For more than a year regulators on the both sides of Atlantic have been working hard applying new restrictions to many markets. Swaps market was possibly the first that underwent major changes. Then followed other derivatives and most OTC markets in general. Attacks on HFT are another substantial segment of modern regulatory activity. Spot fx market was also not left untouched: not only severe restrictions on banks’ prop activity have already caused a serious restructuring of the whole business and generated a great number of job seekers, but with the most recent proposals by Financial Stability Board it’s now not unlikely that a centralized clearing facility be established for this largest OTC (so far) market.
What are the consequences of this unprecedented activity and what are its real beneficiaries?
An average Joe might think that all these measures are intended indeed to reduce “market manipulation” and therefore to “protect” something, for example, his pension savings. Most possibly this is the official decoration for all these processes. We should note here that chances are, though, that an average Joe won’t ever understand what this campaign is all about, however he doesn’t need to.
If looking at these processes more critically one could easily note that all of them imply greater centralization of all markets and increasing the role of exchanges and central clearing houses (and similar centralized structures). Therefore most likely the regulatory process serves the interests of exchanges and large brokers. As an immediate effect it causes increased expenses (consider only the new reporting requirements — not every institution would be able to afford it!), and as a consequence — increased transactional costs, at least for most trading venues. As the result, only really big players in this market will be able to afford conforming to the new rules of the game, therefore their importance will further increase while minor market participants are likely to further lose their share.
Now what is there in this analysis that could be useful for market speculators? Presently the market is right in the middle of the process of restructuring, and when this process is over we will see a completely new world. The market being in a transition is most likely the very reason of the unprecedentedly low volatility, and understanding its reason helps estimating its term. With the increased transactional costs we may expect the “come-back” of trading in underlying, not derivatives, with possible greater focus on commodities. Besides that the new environment may significantly diminish the reward/risk ratio for many (if not most) short-term and ultra-short-term strategies, along with “market neutral” strategies. In other words, everything that used to generate 20% annual profits with virtually zero risk (“a new standard”, as one of my friends said) might render useless.
But the most possible and most influential outcome of the whole process will be dramatic reduction of liquidity in all markets, but especially in fx, that will lead to increased volatility and in general a result that is strictly opposite to that declared by regulators. Then we might expect the volatility-based alpha-generating strategies to celebrate the “great come-back”.
It’s especially interesting that the end of restructuring of markets will most likely coincide with the end of tapering, QE and ZIRP. This may lead to even more interesting market phenomena.
So, don’t throw away your old breakout strategies.