Andy Coyne,  CPO and co-founder of Cobalt provides a perspective on the current state of play in the prime brokerage market.
Andy Coyne, CPO and co-founder of Cobalt provides a perspective on the current state of play in the prime brokerage market.

Why credit over-allocation continues to plague prime brokers and how technology can help

The problem of over-allocation in the FX market is not a new one but has been exacerbated by the move to electronic execution, Prime Brokerage and the related increase in volume and speed.

Credit is the lifeblood of execution but has always been an undervalued and poorly managed asset. It is core to every trading relationship and the key element that drives market access. It is essentially what FXPBs charge fees for. It goes without saying that credit providers need to remain in control of market access for their clients to ensure losses are not suffered and franchises not put at risk. 

A lot of credit infrastructure was designed by way of quick solutions to solve specific problems but not much thought was given to the future. Market operators inadvertently layered on complexity for what is essentially a simple product. It is now expensive, impossible to manage and recognised as a systemic issue that regulators want resolving. They are particularly concerned with over-allocation. 

The key to solving this long-standing problem is by stating what everyone already knows; that the existing model is broken and a start from scratch approach is needed. To make it work, credit providers need to take control of the agenda by eliminating carve-outs and stating that there are only two limits that anyone really cares about, namely, the mutual limit on exposure derived from primary NOP and DSL. 

Add to that, the concept of shared limits on a centralised infrastructure where all parties to a trade can see the same credit line and its utilisation. Today, every carve-out is risky because it only measures credit at the market endpoints. When using multiple endpoints, credit usage at each diverges, not just from each other but also the central limit. This is the case, not only for NOP / DSL carve-outs but also DNs which are a carve out with more restrictions and the potential for rejection. 

Technology
The existing model is broken and a start from scratch approach is needed

Solution already available

The truth is that the technology that solves this problem is already available. There has been a realisation by credit providers that they have a right to dictate how their credit is used and there needs to be a convergence on common methodologies that are applied. Credit providers want a single centralised service that can allocate credit to multiple endpoints simultaneously, without the need to log on to multiple venue UIs or even re-balance carve-outs between venues. Management time and legal overhead spent on limit and DN carve-outs is too much and unnecessary. 

What has not been asked is why can venues handle multiple streaming prices for execution but cannot handle streaming credit limits? Part of the problem is that ECNs are not incentivised to be good at credit management. Venues need credit but are not paid to consume and apply it. It also suits some venues to keep the barn door open and provide a simple kill switch. They are not responsible, however, for picking up the pieces from market disruption that can end with regulatory investigation and PBs leaving the market. Whilst kill switches serve a certain purpose, they tend to be a nuclear option that never ends well. What everyone requires is accuracy at the market access end points. 

Technology
Whilst kill switches serve a certain purpose they tend to be a nuclear option that never ends well

Credit providers have leverage that can make the market much safer. Firstly, they own the risk, so they can dictate the credit methodology and how it is deployed. They are also brokerage paying clients. So why has it taken so long? Since the financial crisis banks have been very much distracted and have been looking at their cost bases. Credit risk management is often incorrectly seen as an overhead rather than a means to reduce risk charges by being more efficient in using it as a means of protection. This new approach requires small changes to the technology stack at the ECNs to adopt a better credit model. The main trading venues are waiting for the primary credit providers to tell them what to do before acting on it. This requires a level of collaboration by the credit providers to push the market credit agenda. 

Some more nimble ECNs are already acting on this and see it as an advantage and a safer way to trade. They will be the first to go live with the new solution. Others may take time as their infrastructures often require greater change. For market operators, the time for action to resolve this long-standing issue is now. 

Future of the market

Currently, most markets are developing differently and, in some cases, with better technology. Regulation like MiFID II applies the same rules across asset classes, so it no longer makes sense for firms to use different solutions in different markets as this can fragment their operations. Instead, they are better using technologies to create platforms or systems that work across their business, rather than one specific market.

As a first step, a market-wide adoption of a digitised, centralised middle and back office which creates a joint record of all FX trades, would make it possible for participants to submit regulatory filings far more easily, plus do so in a consistent format. This would enable better monitoring of any potential systemic risks, plus delivering lower regulatory costs for all concerned, including regulators. Central banks could send a strong message here by adopting a back-office infrastructure which creates a joint record for all FX trades, which would also serve as a clear signal to the organisations they regulate.

Technology
By its nature a digital ledger knows the interconnectedness of the market

An additional benefit is cost transparency. In the current environment, with the accumulation of multiple layers of legacy operations and credit technology and processes, it is often extremely difficult to determine the post-trade cost of a transaction. A central standardised process would not only be cheaper through sharing but by contrast make the measurement and monitoring of post-trade costs straightforward and potentially deliver the same degree of transparency as already available for FX execution costs.

Establishing a joint record that is scalable secure and fast, would also deliver various credit management benefits. For instance, the availability of near real-time credit data would enable more efficient credit processes, such as preventing erroneous credit cut-offs. This would improve client relations, making more efficient use of available lines, avoiding over-commitment risks and alleviating balance sheet pressure. By its nature a digital ledger knows the interconnectedness of the market.

Centralising credit management using a central platform enables more dynamic control across all types of trading relationships. This will dispense with the need for over-allocation and rebalancing in order to accommodate localised management of credit within venues, plus allow for clients to unwind positions more effectively. Those issuing credit will also be taking control of it (as is the case in equity markets) and will therefore be able to recycle it back into the market in the most efficient manner (a key consideration for non-CLS currencies and non-CLS members). Ultimately this will result in venues receiving more business on best price.

In operational terms, workloads will also reduce when using this sort of solution, as less remediation will be required. Efficient credit management and automated processing will drive a reduction in failed trades, thereby also reducing the need for manual intervention and repair. It has been estimated that 43% of market participants expect to see greater levels of automation in both front-office and back-office processes to take place over the next year or two.

Adopting such a progressive approach to technology will open the door to a new wave of market players to enter the FX market – and make unnecessary cost, risk and duplication a relic of the past.