The Last Look…

Are US equity markets throwing a giant spanner in the works of the FX market, or providing it with potentially a big boost? With the start of T+1 settlement in North American securities markets now under a year away, minds have been focused a little in the FX world over what the impact will be, helped by a paper from GFMA published recently.

That paper laid out the issues rather than suggest any solutions, although I did chuckle at the observation that the FX trade should be executed as close to the underlying trade as possible – tell that to those managers still waiting up to 18 hours for the London 4pm Fix to execute their hedges!

The big issue around the change will undoubtedly be funding, and I will return to that, but while we are talking about the Fix, what will happen when US trades are being settled at one day, while Europe and parts of Asia are still T+2? Do users of the Fix have to stop executing at month-end for example because the balances are out of kilter? Do they, in fact, have to stop using FX swaps as a funding vehicle full stop?

The answer to both is probably ‘no’, not least because the capital cost of using the money markets, and the lack of appropriate depth (for these size transactions) in many futures markets, means they have to still use swaps, but the FX industry is probably going to have to get innovative.

This also means the users of the Fix are going to have to think more carefully about how they execute – mainly because their current method for calculating month-end hedges will have to change. Simply put, the managers will know their, for example, euro and Sterling positions two days out from the month end, but won’t know their dollar balances until the next day. If this sounds like fun now, however, just wait until the quarter and year-ends when there is also often a funding squeeze – frankly, anything could happen then.

The one thing I think we do know, is that whatever does happen around the Fix is going to have an impact, for with so many users typically positioned the same way round, any change will be exacerbated.

To go back to the funding, obviously there is a very healthy short-date FX swaps market, with great depth in the overnight and tom-next, but I suspect there will need to be more intraday swaps on offer, perhaps linked to the Fix, to help ease the cashflow problems of managers adjusting country allocations. For the majors this is unlikely to be a huge problem, but, and here is the recurring theme of the settlement risk discussion currently underway in our industry, so much is traded outside of these pairs – what happens there?

I suspect the answer will be in more PvP settlement mechanisms for, initially at least, non-CLS currencies, but these mechanisms will also have to have the processing power and right tech stack, as well as come with the ability to trade intraday swaps.

The requirement for the buys side is going to be technology – calculating with such a natural temporal imbalance manually is just going to be too slow – the question is, do the buy side have access to this technology? Some may have, many won’t – and as such the race is on to either provide the service, or get the technology embedded in the sector. Whether this can be implemented before the end of May 2024 is a tough question to answer – certainly one potential solution, CBDCs, will not be ready.

Whichever way you view the move to T+1 in US markets, the cost of running a currency hedging operation on the buy side is likely to increase

There is an irony that one set of regulators has approved this shift to T+1, while another continues to wring their hands over the size of settlement risk in FX markets. I may be wrong, but surely this shift is only serving to increase the settlement risk problem, albeit until the technology is in place and adopted, rather than dilute it?

One answer could be to build a patchwork solution that bridges the gap to CBDCs and the wider adoption of DLT-based solutions, but interim fixes are rarely the right way to do things, this industry mainly builds for the medium/long term. The answer, as I see it, is for greater adoption of existing solutions as quickly as possible. By doing this, alongside the development of a robust intraday FX swaps market, a working solution can be evolved (which is important given Europe will, presumably in its own time, also go to T+1 – probably just as the US goes T+0!).

Whichever way you view this, the cost of running a currency hedging operation on the buy side is likely to increase, with no obvious financial compensation in return. This could be a real boon to the currency management industry, after all they are the real professionals at dealing with things like this, but what really worries me is the asset management industry in particular chooses the easy – and wrong – option.

The US move to T+1 is a challenge to the FX industry, but one that can be overcome. What we need to avoid is managers deciding it’s all too hard and forgetting about FX hedging, at least for a period of time. This is largely a conservative sector that often changes under duress only – witness the five-minute fixing window (sorry couldn’t resist!) – so will they be open to embracing, and part paying for, the necessary changes to continue using the FX market for their hedging and cash flow requirements?

The fact that the change emanates from one of their core constituencies should help them decide to evolve how they work – the wider FX industry can help by offering innovative solutions that help them do so. All we really need are minds that are sufficiently open to embracing conversation about change.

colin@thefullfx.com