Invention is the mother of necessity. No you didn’t read that wrong, nor did I write it backwards. Historians would generally say that inventions of seemingly useless devices have been the catalyst or building blocks that have created the necessities of modern life. All too often new inventions are stumbled upon, have no specific societal purpose when invented (think penicillin, microwave ovens, lasers) only to become essential elements of modern life when a stimulus or motivating situation, either economically or socially finds a useful purpose. The conventional wisdom of this adage, necessity is the mother of invention is really derived from those periods in history where the creative talents of a few lasered in to invent solutions to very well-defined problems, typically in times of great strife such as wartime (think of the Manhattan project), or to adapt to overarching changes in the rule of law.
Dodd-Frank’s Volcker Rule has already spelled out what is permissible trading and what is not, which has sparked the inventiveness of banks to find new ways to maintain their profitable ventures yet keep within the rule of law as we’ve seen with the spin-off funds of ex-prop desk hitting the street from every major investment bank. Such inventiveness is to be expected given the necessity (of survival). The difficulty will be determining what is truly proprietary trading vs. making a market for a client, interpretation will be an on going matter of debate.
I recently traveled to Chicago to attend a panel session on high frequency trading and regulation in foreign exchange. A hot topic was exchange-traded FX. Dodd-Frank dedicates language to reduce counterparty risk and highly leveraged trading. As Sang Lee writes in e-forex magazine: “the OTC market is driven by principal trading, in which major banks leverage their balance sheets to take risk positions… In exchange for the risk, however, participating dealing banks expect much higher profit potential“. While this counterparty risk is reduced so is the profit potential for the major banks, or rather it’s shifted to other participants. In this changing landscape while some lose others gain, one of the benefactors will be the exchanges.
The FX market is the world’s largest and most liquid, with average daily turnover exceeding 4 trillion dollars. According to the report issued by the Triennial Central Bank, that’s a 28% growth in the past 3 years. During that same time frame volumes traded on CME’s FX products (futures & options) grew by 94%. The CME, SMX and other exchanges are poised to see an increase in volumes as regulation on derivatives moves them from the OTC market. This month’s issue of e-forex has an article on the “Factoring driving growth to FX on Exchanges”, the points mentioned are all catalyzed by regulation’s long arm – mitigating counterparty risk, increasing transparency, reducing highly leveraged margin trading. A set of conditions tailor-made for exchange-cleared products.
The FX OTC market by it’s very nature is a fragmented market, ECN’s and single-bank providers offer up a plethora of liquidity, but when it comes to price discovery it can be a challenge, there is no such thing as the NBBO in FX. One of the panelists at that Chicago event had this great quote: “Fragmentation is the opposite of transparency“. To the delight of the exchanges, they are the antithesis of the fragmented OTC model providing centralized trading and clearing and they stand to gain enormously from changes in the rule of law.
The technology challenges will also begin to mount as centralized trading for FX takes hold. Today in FX there is no localized market so the difficulties in reducing latency are far greater than in the equities market. On the other hand, one could make the argument that this makes for a level playing field since co-location is physically impossible (although the CME is rolling out its L-Net ‘proximity solution‘ next year). Yet as we move toward exchange-traded FX, the same low-latency algo-trading models that have been standard fare in equities will take shape. This will stress-test the performance characteristics of FX trading platforms, and in-turn will increase the demand for real-time risk management. FX is a market that never sleeps there is no evening respite, real-time risk monitoring is
not a option but a mandate.
While foreign exchange is anticipating change in the coming year, it is but a small part of what Dodd-Frank has in store. There are sweeping changes for the greater derivatives markets, especially those that will move from manual trading to electronic for the first time with the formation of SEF‘s. Larry Tabb makes a few predictions on this brewing storm for the coming year. With any change in the rule of law defining them is only the first-step, the larger effort will be interpretation, monitoring and enforcement as they are put into practice. How judicious those governing bodies are is still an open question. Jared Diamond author of Germs, Guns and Steel, a well-known history on the fate of human societies, writes: “The difference between a kleptocrat and a wise statesman, between a robber baron and a public benefactor in merely one of degree.“. The degree to which the judgment of the CFTC and SEC target the participants of our markets as they interpret the new rules while still striving to be profitable will determine where they lie. I just hope it’s not ready, fire, aim.
Once again thanks for reading.
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