The FX industry needs to reduce post-trade costs. But the reason why costs need to come down also makes it difficult to accomplish. The revenues and the margins of both the FX banks and their buy-side clients are being squeezed, but that same pressure makes it more difficult for them to invest in cost-saving measures. It is challenging to persuade either the buy-side or the sell-side to invest in operational efficiency if it involves up-front expenditure.
There is a lack of investment in operational efficiency
Netting is a case in point. The value of netting to the banks, in reduced funding costs, is unarguable.
Multilateral netting is the main reason for settling trades through CLS. Bi-lateral netting is so valuable banks are prepared to incur the extra costs of awkward manual work-arounds. Yet neither the MT 370 bi-lateral netting message standard published by SWIFT in 2012 nor CLSNet, the blockchain-based bi-lateral netting service which CLS has opened to non-banks, has seen anything like the take-up by FX market participants that the additional benefits of automated netting dictate.
The difficulty, it seems, is that innovations such as the MT 370 and CLSNet require investment in centralised matching services and other linkages to overcome the obstacles set by the profusion of systems and processes within banks as well as between them. This lack of standardisation, and proliferation of proprietary systems and procedures, is characteristic of post-trade processing in the FX industry as a whole. The question is how to overcome it.
Change requires cross-industry consensus on ends and means
One answer, favoured by FinTechs active in the FX markets, is to jettison existing technologies. On this view, lavish cost savings fund the retirement of legacy processes and technologies almost immediately. But the savings by any one institution are bound to be constrained if its counterparties do not follow suit. Which is why others believe that an industry-wide agreement on both the objectives of changes to post trade processes, and the means of making them, is essential to success.
Building a consensus for change is difficult. The FX market consists not only of banks but of non-bank liquidity providers and the asset managers and corporates which buy and sell currency to fund purchases and investments. It includes vendors which service aspects of the post-trade process, but never the whole, and a variety of trading venues servicing different segments of the market. Increasingly, FX is also the province of stock exchanges and central counterparty clearing houses (CCPs).
Clearing threatens to increase post-trade fragmentation
In fact, the purchase of trading venues by exchanges with clearing arms potentially presages a shift of a higher proportion of FX trading activity not just into clearing, but possibly on to exchanges as well. The Uncleared Margin Rule (UMR) is encouraging this shift, which is popular also with regulators and buy-side firms that value the risk-reducing potential of collateral and greater price transparency. Banks will also benefit from the capital savings occasioned by wider use of collateralisation and more economical allocation of credit between clients.
However, there is an understandable concern that vertically integrated trading, clearing and settlement silos will emerge, characterised by proprietary message standards that render clearable FX business captive. This possibility, which, if realised, would force FX market participants to build different interfaces to each silo, threatens to increase fragmentation of the industry. It presents a sizeable obstacle to achieving consensus on the reform of post-trade processing.
Regulatory intervention might be necessary to overcome the disincentives to change
But is not the only one. The incentives to alter the status quo – with the possible exception of trading venues, whose need is always and everywhere to add business - are contradictory. The chief beneficiaries of increased operational efficiency at the banks, for example, are their asset management and corporate clients. The buy-side has little appetite to invest in the reform of post-trade processes, but every incentive to press the banks and trading venues for lower prices. That blunts the incentive to change. Likewise, vendors profiting from current inefficiencies have no motive to eliminate their profitable niche.
These various disincentives to reform have persuaded some market participants that regulatory intervention is necessary to force the pace of change. CLS, they say, was created by the central banks precisely because the banks had no incentive to solve Herstatt Risk by voluntary co-operation. The FX Global Code is another central bank initiative whose principles of good practice should, some say, be made a legal and regulatory obligation.
If it was, runs one school of thought, credit allocation would become a major driver of change in post-trade FX. The Code expects banks to protect the FX market by distributing credit prudently and efficiently. Yet broken processes and legacy technology inevitably mean it is allocated clumsily, increasing the risks incurred by both banks and their clients, as recent events have shown. Better management of credit would cut risk and spawn consequent savings in capital costs.
Attitudes to investing in operational improvement are changing for the better
Fortunately, attitudes to post-trade risks and costs are changing already. Banks are shifting technology investment from the front office to the back, to cut costs by raising rates of automation. They are also talking to those FinTechs whose propositions they believe can make a meaningful difference to post-trade risks as well as costs. An important driver is the deteriorating trade-off between offshoring and investment in automation, as the cost of labour rises in offshore locations.
In transitioning to a less fragmented, risky and expensive future, SWIFT has more than one important role to play. Its MT 300 FX confirmation message already reaches all segments of the market, and on a global scale. Standardised SWIFT messages, particularly of the ISO 20022 variety, can facilitate the management of data across internal business silos and inter-operability between market participants and market infrastructures. And the SWIFT gpi service, which enables banks to manage in-flight FX payments in real-time, is a rare example of something that is badly needed in post-trade FX: operational improvement without a massive price-tag.