Paul Ronan
Paul Ronan

Risky Business: Improving Risk Management strategies in the online FX environment.

Paul Ronan considers some of the credit and market risks faced by banks in the rapidly developing online FX environment.

First Published: e-Forex Magazine 22 / e-FX Industry Report / January, 2006

Online FX trading is becoming an increasingly popular option for financial institutions, corporates, fund managers, hedge funds and so on. As the variety of players in the market grows, and the speed of transactions becomes quicker (influenced by new streaming technologies), the strategies and systems developed to cope with the RFQ environment are starting to show their age. Paul Ronan, Managing Practitioner, City Practitioners, considers some of the credit and market risks faced by banks in the rapidly evolving online FX environment and suggests ways in which these challenges can best be met.

New Buy-side Players

Online FX trading has attracted a range of new buy-side players, with hedge funds, in particular, playing a powerful role in shaping the market. These new buy-side entrants are demanding but at the same time, often lack technological infrastructure, creating connectivity issues. Critically for sell-side providers, some buy-side players are beginning to employ sophisticated trading technologies (e.g. algorithmic trading) as well as aggressive strategies, aimed at exploiting pricing inefficiencies in the anonymous markets.

Streaming Technologies

The pace of change in the online FX environment is also being driven by STP and SER services. This is having a profound effect as streaming architectures require more control points in order to ensure a risk free, one-click trading environment. Crucially, transactions are now significantly faster.

Credit Risk

The impact of streaming technology on credit risk can be clearly seen. In the past, during the “onboarding” of a client to an electronic FX portal, a seller usually imposed a carve-out limit. This was known to be an inefficient use of credit but considered acceptable whilst the volume of online clients was relatively low.

“The increasing speeds of transactions, however, mean that credit check needs are now shifting from pre-deal to post-deal”

Now that customer coverage and electronic trading channels have increased, a carve-out limit might be exhausted but an overall credit limit underutilized, necessitating highly manual reallocations of credit.

The increasing speeds of transactions, however, mean that credit check needs are now shifting from pre-deal to post-deal, creating a challenge for existing credit systems. To date, credit systems have played a largely passive role in the trading cycle, providing a response to traders’ demands for credit-related information.

With the traditional RFQ model, no problem arose, as pre-deal credit checking could be factored into the price discovery. However, as the pressure has increased on RFQ response times, credit checking has become parallel to the price discovery, frequently occurring towards the end of the discovery cycle.

Shifting credit checking from pre to post-deal has a further impact: the outcome ofthe credit check determines whether price streaming needs to be altered for the client, either halted or widened according to line usage policy. This in itself creates a tension for sell-side players as, while prices are streamed to clients at sub-second speeds, (via an increasingly wide range of platforms such as proprietary web portals, Currenex ESP and API trading) the streaming controls available to service providers are very often manual.

In order to minimise exposure to credit risk and prevent loss of trade (i.e. through delays in credit checking), credit systems must become more aggressive as well as more closely coupled to the trading system, thus forming a very active point in the trading cycle. This, however, entails a major architectural change as systems must be adapted to publish a continuous stream of credit-related information to trading systems (“publish subscribe”), at ever greater speeds and volumes.

Market Risks: Regulatory Drivers

The EU Markets in Financial Instruments Directive (MIFID) has not yet come into play but when it does so, it could well impact electronic platforms and certain brokers (“systematic internalisers”) as these firms must, pre-trade, “publish a firm quote in those shares admitted to trading on a regulated market”, “on a regular and continuous basis during normal trading hours” and, post-trading, “make public the volume and price of those transactions and the time at which they were concluded”.

Information must “be made public as close to real-time as possible …in a manner which is easily accessible to other market participants”. The Directive’s transparency requirements will put pressure on banks to aggregate, publish and archive far greater amounts of information than ever before, creating significant risks for those institutions that fail to manage trade-related data efficiently.

Other Market Risks: Data latency

In the world of online FX trading, delivering data at high speed is a key ingredient to a successful service. Indeed, delivering the right information to buyers at the right time can often decide whether a seller makes a profit or loses money. Data latency can result in arbitrage opportunities, as a client spots a difference between the price offered by a bank and one of its competitors, and takes advantage of the mismatch. Clearly, highly efficient pricing engines are a must, if sellers are to avoid this trap.

“Not surprisingly, sellers’ worst nightmare is the creation of a liquidity bubble”

Liquidity Bubbles

The implementation of streaming technologies is moving the FX online environment towards an order driven market, creating fresh risk for banks. As one price can result in multiple hits, anticipating the volume of demand is not always easy. Not surprisingly, sellers’ worst nightmare is the creation of a liquidity bubble.

This fear also places pressure on auto quoting engines and their control mechanisms. For sellers using anonymous streaming channels, a strong sense of market depth is required, if this aspect of market risk is to be avoided.

The Interbank Market

The increasing speed of trade flows from e-commerce portals also, inevitably, affects the service provider’s relationship with the interbank market. Efficient and often speedy hedging in the interbank market is required. Any latency or slow visibility of trades on the blotter constitutes a risk.

The vendors in the interbank market have recognised this and are replacing terminals with API’s.

This will allow banks to implement netting and trading strategy engines between the e-commerce flow and the inter bank market.

“Efficient and often speedy hedging in the interbank market is required. Any latency or slow visibility of trades on the blotter constitutes a risk.”

Reducing risk

In summary, to improve risk management within these markets, two key areas should be focussed on. Firstly, risk marketing and trading systems need greater integration to provide credit risk controls. Secondly, in an increasingly anonymous and rapid market, building bridges between customer flow portals and the interbank channels becomes a necessity, in order to facilitate efficient hedging. To a certain extent, the FX market also chases the sophistication and transparency of sister markets, Fixed Income and Equities. Much can be learnt from the systems and business strategies that have evolved within these sectors.