The FX Pivot

September 08, 2020

At the start of May, I wrote an article called "The times, they are a'changin" which looked at the impact of Covid-19 on the functioning of the FX market and its participants. It was written eight weeks into lockdown and focused on the practical implications of what was then assumed to be a temporary state of affairs. What it did do was to examine some of the possible long-term effects on the way in which we work and look at the benefits of working from home and the development of systems and workflow practices that support that.

What it didn’t do was to consider whether this would be the catalyst for Banks to ask themselves (again) whether their essential business model in FX needed a major re-think.

Hundreds of banks across the globe have been trying to extend the life of a business model fundamentally unchanged for 30 plus years but which has been overtaken by advances in technology, the march of events and ever tightening regulation.

Back to basics

Banks are complex institutions; hierarchical, technical, extremely political and sometimes fickle. Yet over the past few years, most have tried to distill what they do into a simple mission statement applicable to individual departments as much as to the bank as a whole.

  • Serve our clients 
  • Run a profitable business 
  • Look after our employees 

The FX division is no exception. It needs to serve its clients (both internal and external) and enable them to manage their FX risk whether via simple exchange or more sophisticated risk management tools. 

It needs to be profitable, both in terms of the narrow FX activities of the Global Markets division, and the wider FX activities of the whole Banking Group, delivering an acceptable return to shareholders, taking an acceptable risk, and conforming to the letter and the spirit of applicable regulations and laws.

At this specific time, when public health dominates the news, an employer needs to ensure the safety and wellbeing of its staff, both physically and mentally. An FX business, like any modern business subject to change, can’t offer lifetime employment, but if it values its employees as some of its greatest assets, it should offer lifetime employability through training and investment in its staff.

A modern FX market making operation needs economies of scale in order to flourish. It relies mainly on technology to monetise the flow and capture the wafer thin spreads in the wholesale market, and this leads to a simple truth – the greater the volume transacted, the more information contained in that flow, the greater chance of internalization, and a more profitable retention spread especially in a low volatility environment.

Whilst some banks have seen the uptick in volatility from the depressed levels of last year as a welcome relief, they would be wrong to count on this as a lifesaving trend. The gains generated by a the slightly wider spreads can more than easily be wiped out by ‘flash crash’ style market movements which seem to occur far more frequently these days, and which can seriously impact less sophisticated operations.

Win the war, not just the battle

Anyone considering the future of the FX market knows that competition will continue to put pressure on the traditional players, and it will come from outside the banking sector as well as from within.

The smaller regional bank is in a difficult position. Many have a loyal client base, although one not exempt from competition. These Banks play a key role in their local economies; they understand the credit profile of their clients and are experts in local regulations and specific market norms.

The FX bid/ask spreads they charge clients are necessarily far wider than those found in interbank market as they have to manage credit risk, provide a service, execute on amounts far smaller than those transacted in the wholesales markets and support a relationship. At the same time, their actions are tempered by the knowledge that open banking regulations, technology & transparency set acceptable limits on the boundary of those spreads. There is a price at which clients will be tempted to look elsewhere.

The solution? Provide clients with exceptional service. Increasingly clients are using electronic tools to manage many treasury processes, online banking, and accounting, and there is no reason why FX should be any different for all standard transactions.

Additionally, clients have come to rely more on mobile applications, certainly in managing their personal financial affairs, and in this time of lockdown and changed working practices, they are also looking at the benefits of having certain functionality available to them when not in the office ( e.g. watch lists, the ability to approve trades and even to execute within certain parameters).

The challenge to the regional banks is that investing in such technology to service their clients current and future needs comes at a cost. And that is in addition to the cost of running a trading  team, maintaining infrastructure, contributing to the running costs of the bank allocated per front office headcount - all for the privilege of trying to capture a portion of the bid/ask spread over and above that of the captured client margin.

In earlier days, before the advent of laws like the French banking Law of 2013 and the Volcker Rule designed to segregate speculative trading activity inside a bank where it may cause a conflict between the interests of the bank and those of its clients, proprietary trading around client positions was the norm. These days, there is much more regulation around what is and isn’t permitted, which reduces the potential for profit as well as for conflict.

