Foreign Exchange Archives - Page 3 of 3

Why digitisation of legal agreements is the key to unlocking the challenges of FX credit

Over the past few years, credit departments in investment banks have been demanding the implementation of better risk controls to manage credit. FX prime brokers (PBs) have placed an even greater emphasis on defining exactly which instruments, currencies, and tenors can be traded by their clients. Due to the scope, volume, and frequency of the different FX instruments being traded, it has become much harder for PBs and executing brokers (EBs) to be fully confident that they are aligned in their management of client risk.

Broadly speaking, the FX PB model has not fundamentally changed in recent years, with buy-side clients utilizing multiple PBs, who in turn face off against multiple EBs. PBs execute legally binding agreements with these EBs, thereby enabling clients the freedom to trade with the counterparty of their choice. It is not uncommon to have dozens of EBs trading with one buy-side firm, with the PB in the middle. With this flexibility comes complexity, however, and PBs and EBs must ensure that they are fully aligned in their management of each client’s credit profile.

Credit line pile up

That is an awful lot of credit lines for the PB and EB to manage, particularly when all a PB wants is a single line of credit with the buy-side client to effectively manage credit risk. However, due to the way the FX market is structured, the PB must also manage the limits and trade restrictions with each EB. As for the EBs, they need to adjust to any changes of the limit scope made by the PB in real time in both the front office and credit departments. These changes could vary from PBs reducing tri-party limits to new developments in the scope of authorized products, currencies, tenors for trading, or even specific relationships being terminated. Because the process of updating credit limits is so manual, it can take hours for these updates to synchronize from the credit department to the EBs’ front-office risk systems.

Taking back control of limits

The industry established a mechanism to manage this complex web of limits using designation notice (DN) agreements established between EB, PB, and buy-side client that outlines the counterparties, limits, and specific authorizations explaining what can be traded.

Today, in 2021, we would expect all FX market participants to have adopted an electronic solution that organises and manages changes to these designation notices in real time. But the reality is that, in some cases, the process remains manual and error prone. Some FX market participants continue to sign and post these legal agreements by email and store them in filing cabinets. Digging through a mountain of paper-based legal documents to find out if clients are about to breach their limits and manually updating changes in trade authorisation scope and limits are unsuitable in today’s fast-paced markets. And in a world where trades often carry the risk of theoretically unlimited losses client credit usage can spiral far beyond pre-agreed thresholds in the blink of an eye.

Driving efficiencies

In conjunction with leading FX market participants, OSTTRA undertook the challenge of identifying and solving inefficiencies in the documentation process for FX prime brokerage. A smarter, centralised, designation notice storage and management solution ensures that EBs are using the same source of information as PBs and that their client credit risk profiles are fully synchronized. As a central electronic repository of designation notices, our Designation Notice Management (DNM) solution enables PBs and EBs to streamline the creation and amendment of client credit lines. Due to the ongoing digitization of contracts, it also allows PBs to terminate agreements and EBs to consume this critical information much more quickly in the case of a fund manager defaulting. As a result, EBs can always ensure their systems are up to date with the latest limit classifications that PBs impose on them.

Our Designation Notice Management service has been successful in reducing risk and increasing operational efficiencies between PBs, EBs, and their mutual clients. However, we understand that in order to provide optimal support for the industry, a centralized service has to offer more than just electronification of designation notices if it is to be adopted by all market participants and ultimately generate the golden-source credit profile for all downstream processes.

The future of Credit Risk Management

Our ongoing discussions with the industry have enabled us to create a road map for the future that expands the depth and breadth of our existing solution. We are working to support additional types of documentation, including FXPB legal agreements, Master Give Up Agreements, three-ways, four-ways, and more. We are re-engineering the components that comprise our credit-risk suite to provide a seamless, end-to-end process from creation of designation notice, through credit monitoring, kill switch, and dynamic distribution of credit in collaboration with a growing number of ECNs.

