Currency derivatives netted

By Jennifer Hughes

Published: November 19 2009 19:37 | Last updated: November 19 2009 19:37

If it didn’t break, why fix it?

That is the question being asked by foreign exchange bankers after Barney Frank, chairman of the House Financial Services committee, announced currency derivatives would not, after all, get an exemption from proposed US rules that would require all derivatives trades to be processed through a centralised clearing system.

Mr Frank’s move came as policymakers are debating the detail of legislative proposals designed to increase transparency and reduce risk in the vast over-the-counter derivatives market. While the proposals are not final, the U-turn on his previous stance has stunned the FX market.

Bankers have been lobbying hard to steer lawmakers away from forcing currency swaps and forwards on to clearing platforms. They fear it will introduce new systemic risk into the financial system and impose heavy costs on companies that trade internationally. Some fear it could drive currency trading offshore.

At the heart of the unease is the fact that currencies are a vital artery in the global financial system in a way that no other market can lay claim to. The $3,200bn-a-day FX market, which trades across borders and around the clock, is essentially the global payments system.

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The purpose of trading includes investment bets and speculation, but also encompasses everyday cross-border business transactions from acquisitions to selling products and covering overseas payrolls.

Swaps and forward contracts dwarf the spot market (which is not covered by the proposals) and are used daily by companies and investors to protect themselves in the period between agreeing a deal and delivering the payment.

“Even if we closed down all the speculation, there still needs to be transactions for corporates, institutional investors and individuals just to do their daily tasks,” said one senior UK-based FX banker.

There is a further resentment: the FX market did not actually seize up during the financial crisis. “We’ve created a system that works. Why are you doing this?”, asked another senior dealer.

But a group of regulators and lawmakers has argued there should be no exceptions to the plans to clear all derivative trades, for fear that bankers will exploit any loophole by creating new instruments to protect their lucrative trading franchises.

The US moves are a shock to the FX market because while it is used to dealing with sudden obstacles – such as the capital controls introduced by Brazil last month – it has faced little in the way of regulatory hurdles.

Its cross-border nature means most changes have come about through a network of industry-led committees convened by various central banks, led by the Bank of England and the Federal Reserve Bank of New York.

It was persistent pressure from the central banks that led the industry to create Continuous Linked Settlement, the multilateral system regulated by the Federal Reserve, through which banks settle hundreds of billions worth of transactions each day.

Settlement risk – the danger one bank pays out but does not get the goods in return – is particularly acute in the FX industry because of the likelihood that the trade is settled in two different time zones, exposing the counterparties to extra risk

This danger is considered far bigger than the credit risk that a clearer would cover because the vast majority of swaps and forwards are short-term in nature, lasting usually less than a month.

In fact, the market developed a central clearing model in the 1990s, but abandoned it because of a lack of demand. Instead, it focused on developing CLS.

Bankers have also warned that clearing in FX could create new concentration dangers which they fear could create fresh systemic risk, given the size and significance of the FX market. The market is already concentrated among a handful of top international banks.

If all participants – from banks to companies – dealt directly with a clearing house, clearers would be taking on potentially enormous financial risk because of the sheer size of the market. If a hub-and-spoke system was introduced – where banks’ clients dealt with the clearer though the bank – the risk would be still concentrated in the clearer and a group of very large banks, meaning little had changed.

This is not a point that clearers accept at all. Roger Liddell, chief executive of LCH.Clearnet, said: “It’s just not true. There are two issues. One of them – is it really that concentrated? And the other – is the risk that horrendous that we should be frightened of it? Concentrating all the risk in one place actually takes a huge amount of risk out of the system because each of the participants in the market would have a single counterparty for all of their interbank trading.”

Barbara Matthews, managing director of BCM International Regulatory Analytics, believes there is a general issue to be considered about concentrating so many markets on to clearing platforms. She warned that policymakers must be aware that clearing houses could create new “choke points” in the system – not unlike the risk created now by any large bank – which must be considered carefully. “Its perfectly natural in a time of uncertainty to look towards some kind of central arrangement,” she said. “But I’m hearing people say it eliminates risk and that’s not true – it just transforms it. If the idea is that risk will be gone, then some people are in for a nasty surprise.”

One currency market participant was more blunt: “If a clearer in FX goes bang, it could bring down the entire market.”

