The back offices of financial institutions are not typically seen as centres of innovation, or even operational efficiency. Similarly, whilst the FX market may be viewed as more technologically advanced than other asset classes, it is also more fragmented and operationally challenging.
It is no wonder then that Post Trade processes in the FX market have become a target for firms seeking to bring more operational efficiency to the market, be that through centralised clearing or automated trading and exception management.
“The Post Trade Task Force is certainly a step in the right direction in agreeing on three key areas or pinch points for Post Trade – onboarding, margining, and on-economic trade data,”Louisa Kwok
Compared to other OTC products, FX remains a bespoke asset class with challenges in standardising and implementing prescriptive regulations, says Louisa Kwok, managing director and head of GlobalLink’s Post Trade business. “The varying drivers for trading FX and how it’s executed, the array of participants and third parties, and different operational processes and workflows makes FX challenging to support particularly if it is only a subset of your portfolio. This makes deeper standardisation challenging.”
No market standards
“For example, there are a number of emerging market currencies that require additional variable settlement instructions (e.g. MYR, THB, BRL, and RUB). There is no market standard for these instructions so that leaves clients, counterparties and their custodians to work out bespoke solutions of how to determine, enrich, and consume these additional instructions which often results in use of free format text fields,” says Kwok.
The bespoke nature of the FX market was evident in 2013/14 when mandatory clearing of derivatives came into effect under Dodd Frank and EMIR in the US and EU respectively, however excluded FX. “Some expected it to come, but it never did,” says Kwok. “If you look at the latest uncleared margin rules (UMR) regulations, generally for entities that need to comply, it incentivises central clearing with lower required margin periods of risk compared to bilateral. This leaves the FX market to figure out how they will comply which means a different workflow compared to rates and credit default swaps where there is no choice,” says Kwok.
Fortunately, there have been some industry initiatives such as the Bank of England’s Post Trade Task Force which have been set up to examine the issues and provide recommendations for tackling them. “The Post Trade Task Force is certainly a step in the right direction in agreeing on three key areas or pinch points for Post Trade – onboarding, margining, and on-economic trade data,” says Kwok.
“However, the difficultly comes with agreement in approach on solving these challenges. There are also working groups within Global Financial Markets Association (GFMA) Alliance that are specific to FX, but which have a wider scope than Post Trade. But the challenge remains with clients needing solutions for problems today; and a wide array of participants within the FX market with varying risks and workflows making it difficult to find consensus that fits all or majority of use-cases,” says Kwok.
While industry-wide consensus can be difficult to achieve, especially when it comes to the FX market, there are a number of new services delivering more automated workflows across all aspects of the Post Trade process and providing a more consolidated view of complex Post Trade activities. Within State Street TradeNeXus, the focus is on how its newly developed products can work with existing infrastructure, says Kwok.
“Some of our more recent launches have involved partnerships that bridge the old and new making it easier for our clients to adopt as a part of their current workflows,” says Kwok. “These include adding greater transparency into the CLS Settlement process, asset manager-specific workflows for non-deliverable forwards (NDF) central clearing, and more recently trade optimisation analytics and workflows to facilitate more streamlined novation and trade tear up/compressions. All of these involve creating a consolidated view of bringing monitoring side by side with client’s matching, messaging, and settlements process.”
Under State Street’s GlobalLink umbrella, which consists of products like FX Connect, BestX and Fund Connect to name a few, the team has launched the GlobalLink Digital platform which brings together Post Trade transparency next to execution venues, TCA and research analytics. On a more strategic scale, TradeNeXus is a part of State Street Digital which is focused on bridging TradFi and DeFi, says Kwok.
“There are a number of new exciting proposed solutions around greater transparency, analytics, single trade source, alternative methods of settlement and so on which would bring efficiency and risk reduction. The challenge with new generation of solutions in the Post Trade space is that we’re not starting with a blank slate. For the new solutions to be successful, it needs to fit in with the current and work within the ecosystem meaning it needs to work for all relevant participants – meaning all parties need to be invested and make an investment in resources to adapt and adopt these new solutions,” says Kwok.
“Unfortunately, capital is not endless and the more systems you have and the more venues you access, the more complexity it brings.”Vincenzo Dimase
Regulation such as the new uncleared margin rules (UMR) and collateral automation can also deliver benefits and increase efficiency across margin activities, says Kwok. “Uncleared margin rules have driven long overdue focus and investment into collateral automation and analytics. With all around increased cost of doing business namely with margin rules and funding, what used to be a Post Trade operational issue is now and increasingly a front office challenge with opportunities to optimize.
“We see this continuing to change as most clients in the final phase of UMR were likely striving to comply. As the dust settles and processes are bedded in, firms will look to gain operational efficiency and in cost in terms analytics that factor margin at execution to inform decisions of who to execute with (taking best execution beyond price), deciding to keep trading bilateral or to centrally clear, optimizing their portfolio to reduce requirements and finding cheapest to deliver,” says Kwok.
One way to achieve higher rates of automation and reduce the cost of Post Trade processes, is to outsource middle and back-office services. “What we have seen in just the last few years is an increase in change on varying scales within FX operations,” says Kwok. “This ranges from additional SSI requirements for certain emerging market currencies to entirely new workflows with FX central clearing. Further to this, increased volatility brings greater sensitivity to timeliness of Post Trade operations. By outsourcing technology, clients can gain economies of scale with specialists that are dedicated to Post Trade technology The landscape will continue to change as new concepts gain traction and new standards are defined.”
