The Covid 19 pandemic has affected everything everywhere in some way and the FX industry has not been immune. Resilience has been tested more than ever before in what has been a unique crisis. Of course the FX market has seen its fair share of market shocks in recent years, the most notable being the Swiss National Bank black swan event of January 2015 when the global currency markets were thrown by the removal of its 1.20 peg on the euro/Swiss franc currency pair.
The turmoil was momentary but the damage was longer lasting, especially for some of the more highly leveraged retail brokers, many of which did not survive that particular crisis. Meanwhile the tier one FX prime brokers (FXPBs) tightened their credit worthiness measures, leaving a void in the prime broker and prime of prime space.
The industry has also seen its share of wider global events that have affected financial markets, such as the terrorist attacks on New York on September 11, 2001 which led financial firms to beef up their business continuity and disaster recovery plans by creating back-up sites of their dealing desks and trading floors.
However, the Covid 19 pandemic has created a worldwide economic and operational impact beyond all previous events in recent years. Those business continuity plans have been exposed as not fit-for-purpose and back-up sites have been left vacant as entire workforces have decamped to their own homes and their hastily arranged home offices. Furthermore, the global retreat to home working has been ongoing for more than six months now and shows little sign of being reversed.
So how have FXPBs reacted to the crisis and have they taken on board the lessons from previous market shocks to help manage the current crisis? Have they passed the tests posed by the pandemic relating to things like liquidity, volumes and credit risks? Has previous investment in platform maintenance, automation of risk mitigation and close management of client exposure helped prime brokers to remain resilient?
Furthermore, are FXPBs now taking steps to prepare for future pressure points on the industry? Has the Covid crisis accelerated some of the evolutionary trends facing the FXPB industry such as the move towards non-bank prime brokers and the prime-as-a-service model? And have some FXPBs fared better than others and if so, why?
Credit risk lessons
For Natallia Hunik, chief revenue officer at US-based prime broker Advanced Markets Group, the management of credit risk has been the biggest takeaway from previous crises through which the industry has gone. “This has resulted in the implementation of an enhanced system of checks and balances at many FXPB units in order to manage and mitigate risk and to make sure that each client’s risk profile is scrutinised from many critical angles,” she says.
It is also important to remember that FX trading is electronic and highly reliant on technology, says Hunik. “We have seen instances where a software malfunction has cost a company $400m in just a few minutes. The industry has taken serious notice of this and I believe that advancements in technology are delivering much higher standards of quality and reliability, which is incredibly important when you are operating a 24/5, high-transaction, high-volume business.” That said, Hunik believes that FXPBs have weathered this uneasy period “remarkably well” albeit with “a little bruising, but with no fatalities”, which is to be welcomed. “We have seen some companies hurt by the oil price turmoil with oil futures contracts going negative but in the grand scheme of things the industry appears to have largely benefited from the increased volatility that has resulted from the crisis.”
When it comes to the benefit that FXPBs have gained from previous investment in platform maintenance, Hunik cites the famous maxim of Benjamin Franklin that ‘an ounce of prevention is worth a pound of cure’. “Investments in maintenance and technology have helped FXPBs enormously during this period of market uncertainty, unpredictable price moves and unprecedented volatility, with platforms prepared to handle sharp market moves and set up to deal with the surge in transactional volume and increased load on systems. Automation helped incredibly when it came to transitioning to a remote setting due to the fact that processes and tasks were automated and well defined making the move much smoother than it could have been,” says Hunik.
“Managing client exposure is of paramount importance for high-risk businesses, such as an FXPB, and there has been an increased focus over the past decade on closer exposure management, credit risk controls and more diligent and prudent approach to assessing credit risk. While we were all caught off guard by the pandemic, it occurred at a time when the industry, and the world in general, were in a much better place to be able handle it than, let’s say, even five years ago.”
While each FXPB generally has the same business model, their approach to executing on the model varies and this has been a factor in explaining why some have fared better than others during this tumultuous period, says Hunik.
“The ones that fared well in the crisis were able to react to a client’s needs faster, and were flexible in responding to changing market conditions. As usually happens during periods of high uncertainty, we have seen many liquidity providers pull away from pricing certain financial instruments. There was a need to quickly find more sources of liquidity to fill these gaps in pricing due to persistent client demand, and the FXPBs that were able to quickly source liquidity are the ones that thrived.”
Equiti Capital, previously known as Divisa Capital, is a UK-based prime broker and FX liquidity provider. According to chief operating officer Michael Ayres, the firm has spent this year focusing on enhancing its in-house reporting and analytics systems. This has allowed the firm to test its credit risk and operational resilience in real-time, says Ayres. “I’ve been pleased to see that we can assess market impacts and take critical decisions ahead of the broader market.”
Ayres says that the prime broker has also spent this year “building out suitable liquidity composition from bank and non-bank liquidity providers to ensure that when there are periods of market distress, our pricing can be counted on”.
“We use a combination of proprietary technology and third-party trading systems in our ecosystem, meaning we could stand strong throughout the period of extreme demands on price discovery and post-trade reporting in the spring,” says Ayres. “We also work with our B2B partners on managing credit risk to ensure they benefit from our risk department’s experience managing numerous previous periods of extreme volatility.”
Of course, prime brokers had been investing in their platforms prior to the onset of the pandemic and some of this investment has helped them to remain resilient in the current environment. “Automating a range of processes on our internal systems at Equiti Capital has allowed our teams to focus on servicing our B2B partners rather than working through manual operations and admin-related tasks,” says Ayres.
“Our in-house risk system, q-Risk, has given us the ability to manage risk both on a macro and micro level, often providing partners with toxicity and trade pattern recognition reports that they would otherwise miss.”
