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 outsourcing their operations business to reduce costs in order to maintain profitability, however many firms may have still not realised the full benefits of doing so.
With the continued focus on risk management, optimisation of existing operations process, the need to keep 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 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 costly changes have been absorbed by the larger enterprises, but 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. Working closely with Broadridge, at GFT we have been examining ways 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 will also arise from 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 such a model will incur a cost to make the change, and the return on investment for doing so will need to be carefully 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 whilst continuously looking for opportunities to reduce operational costs. However, successive waves of new regulation have overwhelmed many firms, meaning their 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 existing in-house systems and legacy processes.
So where next for FX?
There are a number of ways for the industry to move forward from here. An industry-wide utility for FX Operations is very appealing for most participants, and could evolve in a number of ways:
a) A true industry utility would need a relatively large consortium of players to collaborate in a way which has been difficult to achieve across the industry thus far.
b) A small group of large players could emerge as first movers, but this could lead to issues with late adopters, such as disagreements on cost structures and service levels.
c) A vendor led approach, as we have seen in other asset classes, could well be the best way forward. This approach brings together the technology solution and the operations processing capability, providing a powerful platform that can bring benefits quickly, and with a minimal risk profile.
Once on the path to a mutualised approach, the opportunities to evolve the model and create greater benefits becomes a reality. Notwithstanding this, given the technology developments in operations efficiency, a parallel approach is to be recommended. Implementing artificial intelligence (AI) or robotic processing automation (RPA) to make short term improvements in operations processing will help reduce current pain points, whilst firms continue on the more strategic journey to the utopia of an industry-wide utility.
GFT's latest research paper FX Operations: The Next Frontier for Mutualisation is available to download now.