As part of the enhancement program for the core Designation Notice Management service, we are delivering a new user interface and associated user experience that will enable clients to build new documents from scratch using an intuitive template approach. We are building APIs to support the uploading and extraction of limits and client credit profiles in an automatic way. The service will also support documentation pertaining to bi-lateral FX trading relationships as well as additional asset classes. Together, these enhancements will drive a significant improvement in the management of credit risk controls on a cross-asset class basis.

Enhancements of this nature are key, in this day and age with markets in a constant state of flux. No firm wants to sift through sheets of paper or depend on manual updates to figure out if they are in control of the credit risk.

FX PB credit: High time for the industry to come together

Greater engagement is required from all counterparties and venues across the FX ecosystem to improve credit risk management, according to industry experts from the prime brokerage arms of J.P. Morgan, Citi Group, and BNP Paribas.

Discussing how over-allocation of credit in FX affects market participants at the OSTTRA Tech Forum last month, Mariam Rafi, North American Head of OTC Clearing and FX PB at Citi Group, said, “If the market wants to continue to get access to the best sources of liquidity, it needs to quickly come to terms with the fact that we need to move beyond the old paradigms and deploy much more sophisticated technology in order to address longstanding issues with credit in FX.”

Leah Mallas, J.P. Morgan’s Global Head of FX Prime Brokerage and FX Clearing, reinforced Rafi’s call for industry collaboration, “Part of the reason we have seen so many firms dip in and out of the PB space is the lack of attention that has been paid to credit allocation. While we have seen more people waking up to the problem recently, the reality is we still have a long way to go. The devil is very much in the detail. For example, there needs to be much more granularity around designation notices.”

FX PBs have recently placed a greater emphasis on exactly what instruments, currencies, and tenors can be traded by their clients. The challenge is that due to the scope, volume, and frequency of different FX instruments being traded, it has become much harder but not impossible for to them to control risk with the right technologies in place.

Rafi added, “There is no reason, given the current innovation taking place amongst vendors, that risk cannot be mitigated through technology solutions. For example, a hub model where you can dynamically reallocate credit between all the different counterparties and venues would ensure much tighter risk management.”

Nathaniel Litwak, Global Head of FX Prime Brokerage at BNP Paribas, concurred with Rafi but also maintained that an industrywide solution was still some way off, “We have been living through this tech revolution which has been highlighted by COVID, so there is reason to be optimistic that there will be new solutions in the market that will help. That said, nobody can deny that there is a way to go before we find an answer to this longstanding challenge.”

In order to find a solution, multiple vendors have been trying to encourage market participants to adopt a network-wide solution. Igor Zubkov, Head of Credit and Documentation Services at OSTTRA added: “We are continuing to expand the depth and breadth of our solution in order to support different types of documentation –– from FXPB legal agreements, three-ways, four-ways, to Master Give Up Agreements (MGUA). We are re-engineering the components that comprise our credit-risk suite in order to provide a seamless end-to-end process from creation of designation notice, through credit monitoring, kill switch, and dynamic distribution of credit in collaboration with a growing number of ECNs.”

Intelligent automation speeds up client onboarding to OSTTRA Designation Notice Manager

Customer satisfaction is a key focus for our Service Delivery team. Time to market to onboard a prime or executing broker is an area that the market is continually looking to improve. OSTTRA is undertaking the significant challenge of identifying areas of improvement in the onboarding process for Designation Notices. The Designation Notice Manager (DNM) solution is the foundation of our credit risk services, enabling PBs and EBs to streamline the creation, amendment, and termination of triparty credit lines ‒ and paving the way for credit rebalancing across the industry.

Many documents to process

There are 24,000 designation notices across the entire $6 trillion FX market. For a prime broker or executing broker to go live on DNM, the designation notices need to be manually entered, which is a paper-based and highly manual process. As a result, the number processed daily is restricted.

