No Margin for Error in eFX
The FX market is a changing landscape for all participants, with the buy-side seeking new opportunities and the sell-side witnessing more dynamic and sophisticated clients on their books. The difficulties are arising from a lack of communication between the buy- and sell-side, especially as greater levels of leverage are leading to more frequent, and more damaging, margin calls. A deeper level of understanding behind the sell-side’s fascination with real-time margining and its necessity in the modern markets is a good basis from which to understand their wider eFX offering.
Many of the FX professionals at top-tier banks that Lepus has spoken to in the past few months admit to eFX volumes growing to make up anything between 50% and 80% of overall FX trades. Given this increased focus on electronic trading, and the demand from the buy-side for ever faster execution, secure settlement and greater amounts of leverage, internal systems within the top-tier brokers need to be re-examined.
The FX world, particularly the new and high profile sophisticated buy-side participants, live on margin. With tightening spreads and higher volumes becoming the norm, widely available leverage provides firms with a higher risk appetite that has the potential to significantly increase returns. However, the practices surrounding the wide provision of leverage – the margin upon which the buy-side thrives – must be a cause of some concern to the market.
The need for robust real-time margining systems, which not only perform pre-deal checks in a matter of milliseconds but also revalue the portfolio on an intra-minute basis, is no longer a ‘value added’ service, or an optional extra, but a core necessity that cuts to the very heart of the continued functioning of the eFX markets. Credit risk management, and market confidence ride heavily on the ability to offer and accept margin in real-time.
The increased demand for leverage from hedge funds and similar professional investment vehicles is driving a push for more effective internal controls in credit risk management. As is painfully evident, increased leverage in the industry exposes institutions to ever escalating levels of counterparty risk; risks that are only amplified by the highly speculative bets of their clients.
Two important facets are necessary to reinforce the margining system, which is one of the critical focal points of the sell-side’s eFX offerings. The first is real-time pre-deal checks, the second is real-time portfolio evaluations.
There are many institutions – even some large tier-one banks that Lepus has spoken to – that are still not able to perform adequate pre-trade checks against available margins. A fundamental component of the technology is the ability to ensure that a given trade does not break margin limits before the deal is executed. This is ever more important as the speed of trades in the market increases exponentially with the increased uptake of algorithmic trading.
The largest concern with this function of the margin system is the speed at which it can be conducted. According to several banking technologists we have spoken to, it is death in the industry to add latency to client’s trades. As these DMA and algorithmic traders are slicing time periods finer and finer in the search for liquidity and minimal market impact, their success relies upon being able to execute almost instantaneously. Milliseconds are the watchword for being able to conduct these checks.
The second critical aspect to the ‘real-time margining’ paradigm, is the constant revaluation of client portfolios. Effective credit risk management is contingent on knowing the counterparty and their exposure. Marking client positions to market on a real-time basis is a fundamental necessity. While this was once performed in a batch processed end-of-day lot, the intra day volume from large buy-side institutions is forcing this towards sub one-minute time horizons.
However, there are debates in the industry as to how this revaluation should proceed. There are technological cases to be made that a real-time full revaluation of client positions is not feasible. The argument is a powerful one, that indicative revaluations are more useful over the very short term – where a pared down pricing model responds to certain specified market parameters, rather than a full-on mark to market.
Some institutions are, however, bravely pushing forward with true real-time ‘pure’ revaluations, which will mark to market using full pricing models on an intra-minute basis. The difficulty can be expressed as a function of number of clients, portfolio size and available computing resources. For most institutions outside the elite, top-tier brokerages, a full revaluation every 10, 15 or 30 seconds is unfeasible. It is in this space that many of the vendors offering combined pure and indicative pricing models can hope to flourish.
A further consideration is volume in the eFX market. With volumes growing all the time as both proprietary trading and the buy-side use more complicated trading strategies to split large orders, the ability to cope with high volumes in both risk and margining systems is crucial. The key issue in this area is not average throughput, but peak throughput. Those unexpected market movements, runs on a currency or sudden market jitters that cause panicked trading, can sorely test even the most robust margining system’s ability.
An example from the equities markets came during the recent market slump; on 27 February 2007, the Dow Jones Industrial Average Index plummeted in value, partly due to a problem of unprecedented volume on the New York Stock Exchange, according to news reports. A simple problem of being unable to cope with peak throughput saw the Dow tumble some 200 points in minutes.
Scalability is a difficult figure to benchmark; if an institution has an average 100,000 margin-based tickets per day, and can execute with 10 milliseconds’ delay, does that still mean they will be able to offer the same service when the volume inevitably jumps to 500,000? Planning for the future, and building the foreign exchange and related margining systems accordingly, with the bandwidth to ensure minimal latency creep even with theoretical peak throughput numbers is essential.
Risk management should be the critical overriding concern in implementing an effective margining system within the enterprise. Given the potential credit (and reputation) risks that abound in a highly leveraged market, the core real-time margining system should be truly integrated into the overall risk infrastructure.
The margin system should, ideally, feed directly into risk management in order to allow for an enterprise-wide exposure assessment against client positions. What is worth remembering is that the credit risk in offering margin trading is only a small part of the overall exposure to that client the bank might experience across the enterprise. Decisions on client relationships and liquidations must be judgement calls and must be taken from the standpoint of a holistic view of risk.
In eFX, ‘real-time’ margining is not just a product of the generalised ‘real-time’ mania in the financial services industry. It is not another ‘value added’ or ‘nice to have’ service. It is a mission-critical risk management and client relations tool, which allows the sell-side more control over their counterparty exposure in an increasingly risk-filled market.