FX: Questions over feasibility of central netting utility
Establishing an industry-wide netting utility to handle fix execution is likely to prove challenging, even with the support of the organization mandated to promote financial stability.
When the Foreign Exchange Benchmarks Group – a sub-committee established by the Financial Stability Board (FSB) – came out in favour of industry initiatives to create independent netting and execution facilities for transacting fix orders, it also acknowledged the complexities involved in creating a global or central utility for order matching to facilitate fixing orders from any market participant.
The FSB describes a central utility as having the potential to maximize netting opportunities and reduce the need to provide advance information on customer flow to a dealer, but it also accepts that the precise method of executing the residuals to achieve a clearing price will at least partly determine whether such a utility is feasible or not.
We still come back to the need for someone to manage the residuals – unless we move to a new market structure
Kieran Fitzpatrick, Barracuda FX
In the meantime, a number of independent netting facilities have emerged. One example is the Russell FX Network, a collaboration between Russell Investments and Integral Development Corp that combines internal netting within an investor’s trading portfolio with external matching.
With transaction costs now easily measured, investors are searching for better ways to manage them and trading on a netting service is an excellent way to reduce those costs, says Mike DuCharme, head of currency strategy at Russell Investments.
“The ability to match at a midpoint price is incredibly compelling and investors can readily recognize the advantages,” he says. “We believe they will benefit greatly from a facility that provides a safe, transparent and fair venue to net fix executions.”
‘Free’ fix-order execution has proven to be expensive and harmful to both investors and providers, adds DuCharme.
“The loss in revenue to liquidity providers meant that other ways to cover expenses and compensate firms for assuming substantial risk needed to be developed,” he says. “These other ways resulted in volatile trading, devastating fines for many firms as well as career-ending punishment – or worse – for some individuals.”
Netting has always been an important aspect of managing order workflow, although as markets and regulation around fixings have changed, some established market participants have responded by extending their existing fixing offerings to make netting more accessible, says Kieran Fitzpatrick, CEO of Barracuda FX.
On the issue of free fix-order execution, he says that while this risk-free transfer of orders from the buy side to the sell side distorted the market in the past, things have changed.
“The regulatory guidance around it is very clear,” he says. “The buy side is becoming more educated about the appropriateness of the fix and accepts it as a paid-for service with transparent pricing. The banks are obliged to find and communicate a fair price, but they are appropriately compensated for taking that risk.”
Trust is the issue that comes to mind when assessing the characteristics of a netting service that all banks would be prepared to use, adds Russell’s DuCharme.
“The service would need to present unquestionable integrity and safeguards to assure the marketplace that no one would gain an advantage,” he says.
"Connectivity is another issue – making it easy to connect would be crucial to success – while multiple providers might fragment liquidity so that no single system had enough trading volume to encourage others to participate.”
For it to work as an industry-wide utility, every bank needs to be part of it, but some banks already have a proprietary solution in place so do not have an incentive to participate, explains Barracuda’s Fitzpatrick.
“Also, it raises questions around concentration and system risk, and we still come back to the need for someone to manage the residuals – unless we move to a new market structure,” he says.
There are a number of different ways to net fixing orders, either internally to a bank or via an external venue, concludes Fitzpatrick.
“Some banks already net their orders and are happy to manage the residual risk themselves, more frequently through the use of algorithms,” he says. “For those banks that cannot or do not want to manage that risk, a service like ours allows them to pass just the residual risk – or even all the orders – to an external bank for them to manage.
“This is particularly applicable for banks with orders in currencies where they may not have sufficient liquidity or expertise.”