The strange lack of technological disruption in Foreign Exchange
Despite their importance, size and liquidity the global FX markets have remained largely immune to the digital technology revolution. The reasons for this include their global scale, amorphous and fragmented structure and lack of an over-arching regulatory framework, but the principal cause of the lack of innovation is the domination of the FX markets by a small coterie of large global banks. Even the FX services for consumers developed by household name FinTechs have done little more than reduce the margins banks enjoy in one area of their business. In the wholesale FX markets large corporations, asset managers and asset owners continue to pay high prices for FX execution and hedging. This Future of Finance event engages with a group of innovators that have identified ways to challenge the banking oligopoly in FX.
Innovation in the FX industry is taking place largely outside the incumbent banks and stock exchanges that dominate the traditional industry.
Firms as various as the London Metal Exchange (LMX), digital money transfer house Revolut and crypto-currency trading firms ErisK and LedgerX are innovating in FX trading, clearing and settlement.
A group of banks is behind Fnality, which is looking to use tokenised cash to expedite settlements, but a switch to a tokenised FX market awaits the issue of central bank digital currencies (CBDCs).
Traditional FX is dominated by as oligopoly of large banks which dominate transactional activity bi-laterally, via platforms and through FX prime brokerage.
Post-trade operational costs outweigh execution costs, but the major banks have limited incentive to reduce these when the excess costs can be bundled up as a single price to the client.
With FX prime brokers shrinking their client lists in response to a perceived increase in risk and an actual increase in capital costs, a new model of trading FX has emerged.
The new model, based on crypto-currency techniques of tokenisation and “atomic” settlement on blockchain networks, relies on using tokenised assets to collateralise counterparty risk and access credit without the need for intermediation by a bank.
However, “real money” users of the FX market such as corporates and asset owners are unlikely to encourage the use of crypto-currency trading, clearing, settlement and custody techniques.
Innovative ventures are encouraging institutional investors to minimise the market impact of their trades by netting before going to market, but face challenges in building liquidity.
Inertia remains a potent enemy of change in FX, especially among asset owners, which rarely understand how much they are paying for FX and fail to encourage their asset managers to tackle the cost aggressively.
The FX Global Code, introduced by regulators to improve sell-side behaviour in the FX markets, is not attracting buy-side support, failing in its aim of improving sell-side behaviour and inadequately enforced.
Though regulators have threatened the FX markets with direct regulation if the FX Global Code does not succeed in its aims, the threat is seen as empty. As a global marketplace, FX can be regulated indirectly only, via the regulation of its participants at the national level.
Though many users of FX services rely on Transaction Cost Analysis (TCA) to manage their FX costs, most TCA is worthless because it does not use independent benchmarks.
Data standards would help to cut costs by improving transparency at execution and by making it easier to reduce post-trade operational costs by disintermediating some service providers and eliminating repeated reconciliations.
According to the Bank for International Settlements (BIS) biennial survey of the global foreign exchange markets, 40 per cent of foreign exchange trades are completed by telephone rather than digitally. This serves as an apt verdict on a market which boats of being the largest (the same BIS survey estimated the global FX market turns over US$6.6 trillion a day) and most liquid (a dubious claim far from true outside major currency pairs at certain times of day) in the world.
Innovation in FX is occurring outside the incumbents
Such technological disruption as there is comes largely from outside the large banks and traditional exchanges that make up the trading side of the FX industry. The London Metal Exchange (LMX), for example, offers 24/7 trading of two major currency pairs (euro/US dollar and US dollar/Japanese Yen). Revolut offers its retail customers FX bargains 24/7 at inter-bank rates, which it collects from third party data vendors such as Morningstar and CurrencyCloud.
Two crypto-currency trading firms now getting into FX – namely, ErisX and LedgerX – are now registered as clearing houses at the Commodity Futures Trading Commission (CFTC). By trading crypto-currencies against fiat currencies, they are beginning to impinge on the traditional FX markets.
Since they are already executing and settling crypto-currency trades in real-time, they are well-positioned to win business from traditional banks that still settle FX trades on trade date plus two days (T+2). Indeed, they could overtake even the traditional stock exchange and clearing groups that are now entering the FX markets.
CBDCs could tilt the FX markets towards a tokenised model
Other forms of innovation are also occurring, and not always outside the ambit of the incumbent banks. Fnality, for example, was set up by a group of established banks to work out how tokenised cash could be used to settle securities transactions on blockchain networks.
It has now expanded its scope to settle transactions through the use of tokens across six industries (securities, payments, clearing, trade finance, issuance and collateral management) and five major currencies (US dollar, Sterling, euro, Canadian dollar and Japanese Yen).
