While Lee Oliver, Euromoney’s FX correspondent, is on summer break, the weeklyFiX is supplied by guest writers from the industry. Our first contributor is Jonathan Butterfield, executive vice -president, marketing and communication, CLS Bank International.
As we approach the first anniversary of the onset of the worst bout of financial instability for years, we continue to witness roller-coaster conditions across financial markets and a credit crunch that is having a wider impact on the broader economies of many developed countries. The financial markets are having to address market, credit (counterparty), operational and liquidity risk management as a top priority. This has inevitably led to an evaluation of the issues around trading from execution to clearing and settlement in the instruments that have proved so toxic.
The increased focus on risk in the current climate means that settlement and operational risk has rapidly climbed up the agenda, arguably to an unprecedented level. The recent report from the President’s Working Group on Financial Markets (PWG) and comments by Timothy Geithner, president of the New York Federal Reserve demanding robust and speedy action to improve risk management and operational controls over various trading activities have added greater urgency to improving post trade practices. Counterparty risk used to be the subject of bi-annual reviews, now it is a daily activity for senior managers. More than ever, the regulatory community is pulling together and re-invigorating its efforts to drive the industry towards further improvement and the adoption of more stringent standards.
The reality is that settlement risk numbers dwarf any other risk category in many institutions. In some cases, large banks have almost three times more exposure to settlement risk than to credit risk. The sums of money are huge. In FX, the largest market by value, transactions can involve settlement exposures amounting to tens of billions of dollars each day to individual counterparties and, in some cases, exposure to a single counterparty exceeds that institution’s capital.
The inclusion of settlement practices and deficiencies in the PWG is quite a step up for what has often been referred to as the plumbing. Previously, the processes that follow a trade were left to the middle and back offices and assumed to be under control. In the current climate there is huge pressure to ensure a far higher degree of precision in calculating exposures and then assessing how to fund the respective settlement cycles. Nervous and tight credit markets failing to settle, even for the most mundane reasons, can have catastrophic consequences. Given the parlous state of the current financial markets, it is perhaps no surprise that these operational elements have been one of the areas of concern highlighted by the US Treasury-sponsored working group.
So, while the derivatives markets are working hard to tighten up post-trade procedures and standards, FX offers an example of an industry which has taken the lessons learned from earlier failures and acted on them, albeit under significant regulatory pressure at the time, which sounds all too familiar! FX’s history had highlighted all too painfully the downside of settlement risk when a counterparty defaults and leads to massive losses. It was the collapse of Herstatt in the 1970s and the continued growth in trading that provided the impetus for a robust private sector solution to be put in place – CLS Bank – that has been up and running for nearly six years.
The FX industry is the most global market by its very nature and although unregulated, it has multiple bodies dedicated to the orderly running and execution of the market. By comparison with other asset classes such as the OTC derivatives markets, FX has extremely standardised back-office processes and has coped well with explosive growth as trading becomes increasingly automated and a growing number of participants realised its potential as an asset class in its own right. However these standards are by no means universally applied.
The challenge for the FX market has been to grapple with both strong growth and the magnitude of spikes in volatility that can vary from one day to the next. For example, one of CLS Bank’s biggest days in July (despite the supposed summer lull) saw nearly 800,000 payment instructions when the normal run rate is 500,000, and values moved from $4 to $5.5 trillion brought on in part by a major shift in sentiment towards the dollar on the back of Ben Benanke’s speech about the state of the US economy.
Elsewhere, the BIS Committee on Payment and Settlement Systems (CPSS), which is also chaired by Timothy Geithner, produced a final report in May 2008 that renewed the focus on foreign exchange settlement risk reduction and recommended a payment versus payment architecture. The CPSS report made recommendations for clearly established senior level responsibility and authority for measuring and managing FX trade exposures and the implementation of institution-wide business policies that address the appropriate risk assessments. The key to ensuring seamless trade execution and post-trade operational control lies in the infrastructure and an industry commitment to adopt and utilise high and robust standards – the crux of CLS Bank’s success.
According to the CPSS report, CLS now settles 55% of FX obligations from the surveyed institutions, a proportion that they expect to continue rising in the future. The report highlights the changing composition of the market with a growing number of buy-side participants accounting for a higher proportion of daily values. Traditionally central banks have relied on exerting pressure on the banks to influence and drive industry improvement. Interestingly, they are now reaching out to regulatory agencies to press other participants to address the case for greater control and oversight of settlement risk. So, while the PWG has called the financial community to attention, its report recommendations are applicable to multiple communities.
From our experience they may be "pushing on an open door” as both the larger and more sophisticated long money managers and hedge funds are fully aware of these risks and are acutely sensitive to operational performance. The question however remains as to whether or not the remainder of the market will make the effort to change and get away from the reams of paper they consume as part of their current trading and settlement process. The consequential damages of failed settlement in cash or derivatives can ripple through accounts for months, making operational excellence a commercial issue too.
It would seem logical to draw comparisons between the OTC markets currently under fire and the FX world. While they may be at different stages in their evolution, like FX, the OTC derivatives markets experienced rapid volume increases, sometimes by as much as 30% a quarter. At this rate for anything that is not STP, it doesn’t take long for the middle and back offices to become swamped. As with the foreign exchange market, and highlighted by regulators, excellence in operational control is a necessity in order to ascertain a full picture of your institutional exposure by asset and counterparty. These are however, relatively new standards that have not been fully developed or implemented.
Gone are the days when it was acceptable to take a week to confirm a derivative trade. Confirmation or matching, which can only be undertaken by complete automation, should be achieved within hours of a trade’s execution. Clearly regulatory focus is still firmly placed on tightening up the entire lifecycle. You only have to look at the startling performance improvements of major dealers on the DTCC’s DerivSERV platform to appreciate the gains in operational efficiency and control. However, once again, the unfinished business in this area lies with the buy side.
Compared to the more established sell side, the more diverse and dispersed buy side is less travelled along the learning curve, therefore there is more for them to do. A lack of financial incentive to provide and or improve their infrastructure and processes has afflicted fund managers and this community continues to represent a significant challenge. However, pressure is mounting on these participants. Those buy-side participants who have invested represent best of breed within the industry and are more the exception than the rule. For many, operational costs are paid by fund sponsors, reducing the incentive to undertake operational improvements. This is in stark contrast to hedge funds where there is strong focus on operational costs as a direct expense via their prime brokers, which directly impacts their reported performance.
Regulators have traditionally set their sights at influencing the buy side via banks. But recently, more overt pressure has been exerted on other participants to achieve higher standards in operational execution as they become more active across multiple asset classes. In these hard times, it would seem that regulators are currently in no mood to leave the non-bank community to their own devices.