By Gil Mandelzis,  Founder & CEO, Capitolis
By Gil Mandelzis, Founder & CEO, Capitolis

Next-Gen Best Execution: Capital Optimization

It is easy to think of best execution in simple terms, such as was best price hit. But in reality, the subject is much more complex and involves market impact, signalling risk, and of course benchmark. Those are all front office metrics, but true best execution takes in the total cost of the trade, meaning a look across the entire lifecycle. Nowhere is the cost of trading more critical than in the use of capital, especially in the age of Uncleared Margin Rules (UMR).

Most major banking organizations are already in scope of UMR; however, from September 2021 many of their customers will also be subject to the rules. That is when the threshold falls to $50 billion as measured by Average Aggregate Notional Amount (AANA). One year later, even more clients will join the party when the threshold is lowered again, this time to just $8 billion.

A large number of banks already account for their capital costs in FX trading operations and are actually seeking to reduce their impact. Starting in September 2021, their customers will be demanding their help to avoid unnecessary costs that have historically been off those clients’ agenda.

With more firms seeking to analyze the true cost of trading, they are finding that while transaction cost analysis (TCA) has improved beyond measure in recent years, it still does not measure the capital impact of trades with certain counterparties. It also does it assess settlement and counterparty concentration risk. These gaps highlight the need for innovative thinking and, more importantly, innovative solutions to help reduce the impact of UMR and preserve vital capital for trading businesses.

While the cost of capital for a trading business is the headline in the UMR era, another factor is also driving the push for efficiency – the authorities’ desire for reduced settlement risk which is another consumer of valuable financial resources. Recently, the Bank for International Settlements highlighted settlement risk in its recent Triennial Survey of FX Turnover.  As a major consumer of capital, settlement risk has therefore risen to prominence for firms that use foreign exchange.  

More recently, the Global Foreign Exchange Committee (GFXC) recommended changes to the FX Global Code that make the committee’s desire for more to be done to reduce settlement risk perfectly clear. In its recommended language, the GFXC states, “If a counterparty’s chosen method of settlement prevents a Market Participant from reducing its Settlement Risk (for example, if a counterparty does not participate in payment versus payment (PVP) arrangements or does not agree to use obligation netting), then the Market Participant should consider decreasing its exposure limit to the counterparty or creating incentives for the counterparty to modify its FX settlement methods.” 

This is a significant change from the previous language and infers, quite strongly, that if a client is not willing to use PVP or netting arrangements, then firms should trade less with them. This presents a tricky conundrum for firms, because some of their biggest customers may not have, or be unwilling to open, access to PVP mechanisms, which can be expensive to utilize.

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Figure 1


All of this means that the future relationship between bank and client is going to change (yet again) with capital optimization at the center of the new relationship. Settlement risk can be reduced through novations and compression, and every market participant – buy or sell side – will be very aware of their financial resource usage. This is a challenge, but also an opportunity. While competition for business on price alone has failed to produce a winner, could success accrue to the bank that can really help their clients utilize their valuable capital resources? It is certainly possible as this is one of the few real areas of value-add left to financial institutions in such a competitive FX environment.

For the buy side firm, capital optimization allows them to compete more aggressively for investor assets. Investment advisers and allocators are already starting to ask questions as part of their due diligence process regarding operational efficiency. This can embrace conduct – has the investment firm signed up to industry codes of conduct? – but more often is about how managers manage their regulatory burden.

This may be a relatively nascent change, but peer performance (or out-performance) still carries the most weight with investors. Buy side firms that can outperform adviser and allocator benchmarks without taking excess risk or creeping into markets that undermine the investors’ diversification strategy are more attractive than ever. Operational performance is becoming a real area of differentiation for investment managers. Although front office performance will likely remain largely aligned with the benchmark, a firm that uses its capital intelligently is likely to attract more assets on the back of the resulting few basis points’ worth of operational performance.

For the sell side, capital optimization can mean winning more deals. A 20201 White Paper from the Bank for International Settlements highlighted how liquidity in markets thins out towards the end of quarters and financial years because the major players are concerned about their G-SIB (Globally Systemically Important Banks) score. 

The BIS paper found that smaller banks often stepped up to the plate around quarter and year ends, but with slightly wider pricing – they have the balance sheet, but not the market risk appetite. By accessing capital optimization services, the buy side can broaden its counterparty book (thus reducing concentration risk), while the sell side can, in the case of smaller institutions, leverage their strong balance sheet while not taking on excessive market risk.  Larger banks can maintain relationships with their customers without attracting higher regulatory costs.

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Figure 2

Opportunity Set

One of the outcomes of the global pandemic has been an increase in the use of execution algorithms – as observed in the J.P. Morgan 2020 e-FICC trading Survey, which reported a more than doubling of volume executed via the technology2. This increase was driven by circumstances as much as by choice, however. As a “new normal” was established, the interest in algorithmic execution was sustained.

This represents an opportunity for buy and sell side firms to integrate capital optimization techniques into their execution technology – to go to the next level in terms of assessing best execution. Some banks offer RWA (risk weighted asset) pricing to their FX customers: however, that is in a bilateral environment. The next stage is taking the intelligence from within the institution and utilizing it to channel trades intelligently. 

The smart order router (SOR) has changed the face of trading and smart capital optimization has as big, if not bigger, impact. If a ticket is to be executed using an algorithm, then that strategy should be able to send the trade to the destination where it will incur the lowest capital cost. This input is in the pre-trade process and thus will not impact execution speeds; it will become just another step taken to provide the best possible execution experience.

To access this data, for it is all about data, market participants will need to connect to a solution offering flexible and dynamic compression and novation services. Trading opportunities can be fleeting in markets and, while they have a longer shelf life, the opportunity for capital optimization needs to be exploited as often as possible.

Compression and novation services directly reduce settlement and counterparty credit risk by allowing market participants to eliminate positions via a risk or riskless compression, resulting in a cleaner book overall and a lower exposure to UMR-related costs. These services also allow firms to move exposures between counterparty institutions, thus reducing concentration risk through an optimized, risk, and cost-efficient allocation across counterparties. 

Deploying these solutions directly benefits the trading business through capital efficiency, but also makes that firm a more attractive counterparty – something that will be reflected in improved liquidity. In the past, buy side firms have asked their liquidity providers if they price to a certain platform. In the years ahead, that question may very well change to ‘do you utilize novation and compression services?’

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Figure 3


The best execution conversation at the moment is still largely about hitting best bid or offer and minimizing market impact. That will never change, but going forward, traders will demand the most effective use of their capital. They will join hedge funds, who have long understood this concept, and banks who have more recently focused on capital utilization as treasurers began directly allocating capital costs to a single desk rather than the entire business. From September, a majority of asset managers will also have capital optimization on their agenda once UMR thresholds broaden.  That makes the use and cost of capital a market-wide issue. The focus on financial resource optimization is clearly here to stay: If you are not already thinking long and hard about it, you should be.

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For the sell side, capital optimization can mean winning more deals