Non-banks in the UK's FX Market
Up until the mid-1990s, the UK foreign exchange (FX) market for corporates was dominated by the main high street banks. There was a natural and obvious association between ‘money’ and ‘bank’, ensuring that all businesses used their bank when purchasing or selling foreign exchange. As a nation built on trade, the UK has a substantial number of import and export companies, many of which are reliant on a cheap and reliable international payment service in order to remain competitive. Whether the price and service on offer was good was not relevant; UK business had no alternative to their bank. Only if you were a very large corporation would you get access to superior service, relationship and price.
This lack of service and poor price led to some companies finding it very difficult to carry out business internationally and, when doing so, it made them less competitive. This was compounded by a general shortage of knowledge about the ‘mystical’ world of FX, and the effective monopoly banks had on the industry. Often the price companies would get on their FX rate would be as bad as rates achieved at the airport for holiday money. Margins to buy FX could be as large as 4-6%. Furthermore, many businesses had to manually complete forms, visit their local branch and queue simply to send an international payment, an increasingly frustrating chore in the electronic age.
The core of the issue was the fundamental difference between buying FX (through the dealing division) and the international payment or ‘delivery’ of that FX (separately through the settlements division). To get a price (i.e. an FX rate) you had to speak to the ‘FX dealers’, while to send an overseas payment the business would then have to speak to the ‘back office’ or settlements team. More importantly, because these two processes were dealt with by two very separate departments, often in different buildings, there was frequently confusion and error. If there were any issues that occurred with either the FX or payment there were too many people to liaise with in order to resolve the issue effectively and in a timely manner. This resulted in poor service that not only soured relationships with the bank but ultimately with the company’s vendors and customers too.
This business model that the banks created could not (and still cannot) be changed easily to adapt to the ultimate needs of UK businesses. Furthermore, because all the competitor banks adopted the same process, there was a general malaise and lack of investment among the high street banks, with a presumption that their clients would continue to use their services regardless. However, this inefficient and ineffective approach to the market, coupled with the light regulation surrounding FX dealing, led to the rise of alternative suppliers of FX services.
As more UK businesses started to demand a simple and competitive method by which to book and send an FX payment overseas, a small number of dedicated FX ‘non-banks’ began to emerge. They were aided in their move to corporate services by the fact that FX was one of the few areas of finance that didn’t require Financial Services Authority (FSA) regulation and banking status.
Despite such light regulation reducing protection and avenues of recourse for their clients’ monies, what non-banks could offer was a simple one-stop shop whereby a small business could book its FX rate and make a payment at the same time; a simple method for success.
This one-stop shop philosophy attracted many clients. All of a sudden, UK companies could book an FX rate and send their payments with just one phone call. In addition, if there were any problems, the company knew exactly who to speak to as they were given a dedicated dealer and relationship manager. This new ordering process was a breath of fresh air when compared to the laborious process that companies had to endure with their bank.
Overlaying this approach was a strong relationship-based ethos. To a small UK corporate at that time any relationship was a good one. Relationships between small companies and their banks were sporadic and, in general, weak. This relationship-based approach made the client feel valued, an emotion that most businesses crave, regardless of their size.
‘Competitive pricing’ was the non-banks’ mantra, and as we know this was not a difficult promise to deliver when the banks were offering such uncompetitive rates. In fact, non-banks would often ‘lure’ the client in by offering market prices and, after a time, would charge gradually more, until they reached the poor rates that the banks were charging. In fact, many companies had a limited understanding about how the FX market worked and how the rate on offer could vary between providers. The only thing that was transparent was the fee on each payment, something the non-banks used to their advantage.
It was a simple, profitable formula: offer a one-stop shop philosophy, combine it with prices to beat their existing bank, and create a relationship that made the client feel wanted. Within the space of 10 years, non-banks were surfacing everywhere, at first just a handful, and now numerous providers exist, some of which are tiny and often smaller than the clients themselves. The fact that these companies do not need a banking licence and are not FSA regulated means that they are very easy to set up.
