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EMIR AND THE FX MARKET

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Alistair Cotton

Alistair Cotton, head of corporate dealing at Currencies Direct

9thMay marks a key point in bringing clarity to Europe’s foreign exchange market. An EU consultation closes on whether over the counter foreign exchange transactions should be included in the European Market Infrastructure Regulation (EMIR) transaction reporting regime.

The EMIR aims to monitor the risks posed to the financial system by derivatives – that vast category of instruments that includes futures, forwards, swaps and options and which, following the 2008 financial crisis and the role played by credit default swaps, has become something of a financial bête noire in the popular imagination.

Its scope already includes forex derivatives, while the EU’s earlier MiFID brought FX contracts into the definition of financial instruments. But the big question for those of us in the forex industry is whether the EMIR will extend to pure corporate FX hedging transactions or forex forward contracts.

Alistair Cotton

Alistair Cotton

Under the EMIR, since February all counterparties to derivatives traded in the European Economic Area have been required to report details of the transaction, including the type of contract, price, settlement date, parties to the contract and maturity.

From August, this will extend to collateral and valuation details – marking-to-market to track the ‘live’ value of derivatives, rather than the historical book value of the original contract, which will allow regulators to spot institutions’ current exposure if, for example, the derivatives have  dropped precipitously in value.

The run up to August will therefore encourage the flow of data into the system and allow the level of systemic risk to be measured before regulation kicks in.

To put the amount of information this reporting produces into context, when the EMIR was introduced one trade repository reported 50 million transactions in its first week. If this were extended further into the forex market – the world’s most traded market, with an average turnover in excess of $4 trillion a day – then the amount of data produced will be somewhere beyond vast.

However, there are limitations with what can be done with all this information. Even if studying it allows regulators to understand institutions’ exposure, remember that these are open positions, the closing of which may be in no way straightforward (and regulators ordering traders to close positions they view as too risky is surely beyond even the most fevered Europhobe’s imaginings).

In the short term, then, the aim is to move away from what is perceived as the financial Wild West of a pure OTC market, where risk is hard to measure and control hard to exert, and towards the more standardised exchange markets that govern the likes of shares and bonds. To that end, data gathered between February and August could be used to ensure traders have sufficient buffers of capital, or to monitor fragility among parties who are overexposed.

But in the longer term, somewhere in the minds of politicians must be the goal of a potential financial transaction tax. There is a view within the EU hierarchy that a lot of financial trading has no social benefit. The reporting regime could therefore be a prelude to such a tax on transactions by allowing the over-the-counter market to be accurately measured and understood for the first time, and laying down the infrastructure needed to levy an eventual tax.

Whatever the ultimate goal, there are noticeable gaps in the reporting regime. The new rules have exposed differences between national regulators as to whether forex forward contracts should be classed as derivatives. Those of us in the FX business need pretty urgent clarity on what is an FX financial instrument and what is an FX spot contract, given that different member states are doing different things and that there is no single definition of a derivative.

As an example of the uncertainty, imagine you are back-to-back hedging a client position. A US retailer wants to buy some central London real estate for a new flagship store. They need to borrow dollars in the US to cover the cost, but must pay for the purchase in sterling, which exposes them to FX risks at several points. As their FX broker, you look to hedge this by setting up a currency swap, effectively seeking out a UK company looking to do the opposite to them – needing to borrow, in sterling, to fund US purchases, which need to be made in dollars. The swap contract means that the two companies essentially borrow in their own currencies and swap loans with each other.

However, non-European companies trading with each other within Europe will need to conform with the new regulations, even though their home regulators may have very different ideas were the same trade made outside of Europe. And equally, as the EMIR is not a worldwide requirement it could be easy to get around by trading outside of European jurisdiction.

So if the above trade is made in London, should this contract come under the EMIR’s remit? What if it was made in New York? And how should it be reported? After all, these aren’t speculative transactions. The ultimate risk of the contract is counterparty – that one company will not honour the agreement. But the systemic risk is to the banks lending to each company.

And if the EMIR is to monitor risk, rather than regulate derivatives per se, what of forward contracts? These can be speculative and as such can involve highly leveraged positions. But they can also be used for much more mundane reasons, like ordinary people hedging against FX exposure when buying holiday homes. And if forward contracts are to be included, do spot deals then logically follow, as these can also be used for speculative reasons, taking potentially risky short positions?

Clearly, we need some illumination. Thankfully, after 9 May we will learn more about the scope of the EMIR’s reporting rules and their exclusion or inclusion of various foreign exchange transactions.

The EMIR has a noble goal at heart but, for now, brokers will continue to struggle in the dark.

Alistair Cotton is head of corporate dealing at leading European FX specialists, Currencies Direct.

