FX FOCUS April 2015
By Eva Szalay
Execution speeds are measured in milliseconds, but credit allocation still happens via fax, and post-trade risk management proved to be only partially adequate in the wake of January’s Swiss franc move. Eva Szalay probes the FX market’s appetite for more pre-trade measures
When Jan Nowak had a nice cup of tea on a winter morning, he didn’t realise that by the time he finished his drink he would be £21,711 in debt. And yet that’s exactly what happened on January 15, when three bets – each worth £200 and placed with retail broker IG – on the euro making some minor gains against the Swiss franc went disastrously wrong.
Nowak and his peers, who collectively had positions worth about £600,000 and now have amounts outstanding of £18.4 million (see chart), blame IG’s risk management and claim it was the failure of the broker’s system and procedures that caused slippage of thousands of basis points on their stop-loss orders.
Nowak’s story is the result of a chain of events, ignited by the Swiss National Bank (SNB), when it removed its minimum exchange rate in the Swiss franc. The decision from the central bank triggered a well-documented, once-in-a-lifetime move, but in the end it was only the beginning of an extraordinary period in foreign exchange markets.
“What the SNB event has done is to highlight the importance of managing credit risk. Certain client sectors have more credit risk than others and I think right now credit departments may be more cautious than they were before,” says Jill Sigelbaum, global head of foreign exchange and alliances at Traiana.
“Some competitors’ approaches to risk were
very different to ours and… small clients were onboarded without KYC or credit checks”
-HEAD OF CLEARING AT A LARGE PB BANK
Since the event, several major prime broker (PB) banks have raised their capital requirements and jettisoned smaller clients as the cost of credit provision is being repriced, allowing prime-of-prime (PoP) providers to fill the void left by small clients that do not qualify for PB access under the new, prudent framework.
Citibank, one of the world’s largest foreign exchange prime brokerage (FXPB) banks, previously had a large client base of small clients and retail aggregators. It now requires customers to have a balance sheet of at least $25 million and it has raised its fees for PB services. The bank was one of the most affected PBs as it suffered retail client losses and it has given notice to its existing small customers to find a new home.
Previously, Citi offered a ‘PB light’ margin trading solution, dubbed TradeStream, under which small clients could gain access to credit and leverage without the usual extensive credit checks. Before the SNB move, this solution worked for everyone involved as clients gained leverage and Citi boosted volumes.
The bank declined to comment on whether it will continue to offer its margin-trading business, but it confirmed the pullback from smaller clients. “This has been a trend for quite a while. It has become increasingly apparent that the infrastructure used by large PBs isn’t suitable for smaller clients. These clients have typically built relationships with smaller providers, including PoP providers, who are better equipped to handle smaller clients with different needs,” says Sanjay Madgavkar, global head of FX prime brokerage at Citi.
Citi’s misfortunes – it has lost around $400 million due to the SNB event, according to press reports – have caused rivals to point the finger at the US bank, accusing it of accumulating systemic risk in the industry due to its less stringent approach to credit allocation.
“When we bring on a client we do a substantial risk assessment, and our second line of defence is the credit risk and leverage assessment. We have a risk team that evaluates clients from a number of perspectives before onboarding. Some competitors’ approaches to risk were very different to ours and in some cases small clients were onboarded without KYC or credit checks. I think the systemic risk that can be brought on by such an approach should be concerning for the whole industry,” says the head of clearing at a rival bank.
Madgavkar acknowledges some aspects of credit allocation will have to change after the SNB incident, and says margin-based credit facilities will need to assess and incorporate a broader set of potential risks, which depend not only on historic experience but on other assessments too.
“The recent challenges faced by margin providers, particularly in the retail FX sector, revealed the risk of providing facilities collateralised entirely by a limited amount of margin. Credit providers will demand stronger balance sheets and proven risk management practices to ensure their clients are capable of handling shocks,” he adds.