Despite all the advancements in new technology and the influence of regulation, there is still considerable work that needs to be done in the Post Trade FX space, says Kwok. “Whilst many core processes around trade submission and matching have been automated, there are still processes done over email and fax which increases risk of operational error with manual intervention and lack of transparency. In terms of a firm’s choice of provider beyond meeting their functional needs would be demonstration of levels of support, resiliency and investment in innovation and thought leadership. In other words, a partner.”
“If you were to design a Post Trade infrastructure from scratch, it would look very different and you would have the same systems used by multiple banks.”James Pearson
When it comes to automation, there are generally two drivers – a reduction in overall operational costs and a reduction in operational risk. According to Vincenzo Dimase, global director, sales strategy & execution, FX & Post Trade, London Stock Exchange Group (LSEG), there is a greater focus on better management of operational risk but there also remains a trade-off between better workflows and the cost of investment. “Unfortunately, capital is not endless,” says Dimase. “And the more systems you have and the more venues you access, the more complexity it brings.”
The move to electronic trading has been a welcome one in terms of removing manual processes but pockets of manual intervention remain, says Dimase. Furthermore, the move to frictionless trading comes at a significant cost in terms of initial investment and there is still a reluctance to move away from legacy systems which is just the natural aversion to change.
A further obstacle to a more efficient Post Trade process is the fragmentation in the FX market, says James Pearson, head of ForexClear, LCH, part of LSEG. “Even with the move to e-trading, there are still multiple channels in which to execute. Individual banks’ Post Trade infrastructure reflects the fragmentation of the market.” says Pearson.
LCH is looking to bring the Post Trade clearing services together and have market participants more centralised via ForexClear. But a further complication is on the regulatory side. “FX clearing is still done on a post trade basis not at execution,” says Pearson. “In FX it is not mandated to clear so it becomes a different process, which is a slight nuance in the post trade process that is not found in other centralised asset classes.”
All of these factors have added layers to the FX market and to the Post Trade process, emphasising the need for more automation, centralisation and interoperable systems but also contributing to the cost of making these changes.
“If you have 100 clearing parties then you need to have 99 different credit relationships,” says Pearson. “With ForexClear, we are trying to simplify the system by sitting in the middle and providing visibility to regulators. Historically, it has been hard for regulators to transparently see market risk in one place.”
An additional driver for a more automated Post Trade process, along with technology advancement and the concern around operational risk, is the demand for more transparency. This is seen not just in the FX Global Code but also the UMR requirements which have reached stage 6 and brought more buy-side firms into its scope.
But there are some caveats to the UMR which means that not all instruments and participants are subject to the rule, so it has fragmented the market even more in a sense. Even though some firms have taken it as a reason to adopt central clearing for everything but not everyone has done that.
Record-keeping is another aspect, says Dimase. “Under ESMA rules, you are expected to archive data for five to seven years and central clearing helps provide that electronic audit trail. We are delivering an open and venue agnostic service to solve that complexity. That openness is a clear value.”
However, regulation will only go so far. “The proliferation of the FX market makes it hard to regulate but there is a wide demand for more transparency,” says Pearson. “We want encourage users and adopters through benefits such as commercial savings and operational efficiency rather than regulatory requirements.”
There is also a network effect – the more people that adopt central clearing, the greater the benefit. “There is a tipping point element to this,” says Pearson. “With the NDF market we are probably there and we are looking to bring the same level of adoption to the options market in 2022 and 2023.”
So what are the benefits of centralised clearing for market participants? It is back to the spaghetti analogy, says Dimase. “Simplicity is the main word. Instead of five to six connections, we have one. With a consolidated approach to Post Trade, there are fewer machines and adapters to be maintained. Server rooms and costs are reduced so there is a green element as well as a cost element.”
There is also a data management aspect to e-trading and Post Trade workflows’ simplification, says Dimase. Data is consolidated and not spread across multiple systems. This makes it easier to apply advanced analytics and have fewer components to be maintained when opting for a fully hosted approach. But what of the threat to IT staff? “They can be redeployed to other added value activities,” says Dimase. “IT and back-middle office teams can also perform their tasks from home. You no longer need the big disaster recovery sites if you use a fully hosted service.”
Given these clear and multiple benefits, as well as credit simplification, capital benefits and margin savings, one wonders why more automaton and centralised clearing has not been adopted earlier and on a wider basis. Again, it comes back to the reluctance to make large initial investments in return for long-term savings. The concern is that this reluctance will be even more to the fore in the current market even though it is more essential than ever to find long-term efficiencies.
“Over the last 40 years, things have been added on to the FX infrastructure and that has built up over time,” says Pearson. “If you were to design a Post Trade infrastructure from scratch, it would look very different and you would have the same systems used by multiple banks. In the short-term it would be expensive to build but in the long-term there would be a massive operational benefit. People need to avoid making incremental decisions year by year and instead make the long-term decisions now,” says Pearson.
“People say, our Post Trade has been working for the last 20 years, why should I change it? But a longer-term vision is needed,” adds Dimase. “The work on automation of execution has been plenty and now the Post Trade process is going on an interesting journey.”