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THE EVOLUTION AND FUTURE OF FOREIGN EXCHANGE

23/04/2019

By Kathy Maher, EVP Operations, 9th Gear

 

The foreign exchange (FX) industry has experienced a fascinating evolution since its humble beginnings. Long ago, in the 70s, the Bretton Woods system broke down, and a new world of floating exchange rates fueled explosive growth to $80 billion in settlements per day by 1980. That uptick in the market, however, was only the beginning. Settlements surpassed $1 trillion per day in the early 1990s and today, currently top over $5 trillion daily.

 

As a result, it is worth a review of the current structure of the marketplace, particularly how the middle and back offices operate, to anticipate the ongoing needs of FX trading and how it might continue to sustain this enormous market size.

 

Humble beginnings

In the late 1970s, FX trading was supported by two main technological innovations to “automate” the back office: EFT (electronic funds transfer) and the birth of the internet.

 

In 1978 there were over 123,000 telex connections, many of them in FX trading rooms and “wire rooms,” moving funds around the world. In these early days, parties would exchange “test keys” and then wire funds. During the same time, the Information Age was taking hold with the introduction of EFT and the inception of the Society For Worldwide Interbank Financial Telecommunication (SWIFT). Along with these game changers came the first commercial application of the internet in 1980. These events laid the ground-work for the new mantra for the back office: STP (straight through processing).

 

FX operations were ripe for serious automation and, with standardization of SWIFT messages, vendor-supplied FX applications and internally-developed offerings were implemented around the world. Improvements in confirmation matching, payment processing and nostro reconciliation supported this exploding volume growth. Operational efficiency and effectiveness were clearly on the rise.

 

With this growth came higher risk and thus increased management oversight, as FX revenues were no longer a footnote for many global banks. The concept of delivery risk or Herstatt risk had increased focus due to massive money flows resulting from FX trade volume growth. Banks poured millions into credit and market risk systems to measure and monitor risk, often at the expense of funding additional STP initiatives in the back office.

 

Out of these risk concerns came the concept of netting to reduce the magnitude of funds flowing through the payment systems, and in turn, the delivery risk between counterparties. Bilateral netting agreements and supporting technology improvements led to reduced risks and in many cases reduced costs. Executing netting agreements one by one is time consuming and expensive so the industry came together and launched a netting utility in 2002 known as CLS (continuous linked settlement) that has been successful in pushing delivery risk levels down significantly.

 

Faster processing cycles, lower transaction costs, higher STP rates, better risk measurement and lower levels of delivery risk have all been realized steadily since the early days of the 1970s even while absorbing double-digit CAGR over the last four decades. But diminishing returns have set in as efforts to reach 100% STP rates and continued efforts to lower processing costs have tapered off. A 2018 EY study showed that increasing operational efficiency remains a priority at most financial institutions.

 

A desperate need for change

Continuous improvement efforts are admirable, but not transformative. Transformation and the successful outcomes that can result require that the process be re-imagined. Currently, FX spot trades settle two business days from the date the trade is negotiated. Besides historical tradition, why is the delay required? It certainly adds risk.

 

First, traders making markets in currencies normally work within position and credit counterparty limits without regard to whether they have the currency on hand to deliver. They worry about that later. Thus, even with state of the art technology, one cannot deliver what one does not have. How can this be solved?

 

The simple answer is to make liquidity readily available. With the issue of funding resolved, let’s look at the operational process to see where inefficiencies exist and question how they can be eliminated.

 

Once a trade is executed, the trade passes to the middle offices to confirm trade and payment details with the counterparties. SWIFT has designed messages to automate this process and STP rates have risen to the 90% range, but that 100% goal remains elusive. Looking at the reasons for match exceptions will shed some light on the underlying reasons for these mismatches.

 

Not all counterparties use SWIFT, especially non-financial institution customers, and trade confirmation becomes more manual and labor intensive. However, even those with state of the art matching engines are not at 100% rates.

 

In the current paradigm, reaching 100% on a consistent basis has a major barrier. As long as a trade is booked in the separate books and records of each counterparty, the potential for discrepancies presents itself. Although technology tools are available, the concept of a mutual ledger, shared by all, has not become an industry standard.

 

A promising solution

Looking to the future, two innovations have the potential to transform the FX business with the result of clearing and settling trades in minutes, not days. Technology advances in digital ledgers and blockchain make it possible for counterparties to access the same book of record using immutable ledgers supported with smart contracts, producing a single source of the truth.

 

While this single innovation, increases effectiveness, it must be coupled with advances in efficiency to reach the goal of near immediate settlement. The answer also requires solving the liquidity issue by providing access to funding as needed. Coupling an FX trading marketplace with a lending platform to provide funding for trades on-demand answers this call.

 

The future of FX brings with it the potential for long-overdue upgrades to its processes. We can expect the trading procedure to experience a meaningful shift from a cumbersome, time-intensive one to a simpler, streamlined task – successfully re-imagining the system to the benefit of the entire banking industry.

 

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Finance Derivative is a global financial and business analysis magazine, published by FM.Publishing. It is a yearly print and online magazine providing broad coverage and analysis of the financial industry, international business and the global economy.