Anoushka Rayner Global Head of Sales and Business Development at Cobalt
Anoushka Rayner Global Head of Sales and Business Development at Cobalt

Reducing the burden: Exploring the opportunity cost of post-trade FX

Anoushka Rayner explores the benefits of marketwide adoption of a modernised, centralised middle and back office which creates a joint record of all FX trades. The FX market is slowly being dragged into the 21st Century. Whilst front office processes have been transformed to accommodate the realities of electronic trading, other processes have been left behind. Most notably, outdated operations and credit systems which act as a significant drag on FX liquidity, as well as imposing an enormous cost burden.

First Published: e-Forex Magazine 88 / Market Commentary / September 2019

 With global economies, governments and business increasingly reliant on currency trading, it begs the question as to how the largest market in the world still relies on antiquated technology to manage the post-trade infrastructure? 

With new technologies and techniques being designed to make the trader’s life and executions easier, institutions must now look to adopt them if they are to retain a competitive edge in today’s challenging trading environment. Currently, only front-office processes are operating at what is required for the fast-moving FX market. Middle and back office have to catch up with the front office, as they are currently acting as a hindrance on the efficiency of the market. 

Outdated technology

The FX front office has evolved beyond recognition over the past two decades to accommodate the shift to electronic trading, delivering the benefits of increased transparency, efficiency and liquidity and reduced trading costs. In addition, developments such as the emergence of high frequency trading significantly changes the way liquidity is provided, and the diversification of counterparties has drastically altered the structure of the market. 

The front office has become largely automated due to substantial investment in new technology, and it now relies on complex algorithms which have increased productivity while reducing costs. The speed and efficiency at which trades can be executed between participants across the globe has been transformed. 

Conversely, the infrastructure that supports trading has lacked investment and is still reliant on technology and processes that were designed to support voice trading over 25 years ago. As a result, current post-trade infrastructure is antiquated and unable to cope with the speed of FX execution. 

This has led to huge expense, with global investment banks spending huge amounts running their operations and infrastructure. They are now starting to realise the extent of these costs and are calling for more transparency around fees so they can cut costs where possible. Post-trade processing, in its current setup, poses significant operational and systemic risk for the entire FX market.

 

The question needs to be asked about why the largest market in the world still relies on antiquated technology to manage the post-trade infrastructure?
The question needs to be asked about why the largest market in the world still relies on antiquated technology to manage the post-trade infrastructure?

 

Operational drag

At the core of the problem is the fragmentation, replication and complexity of internal processes. This is hardly surprising given that at least 23 services are usually involved in managing current FX post-trade activities, which inflates both costs and operational risks. Multiple vendors are needed, as are multiple copies of the same trade (20+ is not untypical). At the same time, existing legacy processing technology cannot keep up with market evolution and so requires additional outlay to pay for the manual processes needed to cover its shortcomings.

In some cases, extremely costly processes persist. These could be dispensed altogether in a more efficient processing environment. A case in point is matching and confirmations, the costs of which at some top tier FX banks - just for their Electronic Broking and Prime Brokerage businesses alone - run to nearly USD5mn per year.

Attempts to respond to changes in the front office by changing post-trade methods have also made the situation worse, as new substandard processes are layered on top of an already fragile and inefficient process stack. Each new process added therefore effectively exacerbates an already suboptimal process flow, in terms of both cost and risk. 

These issues apply across all FX-related instruments, which, when one considers that volume in uncleared FX derivatives (a market approximately twice the size of spot) totaled ~USD88trn at 2018-year end, illustrates the sheer magnitude of the problem. In fact, for FX derivatives, the risks and costs of these operational limitations are even more acute, as the processes involved are more complex than for spot.  

Regulation such as MiFID II and best conduct guidelines in FX, namely the FX Global Code, have also been important factors in the drive to adopt technology. Institutions now require transparency, and this has opened up opportunities for new data providers, compliance tools, analytics and new approaches to transaction cost analysis.
Credit 
Another major issue in FX is credit management. There is an inability to allocate and manage credit at FX trading venues in real-time and, as a result, banks are leaving themselves exposed. Many of these risk systems sit downstream and are slow; some even require manual processes. Credit is crucial to the FX market, but poor management can cause disastrous consequences for all involved.

Given the large trading volumes now conducted via API and at high frequency, FX is probably the market least tolerant of latency. Yet despite this, antiquated and fragmented credit management processes still persist, causing significant practical problems. The incorrect management of Credit-related risks still remain stubbornly high, while workaround remedies actually reduce credit efficiency, such as over-allocating to accommodate localised management of credit within venues. 

In an attempt to address these risks, credit kill switches were layered into the process but those themselves create different problems instead. They can create disputes when clients find themselves having to reduce positions at unfavourable prices and also requiring a manual unwinding process, exposing both clients and banks to further issues.  

Costs are also an issue in credit management, with top tier banks spending considerable amounts unnecessarily on redundant and inefficient credit processes and technology. 

Liquidity and regulation

Solutions to liquidity and compliance challenges are already entirely achievable at a technical level. A single centralised platform using standardised data can handle all the necessary post-trade activities in one solution. It would mean that compliance with many of the principles in the GFXC’s FX Global Code of Conduct could become an achievable and immediate reality rather than merely being aspirational. A case in point is the principle relating to real-time monitoring of trading permissions and credit provision. 

The cost and efficiency benefits delivered by a centralised industry platform have important implications for liquidity and market participation. Trading volumes in G7 pairs have been declining in recent years for a variety of reasons, but operational and credit inefficiencies are clearly playing some part if they are cutting trade margins to near zero. 

If individual ticket processing costs decline significantly, then logically this will boost existing participants’ willingness to trade, both in general, but also potentially in smaller transaction sizes. By the same token, new participants may be encouraged to join the market once they can see that the processing cost burden and operational risks have been alleviated.

Finally, there are also prospective regulatory advantages to the FX market adopting a centralised solution. Some regulators are already clearly aware of the issues, as shown by the FCA and BoE’s convening of a ‘Technology Working Group’ to reform post-trade processing so as to reduce complexity, encourage innovation, and improve systemic resilience.

A centralised platform could support this initiative in various ways, but one of the most obvious is with regulatory filings. At present, participants (often using manually intensive processes) incur substantial costs collecting trade data and submitting it to regulators. 

Middle and back office have to catch up with the front office, as they are currently acting as a hindrance on the efficiency of the market.
Middle and back office have to catch up with the front office, as they are currently acting as a hindrance on the efficiency of the market.

Future of the market  

Currently, most markets are developing different and, in some cases, 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. 

Market-wide adoption of a modernised, centralised middle and back office which creates a joint record of all FX trades, would instead 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. 

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 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. 

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, rather than killing trading through the use of kill switches. 

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.