How banks can break the foreign exchange bottleneck

The sheer size and liquidity of the global foreign exchange (FX) markets is attracting new players looking to trade FX as an asset class, as well as a growing number of hedge funds that are bringing algorithms from the equity markets to FX at an increasing rate.

As a result, the number of tickets passing through banks’ back offices has escalated to unprecedented levels and prompted discussions, such as a panel session at Sibos next month, on whether an industry-wide solution is needed.

Bill Boss, global head of FX operations at UBS, who will join the panel session at this year’s Sibos, says that one source of potential bottlenecks in operations is the way that a bank organises its booking model, and that inadequate investment in back office systems and processes forces organisations to handle today’s ticket volume with information technology architecture from more than a decade ago.

At UBS, operations is represented on the change-the-bank committee that allocates technology spend and works with front-office partners to effect process change throughout the deal ­lifecycle.

UBS was a founding member of CLS Bank, and Mr Boss believes that much has been achieved already. He says that the volume growth seen today has largely been made possible by the settlement and credit risk reductions delivered by CLS. “Going forward, UBS would like to see the scope of CLS widen by adding more currencies and then products into its multilateral netting service offering,” he says.

“One outstanding challenge in the FX market is how participants exchange and update payment instructions. UBS feels that some current industry utilities, such as Swift and Omgeo Alert, are well positioned to take up this challenge and deliver a global solution. That solution could range from creating a standard settlement instructions (SSI) clearing house to simply enforcing a standard format for SSI updates.”

Structures in place

While Mr Boss believes that continued investment is needed by banks to cope with tomorrow’s volume, he thinks that some industry-wide changes are needed because the scope of the problem is too great for a single market participant to overcome (bilateral, non-standardised updating of SSIs between each market participant, for example).

“Operations are a business differentiator. Any bottleneck at any part of the deal lifecycle will affect a bank’s ability to grow,” he says.

Jeremy Hill, head of currency options, emerging markets and commodities operations at The Royal Bank of Scotland, agrees that the FX industry already has appropriate clearing and settlement structures in place to support increased volumes.

“RBS has seen significant increases in volume in the past three years but investment in internal systems and market platforms, such as CLS, have meant we have increased our straight through process (STP) rate,” he says. “However, there are clearly areas for improvement, such as the establishment of SSI, so RBS also participates in numerous market forums that are looking at the different aspects of the trade confirmation and settlement process.”

Mr Hill believes the growth is organic, and is coming from vanilla business traded with its market counterparts rather than from a significant surge in the use of algorithms. Because cost, per trade, is critical in a competitive low-margin business, he says that there will inevitably be rewards for those banks with efficient processing in place. He also believes that while more investment is needed in firms’ back offices to cope with growing volumes, an industry-wide solution should still be sought.

“Given the size and diversity of the market, a true industry-wide solution is some way off but that should not stop market participants investing in industry solutions that solve particular areas,” he says. “Of course, industry solutions are only really effective if there are no bottlenecks within your own systems.”

Jonathan Butterfield, executive vice- president, marketing and communication, for CLS Bank International, says there was, very clearly, significant pressure among FX prime brokers last August when there were dramatic surges in values and volumes of tickets. Since then, all of the large banks have made rapid and significant upgrades to capacity, not only in core processing but also in risk systems and general ledger systems.

Volume surges

“Now the volume capacity issue is not as dire, but the nuance is that as the degree and sophistication of electronic trading continues to evolve, it is surges in volume that present a capacity challenge,” he says.

In the past, adds Mr Butterfield, peak days were more than twice the volume of normal days but now a high-volume day can be as much as four times the average daily volume in the FX market. However, on top of the capacity issue, Mr Butterfield adds that prime brokerage banks have been using capacity as a competitive weapon for the past eight years and have invested accordingly to capture more and newer business.

Settlement volumes

“It would not be true to say that across the industry there are capacity issues,” says Mr Butterfield. “There are a lot of Tier 2 and 3 banks that are market leaders in their respective home currencies but they don’t face the same volatility as the prime brokers.”

Some camps have long argued that aggregating, or netting, trades for settlement would dramatically cut the number of tickets being processed by the back office, and in the light of increasing volumes, CLS is looking at ways to increase capacity. By June this year, CLS settlement volumes were already up 60%, year on year, but by the end of the year, CLS will be able to handle volumes of up to one million on a normal day and settle two million transactions on a peak day.

The question of how easy it would be to implement an aggregation scheme that would make a material difference to the capacity that the FX industry needs to plan for is still in discussion. Some banks are re-engineering how they use CLS to provide relief, however, Mr ­Butterfield is positive that the debate about an industry-level degree of standardisation around aggregation will continue for some time.