Risky business
When a PB looks at clients, it evaluates a set of risks spanning operational, market and settlement issues. In FX, settlement risk is mitigated by industry utility CLS and it plays a minor part in the PB’s assessment of the overall client risk.
“The SNB move highlighted risk in general. The direct risk highlighted was, of course, that market risk is larger than most of us anticipated,” says James Sinclair, chief executive of technology firm MarketFactory.
Market risk is the measure of the possible replacement cost of trades that were executed with a counterparty that went bust, which arises from market moves between the time of the trade and that of the counterparty default.
Market risk does not account for loss of principal, but rather any loss of principal counts as settlement risk. Until the EUR/CHF move, market risk was evaluated to be around 5% in major currencies such as the Swiss franc and most risk management models used this figure as a marker.
The SNB move showed market risk can be as big as 30%, even in the most liquid currencies, which, in turn, brought into focus the importance of reducing operational risk for clients in order to balance out the increased overall risk bucket.
“It’s the totality of all sources of risk that are relevant when a bank assesses whether to do business with a particular client, or to be in the business at all. Banks typically calculate risk-adjusted earnings, including all risks and costs of capital. Now that market risk has increased, reducing other forms of risk is very relevant,” says Sinclair. One area where market participants feel risk could be reduced is operational risk, but this can only happen if there is more emphasis on pre-trade risk management solutions and less on post-trade processes.
“It’s prudent for everyone to look at their risk management,” says Anthony Brocco, chief executive of trading platform Advanced Markets. “There is a bigger focus on pre-trade risk tools because post-trade is too late, as we have just seen.”
In the past, the PB allocated clients set credit limits on venues they wanted to trade on and monitored whether they were within these limits using a post-trade process, based on notifications from the venue and executing brokers.
“We’ve never felt comfortable with the idea of only post-trade risk management,” says Gareth Bowles, head of LMAX prime sales at LMAX Exchange. “One of the reasons why banks are pulling out of PB is because they feel exposed using post-trade solutions and the SNB event highlighted the shortfalls of that.”
Pre-trade risk management has existed for several years, with technology providers MarketFactory and Fluent offering tools that check clients’ limits before they are able to place trades. Traiana, a post-trade technology provider, also brought a so-called designation notice manager (DNM) to market two years ago, but it had not seen a significant take-up until the past few weeks.
“The big gap is managing credit at the same pace as execution. Execution has been getting faster and faster, but credit hasn’t kept pace,” says Traiana’s Sigelbaum. “Our DNM updates designation notices within milliseconds, so execution brokers know about the clients’ exposures immediately.”
Sigelbaum says adoption is only now reaching a critical level as banks are allocating more resources to updating their risk management systems. Ten PBs are in the process of adopting Traiana’s post-trade solution and working on the monumental task of uploading all their designation notices.
But this is still not enough, say some market players. PB credit assignment today takes place by manual designation notice sharing, and as such it can take PBs a few hours to shut everything down for a client. That’s clearly not fast enough, says Gil Neihous, chief executive of Fluent Trade Technologies, as it means PBs are unable to prevent new trades reaching the market when a client breaches their credit limit.
“Current post-trade risk management in the fragmented FX market is no longer sufficient. The market has changed and participants now urgently require pre-trade risk ‘prevention’ tools in addition to post-trade ‘detection’ ones,” argues Neihous.
At the moment most PBs and providers do not have an overall view of their clients’ net open positions (NOP) across multiple venues or over their net open orders (NOO); a situation that exposes the PB provider to legal, credit and reputational risk.
Before the SNB event, typical risk management metrics were mainly based on a client’s balance sheet size and value at risk, but since then it has become apparent that potential losses can exceed this size and assessing risk purely based on historical events is insufficient.
“The traditional risk paradigm tended to focus almost exclusively on analysing historic market conditions. This has changed and additional layers of forward-looking stress tests are now an important part of our risk assessment,” says Madgavkar.
