Harnessing Technology: E-Trading and White-Labelled Systems
First-mover advantage in the e-trading arena may be very important, but as the new wave of e-trading and white-labelled systems comes online it is the use of ground breaking technology that is now critical. Nowhere is this more evident than in the foreign exchange market. In some cases banks are launching greatly enhanced or second-wave systems but these need to offer enhanced connectivity and functionality from the original systems which changed the buy-side’s way of working.
Foreign exchange has a daily turnover in the region of $2 trillion, making it the world’s largest financial marketplace. It is a mature market but one that continues to change and adapt to the requirements of an evolving set of users, helping facilitate the ongoing growth of world trade.
This has always been a market at the cutting edge of technology. The ability in the late sixties to make affordable, quality telephone calls to anywhere in the world turned this into a truly global market working 24 hours a day. It has also always been a market that has led supervision and regulation and yet for the most part been happy to be self-policing. Of course there has been the odd hiccup, Nick Leeson and Barings being one example, but this has definitely been the exception to the rule.
Increasingly it has been the better perception of problems that has caused this ‘gentleman’s’ market, where ‘my word is my bond’, to introduce stringent checks and procedures to ensure adherence to rules governing trading, credit, settlement and to control and manage operational risks. This is where technology has come to the forefront. The ability of online systems to give real-time information to managers has made this a more visible marketplace and engendered a sense of wellbeing to a number of people who traditionally felt wary of getting involved.
“Best practice and compliance are high priorities for buy and sell-side alike”, said Mark Warms, general manager – Europe, FXall. “By tightening controls, reducing risk and delivering full audit trails for every transaction, electronic platforms like ours make it easier to comply with industry standards and best practice guidelines, and to operate more effectively in today’s global marketplace.”
This has manifested itself in a corporate customer base which requires a fast, reliable and keenly priced service in treasury products. This service has evolved to such a level that these customers will only take their business to banks that can provide such a service. This in turn has forced some of these banks to turn to their larger counterparty banks for help and spawned what has become known as ‘white labelling’, likening it to supermarket own-branding.
The cost of providing foreign exchange prices in a variety of currencies has become costly from two perspectives. Firstly the technology required to provide an online trading system and secondly the staff costs of manning a desk of inter-bank traders, not to mention the additional operational, credit and settlement risks.
This has resulted in some of the larger banks, especially UBS and Deutsche Bank, operating systems where they treat smaller banks as customers, much in the same way as the German Landesbanks have always treated the savings banks. They offer systems whereby rates can be relayed directly from the large bank to the smaller bank’s customer but re-branded in the name of the smaller bank with a margin added. The customer deals with his relationship bank which in turn passes on the deal to the larger bank. This is a seamless operation and allows the smaller bank to make a profit from providing his customer with a service.
The advantage to the larger banks is that in theory a number of the deals match off allowing them to make the spread between bid and offer rates but also that they can see the natural flows from buy-side customers with whom they have no relationship. The smaller bank continues to do what it is good at, having a relationship with its customers and managing the credit risk involved in that relationship.
This type of arrangement also works for banks that want to reduce the number of geographic centres in which they have an established dealing presence. The headoffice or regional hub can supply rates to a branch who can then pass them on to their customers. The customers receive competitive rates and a quality service at a greatly reduced cost to the branch. Also from the point of view of the bank as a whole there is reduced or more manageable risk.
It is self-evident that this situation is leading to fewer counterparties in the inter-bank market. It is also true that some corporate (buy-side) flows are becoming larger and more important and this is especially true in the case of the hedge funds. In fact it is the huge orders placed by these that are blamed for some of the larger price moves. People talk of a ‘liquidity mirage’ referring to the situation where every electronic price available could be hit at the same time adding up to an enormous trade. In reality this is unlikely to happen, especially as systems are designed to allow suspension of rate feeds when necessary. The banks are also happy that there are enough price makers to be able to deal with the trades being undertaken. In the future, however, it may be necessary to have links between systems to govern the overall level of trading.
“There is no liquidity mirage,” said David Poole, COO of ClientKnowledge. “It is a liquidity hazard that banks can control. Banks must decide the appropriate level of liquidity to offer to their clients and the broader market, and then stand by it”.
The bottom line is that the buy-side users of these systems are increasingly selective. They are no longer satisfied with a simple RFQ (request for quote) system offering him FX spot and forward rates but want an ESP (executable streaming prices) system where they can deal in a variety of FX, money market and derivative instruments. This may be enough to attract the buy-side but to keep them it will be necessary to provide a host of add-ons. They want a one-stop shop for the entire trade lifecycle incorporating research, price discovery, deal execution, settlement and post-deal analysis. That the system needs to be user-friendly and reliable goes without saying. Of course not every customer wants all of these features but the ability to deliver and customise what is required is essential.
Each generation demands more from its systems. This can easily be demonstrated by looking at the offerings from Reuters. When I first joined Barclays dealing room, pre Star Wars, we had three Reuters monitors suspended from the ceiling showing fixed pages of rates. Nowadays not only does every trader have Reuters news and information, conversational dealing and matching on their desk but they have EBS and Bloomberg and possibly offerings from other vendors and brokers. Not only the traders, but both Reuters (RTFX) and Bloomberg (FX Streaming) have recently launched new systems to allow the buy-side to have direct trading from its terminals. Both systems are based on prices from a number of banks which will provide executable prices.
Connectivity and integration are also critical issues. For a corporate customer to maximise the potential of e-trading systems, it is essential to have true straight-through processing (STP) via seamless integration between existing treasury management and risk systems as well as real-time interfaces between systems with different strengths in functionality. The growth of algorithmic trading means that the connectivity to so-called ‘black boxes’ is also on some peoples’ lists of requirements. The development of XML-based real-time interfaces means that reliable and relatively low-cost connections can be established. The TWIST initiative is a prime example of this.
Carl Martin, head of technology at Eurobase international group and a member of TWIST’s Technical Committee, comments, “Most standards concern themselves only with passing data back and forth. TWIST actually encompasses the workflow of the whole business cycle enabling two or more enterprises to work together and realise the full benefits of STP”.
Amazon may have revolutionised book sales but a lot of people still use physical bookstores. In fact, judging by the number of these stores which now incorporate coffee shops, they spend quite a lot of time there. People like personal service and corporate treasurers are no different. “e-FX matters but so does the sales force” said Justyn Trenner, CEO of ClientKnowledge, “And it will continue to do so for the foreseeable future”. It is important that systems include dealer intervention and by that I mean some way of communicating with the sales desk. It may be for simple reassurance or it may be advice on starting to trade in a new asset class, but either way it is an essential part of the system. A good example is a small bank which has a particular customer for whom they require that extra special rate. Even an RFQ system struggles to cope with that, unless you can explain it to someone.
One element of this move towards electronic trading which I have only touched on is secrecy. Initially smaller banks were unwilling to admit that they could not provide the systems that their customers require. Increasingly the customers are only bothered about the actual service and not really concerned with where the rate actually originated. This is in line with most of the banks’ (and other industries come to that) services where outsourcing is commonplace.
The reliance on systems is becoming ever greater and this in itself means that the systems must be more robust. Failure of a major system could have a huge and potentially catastrophic impact on the markets. Regulators are constantly evaluating this situation and users are increasingly more selective in choosing the systems they use. Fortunately technology is moving forward at an ever-increasing pace.