There is a tide in the affairs of men…

We have arrived at a crossroads: How do smaller regional banks justify the cost of an online FX customer experience which is being demanded by their clients and being offered by their competitors, and the cost of maintaining a trading team as the revenue potential over and above the client commercial margin shrinks?
On the other hand, how do larger super-regional or global banks, who have invested millions of Euros in their electronic trading systems and infrastructure look to monetise that investment more effectively?

An answer becomes increasingly clear. A partnership between liquidity providing (LP) larger banks, smaller regional banks with strong client franchises and a technology provider to bring the two together is an elegant solution to enable both banks to focus on what they do best.

The LP bank provides the downstream regional bank with an electronic solution to distribute to its clients in exchange for the wholesale flow which it will price in accordance to an agreement set up between the two banks. 

The downstream bank will retain the client relationship, built up over years, will onboard the client, perform the necessary regulatory and credit checks and capture the client commercial margin. 

The technology provider will white-label the solution in the downstream banks livery, and help it to roll out the technology to its sales team and end user clients. An ideal system would be tailored in language and style to its target audience. It would enable the sales-traders at the downstream bank to interact with their clients for trades not executed electronically. It would ensure that from a client confidentiality and regulatory perspective, the end client detail remains invisible to the LP bank whose sole counterparty, in this set up, is the Downstream bank. And in the case where the regional bank is also a liquidity provider in its own right in, say, a frontier currency, it would allow that regional bank to reverse market make in that currency back up to the overall LP bank.

With such a model, all parties stand to benefit from specialization: the end client gets an online and mobile FX solution which saves them time and allows them to manage their workflow more effectively; the Downstream bank keeps the valuable client relationship, creating additional stickiness and retains the commercial margin; the LP bank captures an increased market share through the additional diverse flow which improves the efficiency and internalization rate of their FX rate engine; the technology provider designs, distributes, maintains and hosts the solution for a fee.

Of the division of labour

This division of labour is not a new concept. Adam Smith, the Scottish economist explains the idea in his book known as ‘The Wealth of Nations’ in 1776, when he examines the gains in efficiency of each party in a chain performing a specific task that they have been trained to do and for which they are well equipped. Whether it’s a pin maker, a manufacturer of luxury cars buying best of breed components from external suppliers, or a bank providing FX services to its clients, the focus on delivering the best end result to the customer and an acceptable return on investment to shareholders is similar.

What is unique about this point in time is that global circumstances, market conditions and the state of play of technology have all arrived at a point where the force for evolution is very powerful. The costs of running a successful market making operation have increased, the need continually to enhance the client experience is ever greater, and the ability to commission such services from a specialist technology provider rather than have to build them in-house has never been easier.

Jobs for life?

Any change in a business plan, decommissioning of an old model and investment in a new carries risk as well as opportunities to the existing workforce. Even Adam Smith recognized that such specialization was not without risk for the individual. Some traders in the smaller regional banks contemplating outsourcing market making in exchange for client facing technology may well be fearful for their future. Yet they should not be if their employer recognizes that the skill sets they possess, the understanding of risk, the knowledge of markets, the ability to take decisions are all attributes that lend themselves very well to other roles within the organization, whether they are in trading other asset classes, client facing activity, or control and risk functions. Many external technology companies also value the knowledge and experience of traders extremely highly as they continue to build more intuitive and more sophisticated electronic trading and sales interfaces.  

Carpe Diem

Many Heads of FX or Global Markets reading this piece will recognize their own company’s position in this equation. They may choose to ignore its findings, or simply to ‘ride the horse until it dies’ hoping for a reversal of fortune in the FX market. Yet given the possible range of future scenarios for the FX market, whether seen as a rise of fintech or Big Tech companies encroaching on the traditional domain of the banks, or even a move to a peer-to-peer model as in other markets, this move towards specialisation and client focus is relatively un-disruptive to the greater Global Markets business. Like the markets themselves, the quest to serve clients better is an ongoing challenge.

If you have been affected by any of the issues raised in this article, Caplin Systems may be able to provide help and advice. Contact

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