In partnership with SuccessData, OSTTRA have deployed an automated solution that halves the effort involved in initial onboarding of designation notices. SuccessData extracts the details from PDF designation notices and converts it into a format that we can then upload into DNM. As such, we are now able to process far more of these documents in a shorter space of time. This allows us to onboard PBs and EBs quicker.

“We are excited to support our automation initiative to improve the processing of designation notices, which accelerates the digitization of a critical part of the FX market,” said Laurent Louvrier, co-founder and CEO of SuccessData. “DNM’s use of SuccessData’s solution allows us to help OSTTRA onboard and serve its customers more effectively.”

Benefits of customer onboarding automation

The solution can be triggered any time of the day, seven days per week. In addition to speed, increased accuracy of data processing removes the need for multiple checks and reconciliations throughout the process.

The benefits we see in this space have encouraged us to review other areas of our business that could benefit from an automated solution that can be deployed, scaled, and updated. As we continue our ongoing conversations across the industry about expanding the depth and breadth of our credit risk solutions, it is fundamental that we automate to improve time to market, reduce risk, and improve controls. The use of digitization has been a genuine solution to a manual processing problem that has challenged the industry for a long time.

To learn more, contact info@osttra.com.

FX Credit risk – The solution is simple if everyone is on the same page

A panel of experts from XTX, EBS, Sucden, and OSTTRA argue why all major FX market participants should come together to engage and adopt existing solutions to solve credit risk challenges.

Why resolve the problem of credit allocation in FX by removing the line of business completely, especially when there is an obvious solution, industry experts recently said at a OSTTRA hosted Tech Forum. Recent market events have led to some prime brokers pulling out of certain client sectors or increasing margin requirements.

Recorded on 29 June, Mike Irwin, COO at non-bank market maker XTX Markets, said: “Trying to solve this problem by just removing it off your books isn’t really a credible solution. We all know what the problem is and how to fix the problem, but to actually solve it you need adoption from all trading platforms, dealers, prime brokers, and fund managers to adopt a way in which credit can be managed to the greater benefit of the entire FX ecosystem.”

Also on the panel was Noel Singh, Head of eFX Business development at Sucden Financial, who reinforced Irwin’s call for industry to work together: “Currently, there is a dislocation between the ability to pay for the credit, and no concept of how much collateral the client has with us vs. how much credit we are giving out to the wider market. The only real way to solve this problem, which has frankly been around for too long, is for everyone to adopt a more dynamic distribution of credit, rather than having these static limits.”

The problem of credit allocation, which has hung over the FX market for over a decade now, has been in part due to understandable resistance from counterparties to fundamentally change the way in which they trade by introducing new methods such as pre-trade credit, dynamic distribution of ECN limits, and designation notices. Irwin went on to say: “I’m not against pre-trade credit as it is very relevant for areas such as clearing, but the reality is that does not solve the entire problem of credit allocation in an FX market of multiple counterparties and numerous trading methods.”

Andrew Cheesman, Head of Prime Brokerage and Credit Management at EBS, concurred with Irwin and Singh’s comments, but also claimed that without a solution to the credit issue there will not be a distribution network that everyone needs to get best execution: “Is it a liquidity issue that certain market participants can’t get access to enough credit at the right place and at the right time? Or is there just not the appetite for credit risk? Regardless of the answer, we need to make sure everyone can trade transparently on the same market and credit is a facilitator of that.”

In order to find a solution, multiple vendors have been trying to encourage as many market participants as possible to adopt a network-wide solution. Igor Zubkov, Head of Credit and Documentation Services at OSTTRA concluded: “Adoption, engagement, and involvement is the name of the game. The processes and solutions are available, and we are seeing more and more market participants trying to understand how to use the technology, including existing FX credit services such as DNM, CreditLink, and Rebalancer. Ultimately, credit grantors need to know the overall utilization across all liquidity pools, and how much credit is available that can be dynamically distributed across all the different ways in which FX is traded in as close to real-time as possible.”

For more information email info@osttra.com.

