By Andrew Coyne, Founder, CobaltFX.
The Global Forex Exchange Division (GFXD), the industry body which focuses on improving FX industry infrastructure, has published a paper highlighting the need for Dynamic Credit management and allocation tools in the FX market. In my view, the over-allocation of static credit limits has been an issue for far too long, and GFXD’s call to the industry couldn’t be more welcome.
Credit is one of the least understood and systemic problems facing the FX market, yet it is one that has the most far-reaching impact. Credit and the way it is managed at the institutional level is central to market access control, risk management, balance sheet and compliance.
However, the demand for infrastructure and technological development around credit management has lagged far behind the evolution of the FX ecosystem and the move towards greater automation which we are seeing in most other aspects of the industry. With the spotlight put on this issue by the GFXD and a regulatory focus on systemic risk, there is now a drive for change.
The first step is acceptance that there is a credit distribution problem in the market that needs to be resolved. This is an issue that the European Central Bank and the Bank of England are certainly aware of, and that GFXD is now bringing to the fore.
To provide more context here, the credit issue relates to the long-standing problem around over-allocation or carve outs. Exposure for any counterpart is not offset among venues, and this creates a false exposure on each, which when aggregated, is greater than credit reality. Rather than addressing this, more credit or “fat” is added to on-venue counterparty limits, ostensibly to allow the counterpart to continue trading. Typically, each venue is allocated a credit limit separately, but when aggregated these differ from actual credit appetite and can result in a bank or institution finding it is over exposed.
There is also a human element which exacerbates the issue – trying to monitor credit across multiple venues independently over UI’s is something that is too slow, and fraught with potential problems. For most banks, the process is very manual – and anything manual in a highly electronic market is bound to cause systemic risk. The need for automated solutions to dynamically manage credit allocations couldn’t be more apparent.
The Way Forward
Establishing one global limit set – a Net Open Position limit (NOP) and / or a Daily Settlement Limit (DSL) – for counterparts for executions across all ECNs and ultimately including single dealer platforms and voice trades is undoubtedly the way forward. Institutions can then manage credit in real-time, across all market end points, from a single centralised point.
The advantages of greater credit control are numerous, including that institutions can apply less credit whilst also receiving deeper liquidity and therefore gaining better market access. Ultimately, if banks are able to optimise market access in real-time – which is possible not only by using automated Dynamic Credit management solutions but also optimisation – they will be more profitable, whilst also allowing optimised and full compliance with Uncleared Margin Rules (UMR) and the Standardised Approach for Counterparty Credit Risk (SA-CCR) regulations.
Foreign exchange is one of the biggest markets in terms of notional volume yet the basic problems around credit allocation and operational risk have persisted despite the industry wide push for greater automation, oversight and digitisation. It’s now time to place control back in the hands of the institutions and remove the credit bottleneck in FX, significantly reducing credit over-allocation, mitigating risk and tangibly improving market access.
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