As well as having to cope with the increase in absolute volumes, banks have also had to try to cope with the emergence of a new breed of market participants that deal in smaller sizes more frequently than their clients did in the past. The scale of the problem was highlighted in a report from market intelligence firm McLagan (Z/Yen) published in December 2008; this stated that the average daily volume of tickets processed by one big FX player had increased from 6,500 in 2001 to an expected 200,000 in 2008.
For some, an obvious solution has been to net deals between counterparties. However, an impediment to any such initiative, at least between interbank counterparties, is that CLS, the industry-owned utility, only accepts trades on a gross basis. According to the Bank for International Settlements, CLS settled 55% of FX businesses in 2006.
There have been implications in some quarters that CLS has been intransigent in its refusal to accept netted trades for settlement and that it has effectively imposed a tax on the industry. However, the reality is that CLS, which was effectively established at the explicit behest of the G10 central banks as a way of removing Herstatt (settlement) risk from FX, has to cover its fixed costs, and the acceptance of netting would challenge its ability to do this.
Ultimately, the cost of using CLS has been seen by most FX participants as a price worth paying, a view reinforced during the implosion of Refco in late 2005 and the collapse of Lehman in 2008. As other initiatives have found, the FX market does not have the appetite to reduce its ticket-processing costs if it means reintroducing settlement risk.
Now, though, CLS has announced what it believes is a solution that will alleviate the pressure on many banks’ back offices without an adverse impact on its crucial revenue stream; it has formed a joint venture with Icap to provide post-trade aggregation services. Although the two terms are used interchangeably, aggregation is not technically the same thing as netting.
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“I think the market is pleased with the joint venture. There are already a number of other banks that are potential users of aggregation” Rob Close, CLS |
“The banks understand the value of CLS and do not want to incur settlement risk. They also want to reduce their operational risk and costs. This service helps achieve those aims and it also eases the technological pressure that is on back offices,” says Rob Close, chief executive of CLS Group Holdings. The joint venture, which went by the name of Melody in its development phase, will be 51% owned by CLS and 49% owned by Icap. Citigroup, Deutsche Bank and Royal Bank of Scotland have committed themselves to support it and Close expects more banks to sign up for the service.
The joint venture will use the Harmony network of Icap’s post-trade subsidiary, Traiana. “The way banks tend to communicate is by using Swift. Bringing Icap in and using the Harmony network will bring real cost benefits,” says Peter Conner, chief operating officer, global FX, at Deutsche Bank. “I think that we’ve been in an environment of volume growth, driven by flow from retail aggregators and algo trading. That’s led to a greater ticket volume with a lower notional size. We are in a situation where we need to continuously invest (in raising) our processing capacity. The traditional way of processing has started to make less sense; this initiative will rationalize the number of tickets between the most active participants, like the big PB banks. An additional benefit is that it also reduces operational risk.”
Aggregation
According to Conner, the service will also process non-CLS currencies. “From a risk perspective, I think the banks will work to put more currencies through,” he says. He says that is possible, but not from the first day of the joint venture’s operations, which, subject to regulatory approval, is expected to be mid-2009. “Aggregation can conceptually apply to any currency pair,” he says. “However, the benefits from aggregation will only apply where there is significant activity in the currency pair. CLS today settles the most actively traded currencies but aggregation is likely to be focused on just a few of these, at least initially.”
Feedback for the joint venture appears to have been positive so far. “I think the market is pleased with it. There are already a number of other banks that are potential users of aggregation,” says Close.
Conner agrees: “I think trade aggregation is a good thing. It’s a natural evolution,” he says. “We can lower the cost of processing and over time I think that will filter through to execution costs as well.”
It remains to be seen now whether companies such as the CME will go ahead with reported plans to offer their clearing house up as a central counterparty for the FX market. This is a concept that has been spoken about seemingly for years but it is still hard to envisage in the global FX industry. Close says: “What problems are CCPs trying to address? If it’s purely costs, then this service initiative addresses that issue. If the industry is really interested in using a CCP for other reasons, such as credit, then a CCP does have merits. But if the industry really wants to do that, then it should talk to CLS. The OTC FX market is clearly not broken, so people really should be clear on what problems need fixing.”
