Strong growth in FX activity has been accompanied by significant consolidation among liquidity providers, which has in turn raised the competitive bar for mid-sized providers and smaller banks. Outsourcing can resolve this dilemma, writes William Higgins.

The latest Bank for International Settlement (BIS) Triennial Survey has confirmed that the global FX market is vast and still growing ($1.5-$2 trillion traded per day). Much of this growth is driven by asset managers increasingly treating FX as a primary asset class (their participation rose 57% from 2001 to 2004), In addition, increasing cross border trade/e-commerce and rising emerging market activity have lifted FX volumes by 29% in the last year. This has gone hand in hand with tighter FX dealing spreads driven by competition, including e-commerce portals. At the same time, transaction volumes have increased disproportionately, yet at a decreasing average trade size.

Consolidation challenge

Rising transaction volume (and therefore processing load) is just one factor that drives continual investment in FX infrastructure. As volume growth has not been accompanied by rising total transaction revenue, banks now find the revenue/cost equation skewing further against them.

Ongoing consolidation of FX volume with fewer liquidity providers adds further competitive pressure. Credible participation now requires major capital allocation (driven by Basel II and other factors) to support the operational, counterparty and market risk, and an ensuing requirement for large, continuous technology investment across front, middle and back offices.

Many local banks, including many US/European investment banks and brokers cannot justify this outlay, as FX is typically just an adjunct to their cross-border capital markets activities. The problem for regional/retail banks is rather different – namely the threat to their other businesses. Their lack of FX capability pushes their clients towards global FX liquidity providers, who will be quick to cross-sell to them.

Fortunately it is now possible to separate liquidity provision and the FX “factory” (technology and processing for the front/middle/back office). This leaves banks that are not major liquidity providers with two feasible options:

  • Continue as a liquidity provider, but outsource the factory;
  • Outsource both liquidity provision and factory and receive commission on client transactions from the outsourcing provider.

In practice, a hybrid may also be possible, but the crucial point is that both strategies are realistic and profitable.

Alternatives to consider

A number of banks will be attracted to the first alternative. They can typically exchange the high fixed costs of running/upgrading their factory for variable costs proportionate to revenue. They retain the credit/market risks of liquidity provision, but could potentially dispense with most of the operational risks. Various permutations are possible:

  • Complete factory outsourcing that covers all front/middle/back office applications including white-labelled trading interfaces and e-commerce platform(s);
  • Partial factory outsourcing that covers only clearing and settlement functions/ technology, but retains existing front office technology.

The second strategy of outsourcing both liquidity provision and factory is likely to appeal to regional banks. By effectively acting as distributors for the outsourcing provider, they can acquire a new revenue stream and an immediate FX footprint that protects and extends existing client relationships.

At the same time, as part of the outsourcing agreement, the outsourcer can also benefit from its provider’s expertise in the field of risk management, know-your-customer and anti money laundering procedures.

It seems obvious that global FX consolidation will continue and that only the largest scale operators will be capable of surviving as both liquidity providers and “factory owners”. Happily, other participants need no longer remain locked into what appears a doomed FX business model. In outsourcing, they have a viable alternative that allows them to retain both FX presence and profitability.

William Higgins, Global Head of Operations, Group Shared Services, ABN AMRO william.higgins@uk.abnamro.com

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