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Economic recovery likely to prove a ‘stuttering’ affair

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Economic recovery likely to prove a ‘stuttering’ affair 1

By Rupert Thompson, Chief Investment Officer at Kingswood

Equity markets continued their upward trend last week, with global equities gaining 1.2% in local currency terms. Beneath the surface, however, the recovery has been a choppy affair of late. China and the technology sector, the big outperformers year-to-date, retreated last week whereas the UK and Europe, the laggards so far this year, led the gains.

As for US equities, they have re-tested, but so far failed to break above, their post-Covid high in early June and their end-2019 level. The recent choppiness of markets is not that surprising given they are being buffeted by a whole series of conflicting forces.

Developments regarding Covid-19 as ever remain absolutely critical and it is a mixture of bad and good news at the moment. There have been reports of encouraging early trial results for a new treatment and potential vaccine but infection rates continue to climb in the US. Reopening has now been halted or reversed in states accounting for 80% of the population.

We are a long way away from a complete lockdown being re-imposed and these moves are not expected to throw the economy back into reverse. But they do emphasise that the economic recovery, not only in the US but also elsewhere, is likely to prove a ‘stuttering’ affair.

Indeed, the May GDP numbers in the UK undid some of the optimism which had been building recently. Rather than bouncing 5% m/m in May as had been expected, GDP rose a more meagre 1.8% and remains a massive 24.5% below its pre-Covid level in February.

Even in China, where the recovery is now well underway, there is room for some caution. GDP rose a larger than expected 11.5% q/q in the second quarter and regained all of its decline the previous quarter. However, the bounce back is being led by manufacturing and public sector investment, and the recovery in retail sales is proving much more hesitant.

China is not just a focus of attention at the moment because its economy is leading the global upturn but because of the increasing tensions with Hong Kong, the US and UK. UK telecoms companies have now been banned from using Huawei’s 5G equipment in the future and the US is talking of imposing restrictions on Tik Tok, the Chinese social media platform. While this escalation is not as yet a major problem, it is a potential source of market volatility and another, albeit as yet relatively small, unwelcome drag on the global economy.

Government support will be critical over coming months and longer if the global recovery is to be sustained. This week will be crucial in this respect for Europe and the US. The EU, at the time of writing, is still engaged in a marathon four-day summit, trying to reach an agreement on an economic recovery fund.  As is almost always the case, a messy compromise will probably end up being hammered out.

An agreement will be positive but the difficulty in reaching it does highlight the underlying tensions in the EU which have far from gone away with the departure of the UK. Meanwhile in the US, the Democrats and Republicans will this week be engaged in their own battle over extending the government support schemes which would otherwise come to an end this month.

Most of these tensions and uncertainties are not going away any time soon. Markets face a choppy period over the summer and autumn with equities remaining at risk of a correction.

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European trading firms begin coming to terms with the new normal

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European trading firms begin coming to terms with the new normal 2

By Terry Ewin, Vice President EMEA, IPC

In recent weeks, the phrase ‘never let a good crisis go to waste’ has received a large amount of usage. Management consultancies, industry associations and organisations, including the Organisation for Economic Co-operation and Development (OECD) have all used it in order to discuss how the current crisis, caused by the Coronavirus pandemic, presents an opportunity for new and worthwhile change.

The saying is also commonly used to indicate that the destruction and damage that is caused by a crisis gives organisations the chance to rebuild, and to do things that would not have previously been possible. This has the potential to impact financial trading firms, where projects that this time last year would not have made much sense now appearing to be as clear as day. In Europe, banks and brokers alike are beginning to think about what life will look like post-pandemic, and how their technology strategies may need changing.

We can think of three distinct phases when it comes to a crisis. Firstly, there is the emergency phase. This is followed by the transition period before we come to the post-crisis period.

Starting with the emergency phases, this is when firms are in critical crisis management mode. Plans are activated to ensure business continuity, and banks and brokers work to ensure critical functions can still take place so as to continue servicing their clients. With regards to the current crisis period, both large and small European banks and brokers were able to handle this phase relatively well, partly due to the fact that communications technology has reached the point where productive Work From Home (WFH) strategies are in place. For example, cloud-connectivity, in addition to the use of soft turrets for trading, has enabled traders from across the continent to keep working throughout lockdown. From our work with clients, we know that they were able to make a relatively smooth transition to WFH operations.

In relation to the current coronavirus crisis, we are in the second phase – the transition period. This is the stage when financial companies begin figuring out how best to manage the worst effects of the ongoing crisis, whilst planning longer-term changes for a post-crisis world. One thing to note with this phase, is that no one knows how long it will last. There is still so much we don’t know about this virus. As such, this has an impact on when it will be safe for businesses to operate in a similar way to how they were run in a pre-pandemic world. But with restrictions across Europe starting to be eased, there is an expectation that companies will start to slowly work their way towards more on-site trading. For example, banks are starting to look at hybrid operations, whereby traders come in a couple of times a week, and WFH for the rest of the week. This will result in fewer people in the office building, which makes it easier to practise social distancing. It also means that there is a continued reliance on the technology that enables people to WFH effectively.

