Counterparty risk looms large for FX buy-side
The ongoing ebb and flow of the European sovereign debt crisis and its impact on the underlying stability of bank balance sheets has focussed the minds of buy-side clients when it comes to choosing their FX counterparties.
This has been reflected in EuromoneyFXNews’s e-trading survey. When respondents were asked to rank their selection criteria in choosing FX execution venues, choice of counterparty, including strength of bank relationship, scored as the topic priority, ranking significantly ahead of the reliability and stability of the platform and breadth of currencies offered. “Choice of counterparty based purely on service is limited because there is always going to be risk issues standing behind you,” says Alec Farley, principal dealer of global FX at Legal & General Investment Management in London. “Service alone can’t allow us to ignore the fact that, for example, one of your counterparty’s credit rating has been panned globally.”
Interestingly, breath of product, which includes the provision of algorithmic pricing tools, analytics, and chat functions, was ranked as the 5th most important consideration. This is significant for two reasons. Algorithmic execution tools have been one of the fastest growing services on single dealer platforms (SDPs) over the past couple of years, and banks’ have promoted it as a key differentiating service over multi-dealer portals. More broadly, the introduction of additional features, the colloquially-termed “bells and whistles,” which many of the new platforms coming on line seek to offer, are seen as less important.
“You get to a point where the decision on who you choose depends whether it does everything that you need to do in your job,” says the chief dealer at one UK-based retail FX aggregator, who predominantly uses SDPs. “The fact that someone else has added another bell or whistle is really peripheral to the job in hand.”
The chief dealer adds that the need to maintain a bank relationship will always remain a primary anchor to choosing an FX counterparty. Often the ease of execution for highly liquid instruments, such as G10 currencies, makes it hard to differentiate between a SDPs and MDPs on a pricing basis. However, it is the more difficult things, such as extending credit lines and tenor, or trading more exotic currencies that clients may be unfamiliar with, that creates an edge for single dealer platforms.
Indeed, most buyside customers EuromoneyFXNews spoke to following the survey said that they preferred to use SDPs to trade emerging market non-deliverable forwards, more esoteric eurodollar crosses because liquidity, pricing and market information was far superior.
“There are trades on some crosses that are difficult to price and lack liquidity where a MDP might not be ideal, and might benefit from the use of a single dealer algorithm or DMA (Direct Market Access),” says LGIM’s Farley. “In some EM crosses for instance, it may be more efficient to route to a SDP, and the question remains whether an MDP can adapt to also provide the router to multiple SDP services.”
Furthermore, the extension of credit has been a useful tool in luring buy side clients onto SDPs. For instance, using the recent collapse of MF Global, as an example, it seems natural to expect prime brokers to reduce credit lines to hedge funds and for banks to be more selective where they provide the best type of liquidity.
The larger banks and their prime brokers are flexing their muscle and getting selective in terms of what types of clients they continue to take in, and in so doing, command more loyalty from the buy side that they keep. If enough of these banks do this, there are pressures for the buy side to concentrate their business around fewer firms. That means the smaller and higher risk buy side firms then have to use large FX brokers or 2nd /3rd tier banks, which use APIs and may lack a SDP.
“Today I think we see a return to fewer FX counterparty relationships. The buy side is more willing to paying a reasonable premium to concentrate FX operations with firms they know and trust,” says Javier Paz, a senior analyst at the technology consultancy, Aite.
Nonetheless, it would be deceiving to suggest that counterparty and bank relationship concerns are driving all buy side clients towards SDPs. For clients, such as real money investors, who deal with multiple counterparties, the opposite is the case.
“Counterparty risk is on everybody’s mind, and counterparty diversification is ongoing,” says Farley, who argues that this is simply a function of the fact that FX volumes are only heading in one direction, that is increasing, and thus increases the need to spread volume across the market.
If that’s the case, the MDP model may be the preferable option.
“With an MDP, you’re in advance saying, I choose to trade with these different institutions, so you’re kind of taking out the element of counterparty,” says Jack Crawford, head of currency trading at JPMorgan Asset Management in London.
He adds that for clients such as his firm, where they may have as many as 15 counterparties, the multi-dealer model is preferable because not all of those banks has a sophisticated single-dealer pricing platform, but will in almost all cases, have pricing links into MDPs.
That said, Crawford says there has been a direct reduction in the number of counterparties in recent years, and a realisation from his own clients of the potential risks they’re taking. He adds that credit and counterparty reviews are far more commonplace, as events, such as the European sovereign crisis ebbs and flows.
Other fund managers argue that an MDP model makes it easier to monitor counterparty risk.
“If the only thing that anyone on the buyside cared about was the strength of the counterparty, you could make an argument to choose your counterparty and going to an SDP. But if you recognise that you don’t want all your eggs in one basket that lean us more to an MDP for diversification,” says James Wood-Collins, chief executive officer of Record Currency Management. “The way we think about counterparty risk, is that we’re trying to balance two potentially competing objectives; between counterparty strength and counterparty diversification.”