Over the last 20 years, the evolution in global FX execution platforms, products and the legal and regulatory framework has led to enormous growth in FX Markets but has created numerous challenges. Unlike other asset classes with centralized venues and exchanges, FX is a hugely fragmented marketplace with multiple venues and liquidity pools. The unbundling of execution and credit has fueled the rise of non-bank market makers and algorithmic or systematic trading across buyside FX participants. Credit intermediaries have largely succeeded in managing the risks for G10 Spot, however we are now seeing greater electronification in other FX products- NDFs; FX Swaps; FX Options and EM currencies resulting in increased credit challenges. Although market driven disruptions have been few relative to the scale and volume of FX execution, their cause and potential long-term impact has recently led to calls for widespread changes to the existing risk models, methods and controls.
What is FX Credit and why is it needed?
Credit is the fuel for execution liquidity and must be controlled pre-execution until full and final settlement, as depicted in Figure 1, the original trading relationship and intermediary is crucial.
In FX, the bank and prime broker intermediaries play a crucial role for all participants in ensuring that FX execution can occur on multiple platforms but more importantly settlement finality is achieved by all executing parties. FX Credit is defined, agreed and controlled through legal agreements. Figure 2 shows the timeline view of FX Credit risk, in its raw form it can be broken down into execution risk, counterparty risk and settlement risk.
Execution, counterparty and settlement risks arise from the point an FX order is submitted by the price taker. Credit intermediation allows the price maker to provide a price(s) and enable execution.
Importantly, all participants in the ecosystem are involved in using, controlling or managing credit risks to enable a smooth functioning ecosystem:
- Execution liquidity pools – In-venue credit screening is crucial for liquidity and control for operators and participants alike
- Price makers – Executing Participants need to monitor their utilization against agreed relationship-based limits
- Price takers – Price takers bring diversity in execution and nature of participation, which not only creates opportunities but also presents challenges from an FX credit risk perspective
- Credit Grantors – Grantors are the liquidity provisioners; however, they need to balance their risk-bearing capacity with potential for execution erosion for the end clients
Any proposed changes to the existing FX credit risk framework will need to consider implications for the pre-trade to settlement finality risks but also the potential negative impact on market access.
Another important participant, the central banks, also have a vested interest in ensuring a safe and efficient FX marketplace both in support of their macro policy perspective and for local currency stability.
FX credit processing has evolved through innovation and investment in technology. The unbundling of execution from credit processing has enabled diversity of both execution participation (non-bank, buy side systemic trading) and credit intermediation (FX Prime Brokers and Prime of Primes).
Products such as Spot are much more automated in end-to-end execution to settlement processing while others (e.g., FX Options) may be high touch - Figure 3 represents the typical process
Some platforms operate execution matching exclusively for Bank-to-Bank liquidity as they are the recipients of bilateral credit. While other platforms are focused on Client-to-Bank activity due to their access to a Central PB or multiple PB credit lines.
Along with defining the end-to-end process, Bank and PB intermediaries have developed a standardized frameworks of tools to enable robust risk management. Figure 4 highlights four key pillars associated with second line risk principles, Manage, Measure, Monitor and Control.
Why the Focus on FX Credit?
Turkish Lira – An experiment in economic liberalization.
Recent Turkish Lira events can provide focus areas for what needs to change with the FX credit process or framework. Turkey’s desire to be included in the European Union led to open capital markets and development of financial market infrastructure to help support growth in trading of local equites and bonds, which attracted not only asset managers but also speculators seeking greater opportunities
Currency markets can provide an efficient mechanism for local and foreign participants to deal with local funding needs. However intraday funding gaps, government intervention and policy uncertainty can create risks and issues - Unlike many emerging markets, the Lira is a deliverable currency. Due to settlement occurring outside of CLS infrastructure, there is a reliance on local correspondent banks for physical settlement. This nuance means that foreign participants can and do utilize local entities to manage currency balances and visa-versa, typically on a foreign exchange venue. This implies that all participants are therefore subject to settlement risk associated with these local participants and may in most cases require credit from intermediaries who in-turn will rely on the local banks for settlement.
The combination of economic uncertainty, policy changes and requirement for real-world physical settlement of currency created a squeeze on funding markets which led to large volatile moves in FX rates and subsequent triggers for OTC FX Options, a perfect storm for credit intermediaries.
Consequences of failure in processes or risk framework – What happened?
It could be argued that these events and circumstances are unique to Turkey and are an anomaly; however, we have seen similarities with currency shocks in Russia, Indonesia and will continue to experience these going forward with Argentina, Poland, China, India and Brazil.
Volatility and instability with settlement of Lira – While no large losses can be directly attributed to the volatility in Lira, participants have faced challenging execution and settlement environment when the Turkish government has tried to control or stifle offshore markets by limiting local banks participation.
