much more than a box ticking exercise and in 2017 we are confident that it will be, driven by banks seeking to establish an “edge” over some of their competitors and also by independent analytical firms providing just that – independent verification and analysis.

It should be noted that in spite of the obvious demand for independent analytics, we most definitely do not see more demand for independent execution. The agency model will continue to struggle because quite simply it rarely, if ever, provides access to internalisation engines.

And if there is one thing that improves execution it is an internalisation model that sees less flow hit the street (lower signalling risk and therefore slippage) and often provides price improvement (incremental improvement in execution quality by not crossing the spread).

Best execution will be a bigger thing in 2017 mainly because it will be better informed, used more intelligently and do a whole lot more than justify a basic action.

And This Year’s Winner of Crufts is….

And so the moment that everyone (no, honestly) has been waiting for and the emotional rollercoaster of my Trade of the Year.

A chart of my performance thus far would offer a good replication of the Himalayas, flat is not an option when it comes to returns it seems.

It has been decided that to take some of the volatility of returns out of the equation (actually it’s because I keep getting destroyed by these currencies) I will avoid anything to do with the Scandies. The Norwegian and Swedish crowns are clearly only for the brave – actually foolhardy – as can be seen in last year’s effort (and that of 2014).

So with the old adage “buy dollars, wear diamonds” ringing in my head, this year’s trade will be…sell NZD/BRL. The market, such as it is in NZL/BRL, at time of writing, is trading at 2.4800 so that will do for my best execution policy.

The observant amongst you will have noticed that trade has nothing to do with the dollar (yes I know it probably does with correlations, but they’ve probably changed three times while I typed this line!) and there is a very good reason for that.

Firstly, it’s a bit obvious buying dollar-something and goes against the spirit of the Trade of the Year; but more importantly trading NZD/BRL means that if Julie Ros gets me up on stage later in 2017 and asks about my trade of the year,

I will once again be able to bluff my way through by claiming it’s a winner because, as was the case this year at Forex Network Chicago, no-one has the cross on their app and as such will not be able to shoot me down in flames. It’s all about the box-ticking!

Galen Stops

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