Prime brokers have also taken steps to prepare for future pressure points and potential market dislocations. “We have been working through a number of liquidity optimisation steps this past six months. This has improved both the value of our pricing and the degree of stability we can offer,” says Ayres. “We have also expanded our range of internal KRI monitoring tools using machine learning techniques to provide a robust and intuitive way to manage these market events.”
When it comes to why some FXPBs have fared better than others during the Covid crisis, Ayres cites the importance of adopting a proprietary service model rather than a generic approach. “If your model is to offer an off-the-shelf solution, then you won’t have been servicing clients well enough during this period,” he says.
“We focus on providing a bespoke service and knowing our partners’ business needs so well that, as and when they call up, as their prime broker we are able to step in and deliver. At the core of Equiti Capital is a focus on operational efficiency, which has filtered through into a superior partner experience during these testing times.”
Every prime broker will have met challenges in liquidity, tom/next rates and implied risk levels and it will have been a test to see how responsive a prime broker can be around discovery and resolution management, says Ayres. “We have seen a trend of winning new business throughout this period where we were presented with a specific problem a broker faced and tasked with delivering a solution that would enable them to continue their operations seamlessly.”
While Covid 19 has led prime brokers to take steps to bolster their own resilience it has also accelerated some of the evolutionary trends facing the FX industry and its many service providers, including prime brokers – such as the move towards non-bank prime brokers or the adoption of the prime-as-a-service model.
“’Accelerate’ is the right word, not just in this space but across many industries,” says Ayres. “There has been a drive towards digitisation and automating processes to allow businesses to scale flexibly and with speed. I expect to see a broader focus on data and the ability to share insights with partners and peer groups to better maintain market stability. There will also be an opportunity to implement Software as a Service (SaaS) offerings in the B2B space, something we are delivering at Equiti Capital.”
The right technology
According to Peter Plester, senior director and head of FX prime brokerage at Saxo Bank, the main lesson that FXPBs have taken on board from previous crises is that good risk management and the right technology are critical in making sure that things run as smoothly as possible.
“Making sure that margin rates for example, are set at an appropriate level is key when a crisis hits and volatility spikes. Our extensive work on developing and introducing low latency pre-trade risk control technology is key to servicing the small to medium sized clients as it allows much more flexible allocation of credit to a wider range of liquidity and venues, whilst maintaining sound risk management.”
Another critical factor is the solidity of an FXPB’s relationship with its liquidity providers, says Plester. “Deep and long-term relationships with liquidity providers are important in normal market conditions but when the market gets stressed, they become essential. Making sure that your systems are able to handle unexpected spikes in numbers of trades is also a key lesson learned from previous market shocks. Saxo Bank’s systems are designed in a way to accommodate these and have worked extremely well in times of high volatility,” he says.
“Constant investment in improving technology and operational processes are also necessities to remain relevant in a competitive market,” says Plester. He references the “huge amount” that Saxo Bank has invested in these areas to ensure best-in-class systems and the widest possible market access in terms of different financial instruments.
Expect the unexpected
“As we like to say, in eFX we try always to expect the unexpected,” says Muamar Behnam, Head of Sales at Swissquote Bank, which specialises in online trading services, including FX prime brokerage. He refers to previous shocks that have helped prime brokers prepare for severe market moves – for example, the Swiss National Bank ‘Black Swan’ event of 2015, or flash crashes involving sterling (GBP) in both 2016 and 2017 or Turkish Lira (TRY) in August 2019.
However, Behnam notes that the main challenge of the current crisis has been how to maintain business continuity in a lockdown situation. “As an online bank, we were ready for this type of eventuality,” he says. “Home offices were organised for 600 or so employees either overnight or over the course of the weekend of March 13 – the date of the lockdown in Switzerland. So Swissquote coped quite well with this crisis,” says Behnam.
There have been other tests for FXPBs posed by the pandemic, relating to issues like liquidity, volumes and credit risk but Behnam says that his firm has coped well enough with these issues, helped by the fact that market has proved largely resilient as the pandemic has persisted.
“If you except some sharp market moves in the early months of the year, when the outbreak occurred, it was a year like another for us, albeit with higher volatility and volumes,” he says. “There was no flash crash as such, and although liquidity might have been sometimes thin, it was sufficient to cope with the increased demand.”
Swissquote has also benefitted from the previous investments it made in platform maintenance, process automation and close management of client exposures, says Behnam. “We have built in-house all our risk management systems. It helped us sail through the crisis without any damage. Necessary measures were taken, for example, when the oil price went into negative territory. It was a decision made jointly by the FX dealing desk and the sales desk and it worked well. It prevented Swissquote and its clients facing major losses during those bumpy market days.”
Technology has also been the focus of preparations made for future disruptions, says Behnam. “It is always about improving our technology, to support an extra load on servers and infrastructure. Fuses are set in case of market breakdown to stop the bleeding if any. We try to anticipate the worst to cope with the bad when it happens.”
Feedback has shown that during the crisis, the vast majority of clients were satisfied, says Behnam. “Their relationship managers were always available during the whole crisis, even more than before. This special period helped us build new relationships with our clients. We were here when they needed us. Services were always delivered in the best possible way. But it was more than just that during these times.”
However, as much as Behnam is satisfied with the way his firm has faced the crisis, he still believes there is space for improvement in the future. Similarly, he expects some of the trends in the FXPB market to experience more momentum as a result of Covid 19, one being the emergence of more non-bank liquidity provision. “We initiated the move towards non-bank liquidity provision a while ago,” says Behnam. “It is a trend we are aware of but Tier 1 banks remain our main partners. A smart mix of those is definitely the model to follow in the next few years, crisis or not.”