Best FX compression & optimization service – FX Markets e-FX Awards 2021

As the transition to the new capital regime on counterparty risk and uncleared financial instruments gathers pace, an increasing number of firms with substantial exposure to over-the-counter (OTC) FX derivatives are looking for ways to reduce their gross notional and counterparty exposure in the most efficient manner.

In 2021, their toil is proving particularly laborious. Hundreds of firms will have been caught by phase five of the uncleared margin rules (UMR), which took effect on September 1, and many more will have to adapt the manner in which they calculate their exposure to derivatives contracts when the last remaining – and some of the largest – jurisdictions shift from the current exposure model to the standardised approach to counterparty credit risk (SA-CCR) by the end of 2021.

To fulfil their obligations, many financial firms have sought out our compression and optimisation solutions over the past year, with noteworthy effects on the risk exposure of those in the network.

In January alone, $541 billion of gross notional was eliminated by our clients through our OSTTRA triReduce compression service, more than double the amount achieved the previous year. And, similarly, OSTTRA triBalance executed its largest ever optimisation FX cycle at the beginning of 2021.

“Looking at the past 12 months, I’m most proud of the fact that we are live optimising capital exposures in an ever-growing network,” says Erik Petri, head of OSTTRA triBalance solutions at OSTTRA. “I can say with confidence that we offer the market’s largest optimisation network for bilateral counterparty credit risk for the FX market.”

While reducing gross exposure to meet UMR rules and rebalancing counterparty risk to satisfy SA-CCR requirements can be met separately, Petri strongly encourages firms to accomplish both of these within the same cycle, rather than running separate compression and optimisation cycles.

“It is extremely important for firms to consider optimising both UMR and SA-CCR in one go, otherwise they risk suppressing one exposure while increasing the other, and that’s not ideal. In the FX market there is the opportunity to optimise the two in an extremely efficient way.”

The way we enable firms to achieve both of these goals simultaneously is that, during the set of forward and swap trades are replaced with new transactions with a combined gross notional that is worth less than the original notional. During the optimisation portion of the cycle, short-term risk-reducing FX non-deliverable forwards and forward hedge trades are introduced across all relationships, so each participant remains market-risk neutral. In this way, both initial margin and counterparty credit exposures can be reduced simultaneously, while at the same time reducing the gross notional outstanding.

Until recently, running this type of scenario was largely the remit of global systemically important banks – known as G-Sibs. In the past 12 months, however, an increasing number of smaller sell-side players have joined our network, with the buy side also showing interest in the benefits that compression and optimisation can offer.

“We are now seeing that interest filtering beyond the top-tier banks with regional banks and second-tier banks more focused on net optimisation, not only because of the introduction of SA-CCR but also more generically,” Mattias Palm, head of OSTTRA triReduce FX.

“While SA-CCR is only applicable to banks, we also see increasing interest on the buy side, even though they’re not directly driven from a capital cost perspective,” says Palm. “Bilateral exposure comes with a cost to everyone, and a lot can be done across all kinds of institutions to minimise it.”
While making the necessary technological investments to centralise their portfolios can be considerable for many firms, the benefits for our network of participants, that come from reducing risk through compressing and rebalancing a derivatives portfolio, can run into the millions, not only in the funding cost of initial margin but also the cost of capital.

“It’s impossible to put an exact number at the moment, but we know there are significant savings to be achieved,” says Petri.

“The transition to SA-CCR is a big deal for the industry,” he says. “And it’s something that we expect will drive growth over the coming years. There will be an increased need in the FX industry to keep counterparty credit risk down through rebalancing and compression. FX is one of the asset classes where bilateral liquidity – in terms of outstanding trades – is significant.”

Also, worth noting is that OSTTRA triCalculate has developed a SA-CCR engine that calculates SA-CCR figures for portfolios containing a wide variety of derivatives transactions – margined and unmargined, as well as bilateral and cleared – across all asset classes according to the latest guidelines.