But what could prompt a mass migration of customers to a tokenised model is the introduction of central bank digital currencies (CBDCs). By fully digitising fiat currencies, CBDCs could encourage the most valuable sorts of foreign exchange trade to shift from banks and traditional exchanges to new entrants using trading and post-trading models honed in the crypto-currency markets.
An oligopoly of banks dominates the FX markets, including platforms
Such a transition is likely to be a prolonged and patchy. After all, at present, and by a variety of means, just five banks control four fifths of transactional activity in the FX markets. A small group of banks, expanded to no more than ten, also controls access to exchange trading platforms, which have yet to develop true customer-to-customer franchises.
Smaller banks are unable to compete with larger ones and are reduced to recycling to their clients the prices set by larger banks. The much-trumpeted non-bank liquidity providers (NBLPs), most of which are originally buy-side institutions, are ultimately dependent on credit intermediation by investment banks in their guise of FX prime broker.
In one high profile instance, a major bank jettisoned its NBLP-style clients in the wake of an uncomfortably large loss. That indicated exactly where the balance of power lies. Because NBLPs have credit lines with multiple prime brokers, and no one prime broker has complete visibility into the intra-day exposure of any one NBLP, unpleasant surprises of this kind are bound to occur.
Indeed, prime brokers in general are currently shrinking the volumes of business they are prepared to support, partly because of the risk but chiefly because the cost of the capital associated with the use of their balance sheet to support clients active in the FX markets is becoming insupportable.
Post-trade costs outweigh execution costs in the FX markets
The banks are simultaneously neglecting to tackle a major source of unnecessary costs in their back offices. More than one of the top ten FX banks has post-trade costs in their FX business of more than US$1 billion a year, but they have not managed to rationalise a post-trade infrastructure that fragments matching, credit allocation, confirmation, netting, compression, novation and settlement across multiple providers.
One bank is reported to employ 600 staff around the world to manage manual reconciliations in FX trades alone. Nor have banks managed to reduce the exorbitant price they pay data vendors for price information they themselves have created through their own activities.
These unmanaged costs offset the narrow spreads that are now being achieved in major currency pairs because the price of operational inefficiency is bundled up with the price of execution. Indeed, users of the FX markets are paying separate fees for post-trade services which dwarf the costs of execution.
One study of FX allocations between a master fund and sub-funds run by a major global fund manager found costs of US$270 per US$1 million, against the US$2-4 the professional market was paying. In other industries, bundled pricing and cross-subsidisation of this kind has led to anti-trust inquiries, but the FX industry is so far untouched by that threat.
True, some banks have woken up to the cost of post-trade inefficiency. They have proved that costs can be cut without necessitating a radical overhaul of internal systems, but enough inefficiency persists to encourage alternative service providers.
An alternative to FX prime brokerage has emerged from the crypto-currency markets
One model aims to eliminate the need for bank intermediation in FX altogether. The objective is to enable any counterparty to do business with any other counterparty without incurring the counterparty and settlement risk a prime broker covers. It is a demanding goal.
However, it is being met by the simple expedient of tokenising non-native digital assets. They can then be used to collateralise counterparties providing credit without the need to actually move the underlying assets between accounts.
The model has the additional advantage – not presently provided by crypto-currency exchanges that custody assets as well as handing the execution and settlement of transactions – of improving asset safety by leaving assets with third party custodians.
But prime brokers do more than solve counterparty risk. They also allow firms to trade assets they do not own. In other words, they advance credit. Tokenised assets can be lent. The DeFi token market, for example, brings together lenders and borrowers of crypto-assets without the need for intermediation by bank. The new model FX market is adapting the same technique.
It is a model which can appeal to prime brokers. Where a client can source assets from third parties on a blockchain network, the prime broker can continue to service the needs of the same client to settle and custody assets without taking the counterparty risk of the client on to its balance sheet.
“Real money” users of the FX market are unlikely to warm to crypto-currency techniques
However, collateralised trading on crypto-currency platforms that settle trades “atomically” will appeal to professional intermediaries and speculators only. The underlying clients of the FX industry – the corporates that need currency to complete purchases and the long-only asset managers and pension funds that are investing abroad – are much less sophisticated in their choices. They prefer the certainty of working with banks, and the convenience of platforms where banks control the prices, no matter how unfavourable the price.
Understanding of the costs of FX, particularly among asset owners, is low because it is often offered by custodian banks as a “free” service. Asset owners can be surprised to discover that FX bargains are costing them ten times as much as brokerage fees.
