Banks’ ‘chronic’ overcapacity in FX provision to persist for foreseeable future

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By:
Peter Garnham
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The chronic overcapacity built up by the leading banks in the FX market is likely to persist as the cost of building bespoke electronic trading portals continues to rise.

That is the view of consultancy GreySpark, which has released its latest review on the trends in e-commerce at the world’s largest investment banks.

Frederic Ponzo, managing partner at GreySpark, says the primary consequence of the financial crisis was the strategic shift of the banking industry away from complex derivatives towards simpler flow products, driven by regulation and customer demand.

He says this transition required a rethink of banks’ trading and distribution infrastructure.

Indeed, Ponzo likens the transformation to that seen in the automobile industry through the advent of mass manufacturing.

“Banks must build large and expensive production plants that attract significant fixed costs even when idle, but are capable of producing a large number of standardized products with a low level of defects at a minimal marginal cost per additional unit produced,” he says.

“With very few exceptions, the sell-side has followed this exact strategy, creating a significant amount of new capacity that came online between 2009 and 2011.”

That new capacity was the result of a wave of investment in banks’ single dealer platforms (SDPs), which coincided with a recent glut of other new trading venues, such as new or upgraded exchanges, crossing networks and multi-dealer trading platforms.

The fact the increase in capacity came amid a global economic slowdown that produced a slowdown in trading volumes meant that a vicious circle was produced, in which banks are forced to reduce their margins to attract customer flows that are sufficient to at least cover the fixed costs of their newly built infrastructure.

“Since there is probably not enough volume in the markets to allow all the active sell-side providers to reach that breakeven point, a state of quasi-perfect competition has emerged, further shrinking revenue pools,” says Ponzo.

That over capacity differs between asset classes, with equities and FX under the greatest amount of pressure, according to GreySpark. Indeed, it describes the overcapacity in FX as “chronic” and believes it will persist. 

 Overcapacity in FX (solid line represents capacity; broken line volume)
Source: BIS, NYSE, The City UK, FIA, WSJ, GreySpark analysis

There is further gloomy news for banks on the cost of keeping up with the competition and the ever-increasing cost for banks of building their own trading infrastructure.

GreySpark estimates the cost of building a state-of-the-art SDP has approximately tripled to $120 million during the past five years.

In the past, when SDPs were primarily add-ons to banks’ trading systems, allowing clients to route orders and execute trades, the required investment was relatively low. In addition, to reduce time to market, white-label systems could be purchased from vendors.

However, since then, according to Ponzo, client expectations have risen substantially.

Some believe banks are now engaged in an arms race to develop more sophisticated and user-friendly platforms, a phenomenon which was triggered in 2009 by the launch of Morgan Stanley’s expensive and ambitious Matrix SDP.

Indeed, the latest offering from a leading bank, UBS’s Neo platform, is thought to have been in development for more than two years, and was designed by the same person behind Morgan Stanley’s Matrix.

“New SDPs must combine ever more capabilities with original and superior user-experience features,” says Ponzo.

“Each innovation introduced generates only a transitory competitive advantage. The innovations are rapidly becoming part of the baseline and a mandatory condition that must be met by other providers.”

Of course for banks to improve their margins, excess capacity across asset classes must be removed unless trading volumes suddenly surge unexpectedly in the near future.

However, the likelihood for capacity rationalization occurring in FX appears low.

As a proxy for the industry as a whole, GreySpark consolidated the stated ambitions of 20 of the world’s leading investment banks.

Few of the top banks gave more than a low priority to commodities, while the process of rationalization has started in equities, with several banks, including RBS, exiting or reducing their presence in the sector.

Under the increased capital charges applied to non-cleared over-the-counter trades and ageing bond inventories, a similar phenomenon is under way in fixed income.

However, Ponzo points out that FX is different, with no bank voluntarily exiting a market that is core to its very existence as, for example, a facilitator of cross-border trade.

“Since no international bank can afford to exit the currency markets and because regulatory pressures are limited in FX, the overhang of excess capacity in this market will not be naturally resolved and is expected to persist for the foreseeable future,” he says.

Currency markets might provide slim pickings for all but the biggest FX banks in the years ahead.