“Credit providers will also differentiate more deliberately about possible risk events associated with individual currencies, based on their unique circumstances. Client margin terms will, of course, be related to this analysis and potentially be managed much more dynamically in the future. Issues relating to concentration risk in a client’s portfolio will also be a greater factor and identified by appropriate analytical methods. I believe these will all be part of the risk management toolkit of credit providers going forward,” he adds.
Citi and several other PBs have been working with Traiana to introduce new, pre-trade elements to the existing CreditLink infrastructure.
“We are building a credit-rebalancer tool within CreditLink, which will move credit around from platform to platform, with the DNM acting as a building block to real-time credit allocations for single-dealer platforms. PBs feel exposed to allocating credit manually and they want a tool that allows them to see the client’s credit utilisation across all platforms,” Sigelbaum says.
Traiana has installed kill switches on nine FX trading platforms and is building one for single-dealer venues. It has also started work on a pre-trade, credit-check tool for executing brokers.
In the future, pre- and post-trade risk management tools could sit together at various levels of the trade cycle. Pre-trade solutions address risk at the gateway level while Traiana works on the platform level.
“We do have a pre-trade tool, but I think the two [pre- and post-trade solutions] are compatible and can sit next to each other happily,” notes Sinclair. Neihous agrees, but says prevention must play a larger part in the equation. Fluent’s risk management solution sits at the client side on the execution layer and has 35 pre-trade risk metrics. Once a pre-determined risk threshold is met, the PB can instantly block further orders.
“Effective risk management should not rely on credit rules. There is a full spectrum of additional measures that can be effectively managed. Moreover, these can be managed in a pre-trade manner to prevent risk events from happening at all,” adds Neihous.
“Pre-trade risk management doesn’t stop currencies being volatile. It doesn’t prevent settlement risk, but it does give you more control over operational risk,” notes Sinclair.
The future looks PoP
With the retrenchment of PBs, several PoP providers popped up to fill the gap and some new players are considering entering the credit provision arena. LMAX Exchange recently launched a PoP service and even some proprietary trading firms are believed to be looking at offering PoP services.
“PoPs, backed by funds, could offer direct market access to whoever is behind them and I think there will be some movement in this space, with some firms already looking at providing such a service,” says Ed Anderson, head of institutional sales at FXPro.
For now, the space is dominated by smaller banks and retail brokers, although the arrival of non-bank credit providers could be on the cards if the retrenchment of PBs proves permanent.
“We’ve been exploring the opportunities in PoP, but I was conscious I wouldn’t want to compete with my PB bank and cause friction in our relationship,” says a partner at a Chicago- based hedge fund.
“I went to my PB and asked what they thought about the idea, whether they would be against it or not, and the response was very positive, so I think PBs are quite keen to outsource some aspects of credit provision to some of the larger existing PB clients,” the partner adds.
“I think there is considerable room for PoP providers to handle a certain market segment,” says Madgavkar. “At the end of the day, clients need to be served by institutions best equipped to handle their specific needs.”
Not everyone is convinced the pullback will last, however. Established players such as Citi say they remain committed to their FXPB franchises, even if small tweaks to the business model are required. The bank says it will continue to acquire appropriate clients and it expects to continue growing this year.
“We believe FXPB is an important strategic offering for our FX franchise and our institution, and we are developing plans for newer and better technology, and staffing. At the end of the day we have two core priorities: ensuring our clients have the best possible experience while maintaining a sound business with robust risk management practices,” says Madgavkar.
Brocco believes the current situation will calm down once the initial panic passes. “Becoming safer is a good thing, but we have to be careful with overreacting and causing irreparable damage,” he says.
“The more I think about it, the more I think the pullback might be temporary,” notes Sinclair. “In years to come, I bet we’ll be looking back on how this event just showed the FXPB model works well. The market is trading today, customers are being served and contagion was limited.”
“The FX market is extremely resilient. A major reason is that it evolves to serve real problems rather than being tightly regulated, unlike other asset classes. FXPB will evolve, the model will be tweaked, new players may move in if some leave, but, as I said, PB does spread and mitigate risk. It fundamentally works,” he adds.
