Listen up, forex fellas, we’ve got a little over three months left before the new EU rules on forex hedging take place. Will this mean higher trading fees for retail traders like us?
Wait, wait. What rules?
In October last year, when the world was just reeling over the news of the Brangelina split, the European Commission made a groundbreaking announcement of its own by publishing the deets on variation margin requirements for currency forwards and derivatives.
The short of it is that these margin requirements would require banks, financial institutions, and investment funds to set aside part of their capital as “good faith deposit” for holding securities typically used to hedge against forex price swings. In other words, they’d need to pony up funds to back their trades. Cash me outside, how bow dah?
But what are these rules for?
The idea behind these regulations is to ensure that financial market players have a buffer to absorb potentially large losses from their positions and refrain from taking too much risk in their portfolios, thereby protecting their investors and customers as well.
In effect, this should prevent another Lehman Brothers-esque situation from occurring and snowballing to the rest of the global economy again. These regulations were also designed to reduce exposure to unprecedented market moves like the SNB Shocker of 2015 or the sterling flash crash last year.
That’s all well and good for regulators, but it’s no surprise that most financial firms see this as a huge burden. For one, they’d have less funds to move around since a chunk of their capital would be tied up to margin. This could limit their speculative trading, reducing opportunities to make extra profits. This also means more paperwork and more hours spent on calculating hedges and margins daily in real-time.
Of course these limitations usually spill over to their clients. It might wind up dampening market liquidity as counterparties have their hands tied with capital requirements while additional costs could impact everyone’s bottomline.
Another big risk is that financial institutions might decide against hedging their positions altogether, which could then leave them more vulnerable to losing their shirt in a market shock. A survey revealed that 14% of buy-side firms would rather stop hedging if required to post margin on derivatives.
Should I be worried?
Probably not. These rules aren’t set to be enforced until January 3, 2018 and these cover European markets only.
U.S. financial institutions fall under the Dodd-Frank jurisdiction, which does not require variation margin on physically-deliverable currency forwards and swaps. And then there’s also that possibility of the Trump administration pushing for Wall Street deregulation, too, so Uncle Sam is looking pretty chill right now.As you’ve probably guessed, this has European financial firms worried that they would likely lose market share to less restrictive markets. After all, the earlier phase of the same regulation on non-deliverable currency forwards implemented earlier this year has resulted to a notable dip in trading volumes among banks in the region.
Note that the U.K. might also be covered by these regulations, but it could still be up for debate during the Brexit negotiations. Now London wears the crown for being the the world’s largest forex hub as it moves roughly $2.4 trillion around each day, two-thirds of which comprise derivatives, so it could risk turning over a lot of this market activity elsewhere.
For those trading with brokers in the European region, no need to panic either! Much of the impact on costs and liquidity would likely be felt by larger financial institutions and the impact on the retail trading industry is foreseen to be limited. In any case, do stay on the lookout for any updates from your own brokers to see how they plan on adjusting to these regulations.