Therein lies the problem: anyone can be a non-bank provider of FX. It is not easy to acquire a banking licence and FSA regulation, and companies without them offer no legal security for their clients from a financial or ethical perspective. HM Revenue & Customs, the government body that all non-banks have to register with, only offers regulation around anti-money laundering, and not around treating customers fairly.
In spite of such limited regulation, the growth of the non-banks has been phenomenal, largely due to the nature and make up of the UK corporate market. There are many small businesses in the UK demanding improved service and price and many of these companies have been migrating to the non-banks. However, such rapid growth was never going to go unnoticed and it is now the banks that are having to react and change the way they do business.
One of the ways in which the major retail banks are trying to win back and retain key customers is to place more emphasis on their international banking or treasury centres. These are offices dedicated to their best retail clients, which aren’t big enough to deal directly with their investment arms but warrant a better service and price than that offered by their standard retail banking platform. Has this curbed the flow of clients to the non-bank world? It seems that it may have done for a few of their best retail clients but many small businesses are still migrating to the non-bank providers. FX seems to be a product that can be easily detached from other banking activities.
However, the hunger and focus of the non-banks is not stopping there. As more competitors enter the non-bank arena and drive down the margins charged to smaller companies, the bigger players are trying to poach larger clients from the banks. They are actively trying to move up the value chain, by offering what they deem to be ‘elite payment services’. It might seem ironic that a non-bank sends payments more efficiently than a bank, when all they do to deliver a payment is use a bank themselves. However, where they excel is in the physical capturing of the payment details from a corporate, for example through the use of online systems. The focus of the larger non-banks is beginning to shift from being pure FX specialists towards that of payment specialists offering ‘superior payment execution’. Brand, credit rating and reputation may prevent them in many instances from dealing with some larger corporates, but often it points to more fundamental reasons why the non-banks can’t continue to surge up the corporate value chain.
As the global business environment becomes increasingly competitive and volatile, excellent payment execution is simply not good enough. Profit maximisation and risk mitigation are now the buzzwords around most boardrooms. This is not achieved solely through competitive FX pricing. Of course, the better price a client gets, the more they save at any given instant. However in the world of international business, risk mitigation is paramount. Both banks and non-banks can actively compete on price for unregulated products (such as spot FX). In fact, the more they do, the more the client will win. But, like in any industry, there is more to business than just the price and other factors, such as risk mitigation, are becoming increasingly important for companies of all size.
The most basic form of FX risk management is that of forward contracts. These unregulated products offer simple yet rigid solutions to FX risk mitigation, allowing companies to lock in a profit margin on any traded goods, and prevent any unexpected losses from adverse movements in the exchange rate. However, in such a competitive market, many companies find them increasingly suffocated by their lack of flexibility. There is no ability to take advantage of any favourable movements in the exchange rate, and when competitors don’t hedge (and many don’t) and FX rates move in their favour, the sensible hedger is left uncompetitive and in a worse position.
Therefore, should UK businesses leave their risk unprotected? Absolutely not. Most companies are not in the business of gambling and should always protect their risks. There are, however, many other products available to avoid FX risk but that also allow the user the flexibility to benefit from favourable exchange rate movements, and/or flexibility on the end delivery amount. For example, FX options offer a simple solution by offering companies downside protection with potential upside gain. However, only entities regulated by the FSA (such as banks), can sell regulated products like options. Non-banks can only offer very simple FX products. In fact, they can only offer spot and forwards leaving their clients with no alternative to manage their FX risk other than to use a forward contract, which in today’s competitive world is often not enough. Other advantages of being a bank, such as the ability to offer advice and pay interest on any monies, are further areas where non-banks will never be able to compete in the FX arena.
So it seems that there may be a vicious circle. Banks offer better products yet non-banks offer better service. So where does the future lie? One solution is a hybrid of the non-bank business model with the brand and regulation that only a bank can offer. There is now the emergence of specialist banks who offer the same one-stop shop philosophy and service of the non-banks, but combine it with an FX product suite, credit rating and brand that a bank can provide. These specialist banks try to provide FX solutions to the mid-cap market, which were previously only available to large FTSE 100 companies.