Traditional Net Open Position (NOP) and Daily Settlement Limits (DLS) measurements may not recognize risky or volatility settlement conditions in an appropriate manner. Better credit controls across a wider spectrum of venues and Intraday liquidity savings mechanisms or pre-settlement tools and funding may be beneficial or required where CLS processing is not available.
Large PB suffers losses from Client FX Options exposures – In 2018 PB Reports of losses in the range of $180m vs $30m in margin against a single counterparty due to exotic FXO.
Firms offering FX Options should ensure relevant margin models that are linked to credit measurements. Additionally, management of inventories is crucial otherwise pin risk can cause mismatch in settlement exposures that cannot be met due to stickiness in local funding markets.
Regulatory Challenges – What challenges will FX markets face in the future
G10 policy goal is to incentivize central counterparty clearing and reduce the overall systemic risk in OTC markets by imposing Margin and balance sheet (Leverage and Liquidity) constraints, while the FX Global Code is a set of standards that FX participants have voluntarily adhered to.
Margin: Unlike IRS and CDS there is no mandatory clearing obligation for FX products therefore executing parties and intermediaries have a choice. This implies that FX credit models may need to incorporate multifaceted execution to settlement paradigms, including PB to Clearing, Bilateral to Clearing or indeed a cleared product from point of execution Execution venues and optimization providers will look to enhance margin management tools, credit process and framework to support both deliverable and non-deliverable G10 products.
Leverage: The implications are that margining will become more relevant and important in managing balance sheet exposures, even for deliverable products which do not require posting of IM or VM. In addition, larger firms may be incentivized to reduce their overall exposures facilitating growth in different forms of credit intermediation (Prime of Prime) and Non-Bank Liquidity Providers.
Liquidity: Due to focus on correspondent banking risk associated with intraday liquidity exposures, over the next 5-10 years the industry may see growth in Central Bank Digital currency (CBDC) implying greater direct access to central banks settlement, liquidity savings mechanisms and potential for product innovation including execution and PvP of shorter dated FX digital products.
FX Global Code of Conduct (FXGCC): Over 1000 participants have signed a “letter of intent”, the FXGCC is explicit on what principles need to be incorporated for firms who participate in wholesale FX markets; however, it does not define how and what needs to be implemented. If the FX markets do not take the lead, future iterations may include explicit regulations.
Technology is a key enabler to resolving some of the improvements we have highlighted but in many ways defining industry standard business process and data standardization will be essential to achieve a viable end state.
A Central Credit Utility Model
Credit utility should allow and enable independent evolution and growth of execution liquidity pools while providing all participants with visibility, control and most efficient use of credit.
Designing a Process model in partnership with industry body and representation from all categories of participants, is a crucial first step. Although not mandatory, a central utility service could be the centerpiece of the ecosystem and could implement and enable the interactions. The merits and benefits of a utility model are well understood with-in the financial markets and provide value for both participants and regulators.
We have observed this with varied level of success within the FX markets with the introduction of CLS in 2002. FX Clearing infrastructure has evolved organically since early 2010’s with some market penetration for the NDF product but little traction across other cash products. Importantly, the challenges with an FX credit utility are much broader in scale and participation, unlike CLS and CCP an initial bank only focus may not address the core issues. The importance and inclusion of all participating firms: vendors, platforms, price takers and makers are crucial to the successful transition into a viable FX credit microstructure. As a minimum, a holistic design approach should be taken in order to meet the needs of all participants in the ecosystem.
It is unknown if the utility would need to register as a Credit financial market infrastructure (FMI) – for debate – however, an appropriate governance structure, rulebook and legal framework would ensure appropriate access for FX participants. Additionally, future iterations could enable extension into other asset classes such as Exchange Traded Derivatives, Repo and OTC Equity Derivatives where similar credit intermediation issues exist.
Whilst providing access and implementing core processing would be paramount to the service, the Credit Utility would need to ensure some core improvements to the current toolkit which would allow intermediates to meet their goals in order to Manage, Monitor, Measure and Control FX Credit risks. Increasing participation, improving tools and links, increasing distribution and addressing the overallocation issues would be the primary goals of the service.
The above provides a high-level view of what functionality would need to be encompassed into the utility service. Although much of the detailed picture will already be known to participants and providers alike, many new facets could be introduced with engagement across a wider spectrum of FX market participants.
Structured formal engagement is a first step and one of the core initial debates would center around the need for and merits of a central utility. Indeed, the intention of the paper was not to provide all the answers and disclose a definitive service proposal. Instead this is the start of a journey. We welcome and encourage broader engagement and debate on the merits of extending the current process and framework to a Central Utility model in order to enable an efficient well-functioning FX Credit ecosystem.