Finally, we have the post-crisis period. In terms of the current crisis, this stage is very unlikely to occur until a vaccine has been developed and distributed to the masses. Although COVID-19 has caused mass economic disruption, many analysts are predicting a strong rebound once the medical pieces of the puzzles are put into place. It may not be entirely V-shaped, but the resiliency displayed by the financial markets thus far suggests that it will be healthy.

Currently, many European trading firms are taking what could be described as a two-pronged approach.

The first part of this consists of planning for the possibility of an extension to phase two. Medical experts have suggested that there could be some seasonality to the virus, with the threat of a second wave of COVID-19 cases in the Autumn meaning that the risk of new restrictions remains. If this comes to fruition, there would be a need for organisations to fine-tune their current WFH strategies and measures, and for them to take greater advantage of the cloud so as to power communications apps.

The second component consists of firms starting to think about the long-term needs of their trading systems. Simply put, they are preparing themselves for the third phase.

It is in this last sense, that the idea of never letting ‘a good crisis go to waste’ resonates most clearly.

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Currency movements and more: How Covid-19 has affected the financial markets

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Currency movements and more: How Covid-19 has affected the financial markets 3

The COVID-19 pandemic has been more than a health crisis. With people forced to stay indoors and all but the most essential services stopped for multiple weeks, economies have suffered and financial markets have crashed. Perhaps the most public and spectacular fall from grace during the early stages of the pandemic was oil. With travel bans in place around the world and no one filling up at the pumps, the price of oil plummeted.

Prior to global lockdowns, US oil prices were trading at $18 per barrel. By mid-April, the value had dropped to -$38. The crash was not only a shocking demonstrating of COVID-19’s impact but the first time crude oil’s price had fallen below zero. A rebound was inevitable, and many traders were quick to take long positions, which meant futures prices remained high. However, with stocks piling up and demand sinking, trading prices suffered. Unsurprisingly, it’s not the only market that’s taken a knock since COVID-19 struck.

Financial Markets Fluctuate During Pandemic

Shares in major companies have dipped. The Institute for Fiscal Studies compiled a round-up of price movements for industries listed by the London Stock Exchange. Tourism and Leisure have seen share prices drop by more than 20%. Major airlines, including BA, EasyJet and Ryanair have all been forced to make redundancies in the wake of falling share prices. The automotive industry has also taken a knock, as have retailers, mining and the media. However, in among the dark, there have been some patches of light.

The forex market has been a mixed bag. As it always is, the US dollar has remained a strong investment option. With emerging markets feeling the strain, traders have poured their money into traditionally strong currency pairs like EUR/USD. Looking at the data, IG’s EUR/USD price charts show a sharp drop in mid-March from 1.14 to 1.07. However, after the initial shock of COVID-19 lockdowns, the currency pair has steadily increased in value back up to 1.12 (June 25, 2020). The dominance of the dollar has been seen as a cause for concern among some financial experts. In essence, the crisis has highlighted the world’s reliance on it.

Currency Movements Divide Economies

Currency movements and more: How Covid-19 has affected the financial markets 4

In any walk of life, a single point of authority is dangerous. Indeed, if reliance turns into overreliance, it can cause a supply issue (not enough dollars to go around. More significantly, it could cause a power shift that gives the US too much control over economic policies in other countries. Fortunately, other currencies have performed well during the pandemic. Alongside USD and EUR, the GBP has also shown a degree of strength throughout the crisis. However, these positive movements haven’t been shared by all currencies.

The South African rand took a 32% hit during the early stages of the pandemic, while the Mexican peso and Brazilian real dropped 24% and 23%, respectively. Like the forex market, other sectors have experienced contrasting fortunes. Yes, shares in airlines and automotive manufacturers have fallen, but food and drug retailers have seen stocks rise. In fact, at one point, orange juice was the top performer across multiple indices. With the health benefits of vitamin C a hot topic, futures prices for orange juice jump up by 30%. The sudden surge had analysts predicting 60% gains as we move into a post-COVID-19 world.

Looking Towards the Future through Financial Markets

The future is always unknown and, due to COVID-19, it’s more uncertain than ever. However, the financial markets do provide an indication of how things may change. The performance of USD and EUR in the forex markets suggest there could be a lot more trade deals negotiated between the US and Europe. The surge in orange juice futures suggest that health and wellness will become a much more important part of our lives. Even though it was already a multi-billion-dollar industry, the realisation that a virus can alter the face of humanity has given more people pause for thought.

Then, of course, there’s the move towards remote working and socially distance entertainment. From Zoom to Slack, more people will be working and playing from home in the coming years. The world is always changing, but recent have events have made us appreciate this fact more than ever. The financial markets aren’t a crystal ball, but they can offer a glimpse into what we can expect in a post-COVID-19 world.

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