Perspectives on 2014: James Kemp, global FX division

In its first three years of operations, the global foreign exchange division (GFXD) of the Global Financial Markets Association has undergone a subtle shift. Established by the largest FX banks in 2010, the division's initial focus was mainly on lobbying policy-makers globally for the exemption of certain FX products from new regulations. Over the past year, while lobbying has remained necessary, the GFXD has begun to zero in on implementation, particularly of new rules on trade reporting and swap execution facilities (Sefs) under the US Dodd-Frank Act.

In 2014, the focus is likely to shift again to what looks likely to be a particularly challenging rollout of mandatory trade reporting under the European Market Infrastructure Regulation, starting on February 12. European reporting rules are more complicated than US rules for a number of well-documented reasons. But an additional concern is that, while the Commodity Futures Trading Commission (CFTC) has become accustomed to trotting out ‘no-action relief letters' this year to give dealers and clients some breathing space when deadlines prove too tight, there may not be an equivalent mechanism in Europe.

"Part of our job with the regulators is to point out some of the challenges people are having. Yes, the date is February 12, but what level of compliance are they looking at? Do they expect all the big dealers to be reporting on day one? What about all the corporates? I imagine they'd like to see compliance, but I also know they're very aware of the challenges," says James Kemp, managing director of the GFXD in London.

While the GFXD's role is to deal with the challenges that arise from regulation, few could have foreseen the scale of confusion and market disruption that resulted from the launch of Sefs on October 2. The now-infamous Footnote 88 in the final Sef rules, published by the CFTC in May, meant that multibank platforms trading FX options and non-deliverable forwards (NDFs) were required to register as Sefs despite no clearing or Sef-trading mandate being in place. The chaotic introduction of Sefs led to a reported decline in liquidity in some products, particularly NDFs, during the early days.

"When liquidity is reduced or low, the real challenge comes if you get a market disruption event, like a shock in an emerging market currency. Can a shallower market absorb that risk adjustment? We know that the deeper the liquidity pool, the greater its ability to absorb risk. But if you need to get out of a position, would you be able to now? I would think shallow regional markets such as NDFs would struggle in the current liquidity split," says Kemp.

Despite issuing several no-action reliefs for certain challenging elements of the Sef rules, the CFTC allowed one critical exemption for trade confirmations to expire last month without issuing further relief or guidance. This leaves Sefs in a tricky position when issuing confirmations, but Kemp believes the issues should be ironed out once NDFs are legally made available to trade on Sefs.

"The challenge with confirms at present in the Sef environment is that some of these terms are bilaterally agreed between counterparties. Once in a mandated clearing model, you'll then potentially have standard terms and conditions that you're working to. But we expect clearing mandates to come out on a per-currency basis, so you might have one NDF currency pair moving into clearing and others not, meaning it's not a complete solution," he explains.

Mandatory NDF clearing under Dodd-Frank is expected to begin sometime next year and, given voluntary clearing is already under way through several central counterparties (CCPs), the market is not expecting significant complications.

But moving towards central clearing of FX options has proven far more complicated, and the GFXD published a major report last month, concluding almost two years of work to size the same-day liquidity shortfall that would face a CCP if two of its largest members defaulted. Having shown the shortfall could be as high as $161 billion, it is now up to the industry and CCPs to determine the most appropriate solution.

"What the CCP model for deliverable FX becomes is the most important thing right now. While important, the requirements on any other participants, be it CLS or others, are a secondary thought. A model first has to be formulated that would function and be acceptable to supervisors, and then you can look at what the industry would need to make it work. I would expect to see some emerging models around this next year. There aren't any official deadlines, but in 2015 there is implementation of initial margin requirements, so that might set some sort of deadline for the industry," says Kemp.

Another area of concern is the impact of the European Union's proposed financial transaction tax (FTT) on the FX market, which would inevitably increase transaction costs for end users and, Kemp believes, deter some corporates from hedging their FX exposure.

"The FTT is still a significant concern for us as an industry," he says. "If regulators brought in the tax on FX products, it would be detrimental to trade and investing. Because existing transaction costs in FX are so low, the increase in transaction costs caused by the proposed tax are significant – 400–700% for corporates, and up to 4,500% for investors. The concern is if people stop hedging, that introduces more risk and costs into their business or into the funds they manage – that cannot be good news."