GFXD Calls for Greater Use of Dynamic Credit
Posted by Colin Lambert. Last updated: August 9, 2023
With The Full FX View
Dynamic credit is not a new concept, it has been, specifically, promoted by Cobalt for many years as that firm sought to provide a solution for over-allocation of credit lines, arguing it was a constraint on trading. Credit is also regularly referred to as the lifeblood of the FX industry, with its importance growing exponentially as non-bank firms in particular have taken on an increasing share of liquidity provision and some buy side clients have sought to engage in the market on a principal basis.
The argument put forward by what recently became Cobalt FX under new ownership, has been bolstered by a new paper from the Global Foreign Exchange Division (GFXD), which pointedly calls for greater adoption of dynamic, real-time, credit solutions in the FX market. By deploying such solutions, the paper argues, the industry will be able to address “systemic credit over-allocation with the foreign exchange market” and “maximise the benefits of a single pool of credit”.
It further observes that dynamic credit solutions will enhance the FX market structure for institutional players by facilitating increased trading opportunities and enabling them to meet client demand when and where it is most needed. It will also foster good governance and practice by supporting the principles of the FX Global Code.
The paper observes that the growth in FX market volume has been matched by the development of new trading technology solutions designed to offer dynamic and real-time credit monitoring and management capabilities that provide “a compelling response” to the challenges of managing the over and under allocation of credit.
Earlier this year, the GFXD published a paper, Encouraged Practices for Participants in the FX Prime Broker Ecosystem, which outlined six key principles to promote the utilisation of dynamic credit solutions that have been developed to improve credit limit monitoring and management capabilities within the FX and FX prime broker (FXPB) market. It says the adoption of real-time dynamic credit solutions will also help to address the areas of increased supervisory focus on FX market credit.
“Increasing the adoption and capabilities of real-time credit limit management solutions will assist in mitigating systemic and counterparty risk, potentially caused through the over allocation of credit,” the paper states. “Heightened awareness of the benefits of automated credit management solutions was evident after the recent collapse of Silicon Valley Bank.”
Credit needs to move from a static ecosystem of multiple pools and locations of credit to singular pools that can be dynamically distributed where and when they are required
Another driver has been the evolving regulatory landscape, culminating in the lowering of the threshold for SA-CCR (Standardised Approach to Counterparty Credit Risk), which has has seen many more firms come in scope of the regulation. “The impact of SA-CCR and the increased cost of capital also determines the ability to face counterparties, especially in longer dated trades, making the decision of optimizing credit allocation even more important,” the GFXD paper observes.
The paper investigates current practices in the static allocation of credit, identifying use cases in both the FXPB and dealer world. The GFXD also says it conducted a survey in conjunction with FXPB’s and executing dealers (ED’s) which “identified the willingness to embrace the new dynamic credit monitoring technologies and to work towards addressing this dilemma”.
It adds, “Credit needs to move from a static ecosystem of multiple pools and locations of credit to singular pools that can be dynamically distributed where and when they are required.”
The Full FX View
If anyone wondered about how the creep of regulation into FX markets was impacting thinking, it can be found in this GFXD paper. Although the paper does not mention Cobalt FX, this could be a marketing tract for that firm given how it has fully embraced the ideas that its founder, Andy Coyne, has been outlining for several years – including at the recent Full FX Scandinavia conference in Stockholm.
The fact is, dynamic credit is a very good idea and it will enhance efficiency in the FX market. It can probably also work with other solutions aimed at reducing the impact of regulations such as SA-CCR – for that is the real driver behind the GFXD paper I suspect.
Although a slow burner, SA-CCR is now fully embedded in the market and finally, people are waking up to the availability of solutions to help solve many of the associated issues. It could be asked, “why did this take so long?” and the generous answer would involve the pandemic and the need to hit the headline challenges from UMR and SA-CCR first. The less charitable answer is people had their heads in the ground and didn’t want to shake the market structure tree.
That time is now behind us and hopefully, this paper does lead to a new mood in the industry – one where the major players are open to innovative ideas that make their lives – and of their clients – a bit easier. Cobalt has been gaining slow traction for the past two years and recently announced two banks had gone live on the platform. Hopefully, more will follow, and people will also be open to engaging with other good ideas out there beyond dynamic credit such as smart clearing, DLT FX settlement, and optimisation to name just three.
The paper also looks at the opportunity for both FXPB’s and dealers from dynamic credit allocation. It argues that another benefit of the increased adoption is the potential to lower systemic risk across the broader FX market. It notes the increasing supervisory focus on the systemic risk associated with the over allocation of credit risk and FX settlement risk generally and states broader market adoption of dynamic credit solutions that enable optimal credit limit management and improve capabilities for real-time credit limit monitoring help to mitigate the possibility of systemic risk. “Single pools of credit also maximise the netting benefits and can lower settlement risk,” it continues. “This outcome would require broader adoption by all market participants including – FXPB’s, ED’s and service providers and vendors.”
A key theme of the paper is stressing the technology to deliver this enhanced solution exists today. The challenge, it says, is how to encourage greater market adoption and understanding the implications of dynamic credit allocations solutions.
Firstly, GFXD says that while the tools are available, the process of adopting and integrating new technologies needs both the timing and funding to be prioritised. Adequate funding, appropriate risk assessments and impact analysis on current business processes all need to be considered, it points out, adding one example is to ensure the inclusion of new credit facilities for e-trading platforms can address any latency issues that may eventuate between execution and credit rebalancing process.
The paper also observes that by definition, credit limits will become dynamic, and this suggests the FXPB has the flexibility to control the allocation and rebalancing of credit from one source to another, to accommodate the demand. Evaluation of a dynamic credit limit environment from both sides of the trade need to be considered and agreed between all parties, the paper states, adding, “This is a major shift from the current state of static, established trading limits.”
Broader adoption of dynamic credit will create the network effects necessary to improve the overall functioning and efficiency of the global FX market – for all market participants
It also observes that Designation Notices (DNs) have to become dynamic as well. Currently, the premise of a DN is a predefined acceptance of credit given by a PB to a dealer, these limits are agreed and remain static because of the executed legal DN document. Having a multiple DN structure is also administratively burdensome for an FXPB to manage,” the paper observes, adding. “This process would need to be reviewed to include enabling dynamic limit adjustments from PB’s to ED’s in real-time.”
It acknowledges this may represent “a sizeable change in philosophy and architecture” for dealers, effectively enabling the FXPB to effect real-time changes to limits to their ED’s and SDPs. It adds, however that the notable benefit is that this process offers more certainty of execution/trade acceptance by the PB.
To succeed in its mission to see greater adoption, GFXD also says that creating a network effect for adoption of new technologies is important provide the benefits of scale. “New “dynamic credit allocators” will attract more flow where and when its required,” the paper states. “Increased market adoption could enable larger trading volumes that are effectively monitored and managed more diligently.”
Finally, the paper argues that central banks could use their convening power to help catalyse private sector engagement and solutions for addressing structural problems in FX markets. This could include promoting the increased adoption of dynamic credit allocation tools amongst FX market participants to capture the improved credit management tools that are now available.
“The intention of this paper is a call to action – to encourage FX market participants into a broader discussion and to promote the adoption and implementation of dynamic credit solutions,” GFXD writes. “Broader adoption will create the network effects necessary to improve the overall functioning and efficiency of the global FX market – for all market participants.”