Where next for FX?

Regulation is tightening within the banking industry and with the advance of technology, it is becoming more and more challenging for firms to retain acceptable profit margins within their foreign exchange (FX) business.

Over the past decade we have seen many firms off-shoring and out sourcing their operations business to reduce costs in order to maintain profitability, however, firms may not have realised the full benefits of doing so.

With the continued focus on risk management, optimisation of existing operations process, keeping up with technology changes, client servicing and being compliant with the ever changing regulatory landscape, it is becoming harder and harder to remain competitive.

The biggest of these changes that we have seen has been the imposition of tighter regulations following a number of international FX rigging scandals, which resulted in banks paying out $10bn in fines and traders being replaced by advanced automated trading systems. These changes are costly, and have been absorbed by the larger firms, however, smaller firms are finding it increasingly difficult to budget for the required cost of change to comply, and ultimately face losing their FX business.

FX trading is becoming more and more competitive, particularly within the emerging market space. Volumes remain high, whilst spreads are tightening and values are increasing, driving down the profitability of the business, whilst the need to stay competitive and profitable is undiminished. All of these issues are combining to force a change in strategy.

This situation has provided the opportunity for innovative technology companies to step in and offer value-added services. We have been working closely with Broadridge to find a way to counter the problems mentioned above that are being faced by many firms. A potential solution may be to mutualise the FX post-trade operational process through a Managed Service Provider (MSP); an approach that builds on the industry trend for the mutualisation of cost models, whereby a common facility is shared or operated by many different market participants.

A mutualisation model is one approach that can help deliver scale and more efficient processing right now, which we believe will lead to dramatic cost reductions for financial institutions. Other opportunities to deliver efficiencies in this area may arise from migrating to the cloud, implementing machine learning and artificial intelligence, or developing a distributed ledger technology solution, although this is expected to have a longer horizon.

Benefits of a mutualised approach

The mutualised approach is an enabler for automation which sees the MSP being able to ‘pool together’ the regulatory obligations of multiple firms and deliver the required reporting on behalf of each firm as a service. As well as taking away the technology burden of supporting large in-house systems and the operational pain of undertaking individual regulatory compliance, firms that have signed up to this approach will realise substantial savings from a their reduced spending in this area, benefiting from mutual economies of scale. Additional benefits can include reduced operational risk and improved customer service.

Challenges in moving to a mutualised approach

There are a number of challenges to be faced in moving to a mutualised approach, but taking a strategic view of the benefits and working with the right partners, none of these are insurmountable. Moving to a mutualised model will incur a cost to make the change, and the return on investment will need to be measured over a number of years. Other challenges are likely to include a revised segregation of duties and responsibilities, and improvements to systems and processes to ensure the security of data. In addition, challenges arising from internal politics should not be overlooked, since the mutualisation model will result in substantial changes and efficiencies in systems, processes and the resources required to manage the FX business. Finally, some firms may be resistant to the approach as they worry it may compromise their position with regulators; an issue that should be overcome with an open and transparent dialogue.

Why haven’t firms already implemented managed services for FX?

The answer ultimately comes down to priorities and dealing with the pressure of day-to-day issues. Despite many firms investing in front office platforms that will deliver higher volumes of trades, there has been an historic severe lack of investment in middle and back office technology and operational processing. The result has been an overreliance on legacy systems that are not scalable, prone to manual intervention and increased trade failures, with offshore resources being used to supplement inefficient systems. The volume and quality of data involved in a highly inefficient process is also a major concern.

The primary objective for most firms is to be profitable while continuously looking for opportunities to reduce operational costs. However, successive waves of new regulation have been overwhelming for many firms, meaning the focus has shifted to implementing large regulatory-driven change programmes such as BCBS239, MiFID II, FRTB etc. In recent times we have seen many banks receiving considerable fines for failing to report correctly, therefore great attention has been placed on ensuring in-house legacy systems are compliant and able to provide the required reporting data, with heavy investment in the compliance, risk and regulations space.

The option to reduce the regulatory burden by sharing the problem to an external partner seems to have been largely de-prioritised given the overwhelming priority to sort out exiting in-house systems and processes.

Conclusions

As financial markets become competitive with new entrants, advances in technology, continued focus on regulatory requirements and most importantly the need to remain in business, firms need to explore all available and potential solutions that will help them to operate in the most cost effective and efficient way, without causing disruptions to their existing business.

In a recent report published by Broadridge, the vast majority of firms are expecting transformative change by 2020, although 38% are still taking a “wait and see” approach on their blockchain investment and implementation. Given that these emerging technologies are still some way off, a mutualised approach which can be rapidly implemented, may provide a useful way to deliver regulatory compliance, reduced complexity and cost savings right now.