Will a compelling single event force the FX industry to reduce FX post trade costs, or will the catalyst for change be new processes and technologies to manage credit? At a recent SWIFT webinar moderated by Dominic Hobson, industry experts debated how the FX industry should respond to pressures to increase efficiency and reduce costs.
This is the second article in a two part series detailing the ideas shared at the webinar.
The webinar participants were:
- Matt Cook, Senior Markets Manager, Capital Markets & FX, SWIFT
- Duncan Lord, Director, Core Operations Delivery Management, Barclays
- Adrian Patten, Co-founder and Chairman, Cobalt
- Mike Robertson, Global Head of Transactional FX Trading, Bank of America Merrill Lynch (BAML)
- Alex Walker, Head of Post-Trade FX, Refinitiv (FXall trading platform is part of Refinitiv)
In the previous article, the panel were arguing that a compelling event was needed to make the industry address the issue of post trade costs. Excessive costs and risks in post-trade processing in the FX industry reflect the fact that all of the three main segments of the market – prime brokerage, electronic brokerage and the wider franchise – have, over time, developed entirely separate processes and systems. There is also the factor that the low cost of labour in offshore locations will continue to inhibit changes to operations because cost savings alone are not an adequate rationale. Duncan Lord, felt that, “The argument for doing a piece of work is the reduction in operational cost but, if you are in a low-cost location, that argument is a lot weaker. People have to do it for other reasons now, such as risk or control.”
Mike Robertson countered that the cost of labour arbitrage is now subject to the law of diminishing returns, as labour costs rise offshore. “Those cost efficiencies do not remain there forever,” he said. “Salaries go up. Wages increase. It is in any event hard to scale. So we have begun to look at that model more critically and ask ourselves, ‘Where is the puck likely to be in three years’ time in that particular jurisdiction? Consequently, is the model sustainable?’ The answer, generally, is, `No.’ So we are investing more in systems and automation.” However, he was sceptical about the possibility of change occurring through new technology alone and still felt that industry-wide consensus on the need for change was an essential prerequisite.
So could the FX Global Code, a real example of industry consensus, be the catalyst. The problem here is that it is principles based and so less likely to force the industry to change. “From an operations perspective, the language was too soft,” said Lord. “It would be far better if the Code said, `To be in this market, you must do X or you must do Y.’ If you had something to hold people to account, it would be helpful. The market can sort this out, but regulatory action would help accelerate change.”
Duncan Lord pointed to CLS as an example of a successful re-ordering of an inefficient process that saves banks money. “Sixty per cent of our trades are going into CLS, and a fraction of our staff are supporting it,” he said. “It is a standard, common process that everybody has to adopt.” But, as he pointed out, the creation of CLS was ultimately driven by central banks, exasperated by the failure of the FX industry to solve Herstatt Risk voluntarily.
More, or just better regulation?
However, the only regulations directly affecting the FX industry operationally today are EMIR and Dodd-Frank, which require the industry to post initial margin against non-cleared FX derivatives. The implementation of the final stage of the Uncleared Margin Rule (UMR) in September 2020 is expected to divert an increasing proportion of FX trades being netted and cleared before settlement. Mike Robertson, is convinced clearing can cut credit and capital costs at banks. “The short answer to that is `Yes,’” he said. “We see product coming out of the marketplace, which helps our clients to do more netting before they even submit the trades to us. Clearly, the client sees the value there. If you take it downstream to ourselves, there is definitely a change in the cost structure as a consequence of doing more of that and it flows into the capital allocations.”
There are concerns however that any savings in post trade costs will be blunted by a lack of inter-operability between CCPs, and the development of vertical trading and clearing silos. Duncan Lord is concerned that, without standardisation to enable inter-operability, clearing will simply add a further layer of operational complexity to an already intricate post-trade architecture. “We have got people coming with different offerings, and slightly different solutions, which will in turn force us to build different models to support them,” he said. “Our worry is that, if we carry on like this, in five years’ time we will have another spaghetti junction of manually supported solutions.”
Alex Walker, warned that there was already a risk of proprietary messages gaining traction.“It is very concerning that we might find ourselves in a non-standard world again,” she said. “We have had various discussions around clearing with clearing houses, and it is very disappointing that we are again talking about non-standard messaging. It is shame that we have not learned from the equities experience of clearing. I would certainly hope that we do become more standard, and more inter-operable.”
New processes and technologies to manage credit
Adrian Patten stated that there are parts of the FX industry that have no need to move to clearing because they do not deal in complex instruments that concern the regulators today. In fact, Patten believes that credit will prove a more powerful agent of change than clearing. He predicted that non-bank liquidity providers, which are currently dependent on the credit afforded to them by FX prime brokers, will soon break this dependency. They have the opportunity, he argued, to form bi-lateral credit relationships. As Patten pointed out, this is not as revolutionary an idea it appears. “In FX, it is quite easy,” said Patten. “You just need a bit of collateral, and most counterparties do not want delivery anyway.”
He also thought the Code should be made legally binding. If it was, he predicted that credit management would unlock change. As he pointed out, the Code expects banks to protect the FX market by distributing credit prudently and efficiently, yet credit is managed haphazardly. Each trading venue limits credit exposures in a different way and FX prime brokers rely on a crude ‘kill switch’ to halt transactions that exceed credit limits.
Mike Robertson warmed to this idea. He likened the idea of bi-lateral credit relationships to Libra, the digital currency launched by Facebook. “There is a conversation taking place about unregulated co-operation, if you will, around a specific type of instrument,” he said. “Off-bank clearing does exist, and it is being promoted by the fact that regulation is more entrenched in the bank space and less entrenched in the non-bank and FinTech space. There is something happening here. There is definitely some kind of change taking place in how we look at clearing and settlement.”
The question about whether these new processes and technologies for managing credit would end up reducing the post trade costs of the industry remains open for discussion, perhaps at the next SWIFT-hosted FX webinar.
For the latest insights and innovation from across the global FX industry, don’t miss the FX programme at Sibos 2019, Monday 23 – Thursday 26 September 2019, London. Find out more about the programme and register on the Sibos website.