Additional reporting by Jeremy Grant

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It’s not easy running a stock exchange these days, especially if you’re TMX Group Inc. The list of challenges facing the owner of the TSX and the Montreal Exchange just keeps getting longer. There’s changing technology, consolidation, and perhaps most worrisome, competition from upstarts like Alpha Trading Systems, a bank-owned market that since going live a year ago has managed to grab more than 15% of total equity transaction volume in Canada. So here’s the question: Are the good times over, or is this merely a bump on the road to a rosy future?

THE BULL

BRENDAN CALDWELL,

chief executive of Caldwell Investment Management Ltd.

When it comes to exchanges in general and TMX Group in particular, Mr. Caldwell is a glass half full kind of guy.

“You have to understand that the TSX has been dealing with competition, massively larger than Alpha would ever dream of being, for many years,” says Mr. Caldwell, whose firm made a fortune owning shares in stock markets around the world and still owns 0.04% of TMX.

“Virtually every one of Toronto’s major stocks is listed somewhere else, either on Nasdaq or the New York Stock Exchange or London.”

What investors need to understand, he argues, is that stock markets are proxies for a nation’s economy. If you believe that a country will do well, the best way to make that bet is to buy shares in the leading bourse.

“Seven years ago when Toronto went public, you didn’t have to know oil was going to $150 or that gold was going to $1000, or that these little BlackBerry devices were going to be world beaters,” he says. “All you had to do is believe something was going to go well in Canada.

“So too, over the next number of years if you believe that Canada, which seems to be beating the socks off every country in the western world, if you believe that story is going to continue, then the TMX is a wonderful way to play that.”

Looking at the numbers, TMX is hard to beat, with a return on equity of over 20%. Though the shares have slipped to the low end of their five-year range, it has exposure to what Mr. Caldwell calls “the fastest growing area of the U.S. securities market” through its majority ownership stake in the Boston Options Exchange.

Tom Kloet, the chief executive, is another important factor. “This man knows exchanges inside and out,” Mr. Caldwell says, noting that before coming to Canada Mr. Kloet helped transform the Singapore Exchange into a global powerhouse and then took it public.

It might be that Alpha and the other so-called alternative trading systems do cut into the TSX’s market share, but the overall market size is growing rapidly as institutions adopt sophisticated new trading strategies that dramatically increase transaction volume, so at the end of the day that really doesn’t matter.

“Either way, you’re looking at a business that’s going to do well,” he said.

THE BEAR

JOHN STEPHENSON,

portfolio manager, First Asset Funds Inc.

“There’s no question the glory days of the TMX are over,” says Mr. Stephenson, whose Toronto-based firm has about $1-billion under management.

With the door on competition flung open by Alpha and other alternative trading systems, the TSX is fighting declining revenue and shrinking profit margins. And with increasing globalization of markets, all of TMX’s bourses are up against competition from global exchanges in the United States, Europe and Asia to greater degree than ever before.

“Global competition for investment dollars is massive,” says Mr. Stephenson.

“Even players like the New York Stock Exchange, which is far bigger and better established and capitalized, are under threat of takeover.”

The new entrants on TMX’s home turf are just the latest challenge for TMX. But on top of that is the growing demand among institutional investors for privacy.

“A lot of institutions want to trade off the public exchange. Large organizations like Fidelity, they just don’t want their trades being out there with everyone knowing what they’re doing. So you have the rise of so-called dark pools which are privately run exchanges. All of that creates problems for conventional exchanges.”

Before the credit crunch many analysts pointed to the Montreal Exchange and its derivatives market as the future growth driver for the company since derivative trading was exploding and the MX was really the only game in Canada.

But MX volumes plummeted in the crisis and despite the rebound in equity markets, activity on the MX remains anemic.

“The Montreal Exchange is a positive but really as a total it’s small. It’s good they bought it but it’s not a game changer,” he says.

The basic problem is that while Canada wants to be at the forefront of the securities industry, it’s a small player in the scheme of things and ultimately it’s difficult to see how markets here can survive independently.

The good news is that there will always be a need for public stock markets,” says Mr. Stephenson. “But the heady days are over. It’s not a disaster. It’s not a train wreck, but it’s a slow decline.”

jgreenwood@nationalpost.com

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