“The risk issues are re-establishing risk mitigation credentials in terms of settlement risk elimination,” he says. “Even after aggregation, surveys show, individual amounts outstanding, on a day-to-day basis, can still be very large. You may get a volume relief but not counterparty risk relief. One of the reasons our members are not ready to change is that these two forces are close to being mutually exclusive.”

However, Mr Butterfield argues that while a pressure valve may be needed, a one-size-fits-all solution to aggregation will be difficult to achieve because there are material differences in the ways the large banks operate, and so where the best benefit would accrue in terms of taking volume out. Their preferences are to do it in quite substantially different points in the cycle.

Flow automation

“Some want it before it hits the risk system, most want netting to occur after the risk system but before the general ledger, and some want it after the general ledger, and not a moment sooner,” says Mr Butterfield.

In the meantime, Swift is helping banks to address the main ‘pain points’ they are experiencing today, through its FX programme, by putting greater efficiency and STP into the allocations process, automating the flows between the buy-side and the executing and prime brokers for take-ups and give-ups, specifically between hedge funds and their prime brokers. This will include a number of different solutions from lighter connectivity for the buy-side to standardised formats, which will in turn reduce the cost of processing these messages.

Jackie Farrow, head of the global FX programme for broker/dealers within the markets division of Swift, says that the increase of hedge fund trading FX algorithmically and as an asset class is adding to the bottlenecks.

“Their volumes have been stressing prime brokers processing, particularly during the peaks of last summer,” she says. “The increasing volumes from the hedge funds is also exacerbated by the fact there is no industry standard for the way in which the buy-side is communicating, and sending its FX trade details, to the prime brokers.”

Another pain point is front-end fragmentation. “The sheer proliferation of portals that the FX ecosystem has seen in recent years is also increasing volumes,” says Ms Farrow. “A few years ago, FX was a pretty stable, mature business. This has all dramatically changed as a result of the new entrants and the different front and back office languages being used. As a result, there are a lot more breaks in handling end-to-end STP.”

Ms Farrow says that Swift is also looking at achieving trade capture at source, or trade portal hook-up. “The growth of trading platforms has led to greater fragmentation in the FX market and Swift is working very closely with Bloomberg to Swift-enable their order management systems and execution platforms to support flows from execution through to settlement in a way that does not occur today,” she says. “This will enable a message flow that will support block trades and allocations, matching of trade confirmations and will introduce a level of STP for both the buy and sell side. This will also enable users to reach the custodians for the receipt of settlement instructions.”

Ms Farrow says that the prime brokers and CLS settlement members have recently faced challenges in their back office in terms of capacity and processing the number of trades they are receiving and passing on to CLS for settlement. Back office investment since last summer has increased confidence in coping with increased volumes again, but growth in FX is spiralling.

Initiative development

“Just in terms of Swift’s global FX messaging, growth this year already is reaching between 25% and 35% and we anticipate significant further growth in the coming years,” says Ms Farrow.

Swift has also established a Foreign Exchange Advisory Group, which meets quarterly with Swift to develop initiatives in the post-trade/pre-settlement space for FX.

“The FX practitioners are looking at specific initiatives where standardisation and business modelling is needed to enable automation,” says Ms Farrow. “The group believes that the market has not yet reached the point where they feel there is need for an industry consortium to address the bottleneck.”

Sang Lee, managing partner at Aite Group consultancy, who is also speaking on the Sibos panel session, says that the low take-up of the recent launch of the FX MarketSpace implies that clearing and settlement market participants are happy with the current industry arran­gements of FX prime brokers and CLS.

Hedge fund participation

“If that had been a compelling selling point, it should have been a no-brainer for participants to jump into the market, as Chicago Mercantile Exchange is a tried and tested platform,” says Mr Lee.

While he says it is inevitable that electronic trading would contribute to increased volumes of smaller orders, and the increased number of tickets processed, he believes that the FX market is nowhere near breaking point.

“New entrants from equities are moving into the FX market and trying to apply the same type of strategies,” he says. “It is clear which way this market is headed, in terms of further bottlenecks. Traditionally, EBS and Reuters were interbank platforms but there is now a lot more participation from hedge funds.”

It is understood that on EBS Prime alone, almost 20% of volume is generated by the automated order flows of algorithmic trading. Furthermore, the lack of a centralised clearing facility for FX is adding to the problem, although the launch of CLS has helped this, and the FX prime brokers have also stepped up in terms of providing clearing and credit tools necessary to anticipate market growth.

“No one could have predicted the level of growth there has been in FX, and it took many by surprise and caused bottlenecks,” says Mr Lee. “The FX market does not have an industry-wide centralised clearing utility, so realistically, prime brokers are looking at scaling up their capabilities as it is the simplest thing to do at this point. If you get down to any kind of industry-led consortium initiative, it takes a very long time and has a high likelihood of failure.

“These banks are not only participants in the marketplace, but also competitors. This could lead to more friction, which everyone wants to avoid at this point,” says Mr Lee.