SINGAPORE (Reuters) - It has been the dark side of currency markets: a secretive multi-billion dollar world of simulated contracts that skirts around government controls and rules.
Now regulators are about to force this global market in non-deliverable forwards (NDFs) out of the shadows with rules on trading and central clearing that brokers fear will cause the market — and their industry — to shrivel.
Almost every financial centre from Hong Kong to New York is set for new rules which will force trades in NDFs to go through a central clearing house, and data on these transactions to be reported.
The U.S. Dodd-Frank legislation goes further and requires derivatives to be traded electronically, and bans banks from proprietary trading in any product, including NDFs.
The American reforms include other rules on engagement, the most draconian being on the mandatory number of quotes that a participant should solicit for every trade and a requirement that pre-arranged orders be flashed on screens for 15 seconds.
That’s anathema for a market which was born out of a need to bypass regulation and is now used on a global scale by the biggest banks, businesses and fund managers to hedge exposures to emerging market currencies such as the Chinese yuan and Brazil’s real.
It’s not just the scrutiny of NDFs that’s a worry for bank treasurers. Dealers and brokers fear there will be a decline in liquidity and profitability, loss of anonymity and the risk of being undercut by rivals.
“It’s a business killer,” said one source at a leading bank in Singapore, who declined to be named owing to the sensitivity of the matter.
Unmonitored and undisclosed, no one’s quite sure what kind of NDF volumes and trades go through now. Brokers can only guess that the NDF market in the Chinese yuan is now the largest, with volumes of $4 billion to $6 billion traded each day. NDF markets in the Korean won and Indian rupee are almost as large.
Among the most non-interventionist and pliant of derivatives, even the most benign of the rules spells revolution for the NDF market.
The U.S. plan to move bilateral, non-standardized derivatives, mainly interest rate swaps and NDFs, onto electronic trading and central clearing platforms has been set in motion, but their final reach and impact is unclear.
That is partly because Singapore’s central bank and other regulators in Asia, home to the biggest NDF markets, have so far only proposed rules on central clearing and trade reporting, not on electronic trading.
Non-deliverable forwards were born in the early 1990s as a way to beat capital controls in emerging markets, with the first markets being in the Taiwan dollar and Mexican peso. The contracts were in dollars, and there was no need to hold the underlying currency.
Initially created to help foreigners trade or hedge a currency whose domestic markets were inaccessible to them, NDFs have become the clandestine playground for speculators and a boon for brokers, who could tailor deals for specific sizes and timings, even split settlement dates.
NDFs also helped the broking industry salve its wounds from the 1993 introduction of EBS, a rival electronic trading platform to Reuters Dealing.
The rise of electronic platforms infused transparency and efficiency in spot trades for major currencies, but killed the interbank bilateral trade, putting plenty of bankers and voice-brokers out of work.
The worry for brokers now is that Dodd-Frank and rules from other regulators on clearing will cut the market down to size. Ben Feuer, head of foreign exchange for Asia at broker Newedge, says there is no doubt the NDF market will shrink and some products may even disappear.
“The larger institutions will be able to conform to the new regulations and associated costs incurred. However, smaller market players can be squeezed out of the market, directly affecting the volumes,” Feuer said.
The U.S. proposals for forced electronic trading and the need to substantiate other risk-management activities or client trades will radically reshape a market that has been for long accustomed to bilaterally and flexibly negotiating speculative bets on the likes of the Korean won and Chilean peso, away from the prying eyes of authorities and peers.
“NDF traders will resist using the machine,” said one Singapore-based broker. “When you use the machine, you lose the spread and volatility. It’s going to kill employment, that’s for sure.”
The timeline for implementing the rules remains fuzzy, given there is uncertainty over how different jurisdictions will interpret them, although the Group of 20 (G20) leading economies wants them to be in place by the end of 2012.
In the United States, the regulation on swap trading and former Federal Reserve chairman Paul Volcker’s rule on what banks can and can’t trade reaches deeper into every aspect of the derivatives market.
European policy makers are yet to finalize their version of the rules, Asian regulators are adopting just a few of them, and the systems that would enable trading, settling and reporting of transactions are not yet operational.
The U.S. Commodity Futures Trading Commission (CFTC) and the U.S. Securities and Exchange Commission (SEC) have set guidelines for platforms on which multiple parties can trade, called swap execution facilities (SEFs).
Much of the ambiguity and angst stems from those rules. Trading has to be on multilateral platforms. Participants on a SEF have to place a Request For Quote (RFQ) with a minimum of five other dealers. A pre-agreed trade has to be flashed on the screen for 15 seconds, potentially opening it up to rival bids, before it is closed.
“It’s about sending RFQs to X amount of people, it’s about potentially having to flash quotes on the screen for 15 seconds... and a whole host of things that are very prescriptive,” said Keith Nicolle, head of e-commerce for Asia at broker GFI.
By leaving almost no room for participants to get a deal done on the phone, the CFTC is possibly being more rigid than European authorities, whose version of a swaps platform is called the Organised Trading Facility (OTF).
As of now, banks in Asia are hoping Dodd-Frank’s reach is contained within U.S. borders, mainly to U.S. companies and institutions trading with the United States.
“The only caveat to that is that Dodd-Frank may somehow reach deeply into Asia and we might inherit most of their rules. I doubt that at this stage,” says GFI’s Nicolle.
It is conjecture at this stage, but brokers imagine the NDF market might splinter into two: the liquid, deep ones migrating to the new electronic platforms and central clearing houses while the smaller markets will stay off the official radar.
“Using the top down-bottom up approach, defined by several of the leading regulators, the impending regulatory mandates will only affect products where a clearing service is offered,” said Gavin Wells, chief executive of LCH.Clearnet’s ForexClear.
“We estimate that around 12, maybe 15 NDF currencies could be cleared in light of this.”
Clearing houses are already gearing up to take advantage of the regulatory changes. LCH.Clearnet, the world’s biggest clearer of interest rate swaps, has just launched a service for NDFs in the Chinese yuan, Korean won, Brazilian real, Indian rupee, Russian rouble and Chilean peso. It will add more in coming weeks, including the Indonesian, Malaysian and Philippine currencies.
Bank dealers envisage a situation where banks become SEF aggregators, merely routing client orders onto an established SEF for a fee. It is also quite possible some of the hedging and speculative activity will migrate in the interim to the exchange-traded derivatives, such as currency futures, where the connectivity and liquidity already exists.
On the bright side, end-users of currency derivatives could find clearing makes the FX marketplace far more efficient. While it is not fully clear at the moment, it is also likely that the capital banks need to set aside for uncleared trades will be higher than that for cleared ones.
“Clearing NDFs will make the market more transparent and will squeeze spreads, which traditionally is bad for a broker,” said Stephen Miles, managing director for broker Tradition and head of the Singapore Money Brokers’ Association (SMBA).
“However, by clearing NDFs, then it possibly opens up the market to a bigger audience. For instance, margin FX portals may well be able to participate in the NDF market.
“The threat is that spreads will narrow. But market makers can still make money out of volatility and volume flows.”
Editing by John Mair