Pre-market netting can help “real money” investors cut FX costs
Efforts are being made to encourage “real money” clients to trade FX more intelligently. Siege FX, a London-based venture, enables institutional investors to reduce market impact by netting trades with each other before entering the bank-dominated public arena of spot FX. FX Hedgepool offers a similar peer-to-peer matching platform out of New York.
Netting services of this kind obviously depend on the ability to find a countervailing match. Though the act of searching for a match can of itself discover liquidity, buy-side netting engines do face a chicken-and-egg problem: as long as institutions are too sceptical to attempt to net, they will never be disappointed, and the banks will continue to profit from their scepticism.
In a separate but similar development, asset manager Vanguard has collaborated with blockchain vendor Symbiont, fellow asset manager Franklin Templeton and custodian banks BNY Mellon and State Street to use blockchain to cut the costs of FX forwards trading. Vanguard has previously mused that blockchain networks could be used to disintermediate banks and bank-controlled platforms from FX by enabling peer-to-peer matching of trades.
Asset owners are failing to understand and manage excess FX costs
But, unlike every NBLP, few traditional buy-side institutions are actively looking for alternatives to the status quo. Inertia, especially if the alternative demands sweeping changes to existing workflows. This inertia is a powerful constraint.
As signatories to the FX Global Code, a code of conduct for the FX industry which regulators published in the wake of a series of scandals, asset managers are conspicuous mainly by their absence. Yet Annex 1 of the Code consist of 18 pages of illustrative examples by which the sell-side exploits their inertia.
Asset owners are the root cause of this indifference. They and the corporates are the ultimate sources of liquidity in the FX markets, yet they do not believe the FX Global Code is aimed at them, and they have refused to understand the issues. As a result, they are unable to force their asset managers to drive the necessary changes.
The FX Global Code is proving ineffective
However, there is a view that the FX Global Code is flawed, not just in the sense that it does not protect asset owners from exploitation but also in the sense that following it does not protect sell-side dealers from breaching the law.
Mark Johnson, for example, the former head of global cash foreign exchange trading at HSBC found guilty in a New York Court in 2017 of exploiting confidential information in a client trade in 2011, behaved entirely in line with the stipulations of the Code.
In addition, parts of the Code are simply ignored in day-to-day business. But, whatever its shortcomings, the Code exists because it is not realistic to impose a uniform legal or regulatory regime.
As a global marketplace, FX cannot be regulated directly, only via the national regulatory regimes which apply to each market participant. The threat by regulators to regulate the FX market directly if the Code does not succeed in changing behaviour, is widely regarded as empty.
Transaction Cost Analysis (TCA) is not a useful measure of costs in FX
An alternative to regulation is data, but data that is genuinely useful to end-users is hard to find in the FX markets. Transaction cost analysis (TCA) is used by banks and brokers to reassure clients that the prices they are paying are fair.
Although the second iteration of the Markets in Financial Instruments Directive (MiFID II) forbids banks and brokers using rates from single banks or platforms in TCA calculations, the rule is not enforced.
In TCA reports, the impact of a client trade is routinely measured against the bank rate, instead of an independent rate. In effect, banks and brokers are marking their own homework, without clients (or regulators) protesting.
Data standards are needed to improve operational efficiency
Another obstacle to the effective use of data in FX is the absence of standardised formats. Data inputs as basic as currency pairs, rates, tenors and even the number of digits after the decimal point are not standardised.
This damages transparency, making it hard to reduce unwarranted costs in FX. It also obstructs efficient data exchange, making it hard to reduce reconciliations and improve the efficiency of operational processes.
The contrast with the crypto-currency markets, where the ERC-20 token standard has developed into a universal language for tokens, is marked. But agreement on standards, let alone obtaining a consensus to apply them, is a remote possibility.
Forceful intervention by a regulatory authority could impose standards, but the experience of the FX Global Code is discouraging. Market forces might be adequate, if blockchain displaced the present systems or asset owners finally understood that they are underwriting the costs of inefficiency, but neither outcome is imminent.
Questions to be addressed at FX Part II
1. How likely is it that crypto-currency techniques are widely adopted in the FX markets?
2. Are crypto-currency exchanges better placed to prosper in FX than traditional exchanges?
3. Is the biggest problem in FX operational cost rather than execution cost?
4. Is it possible to make effective regulatory interventions in the FX markets on a global scale?
5. What can persuade asset owners to take their unwarranted FX costs seriously?
6. What is the data opportunity in FX and how can it be exploited?
7. How can data standards in FX be (a) agreed and (b) adopted widely?
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