The Last Look…
Posted by Colin Lambert. Last updated: March 22, 2021
Outsourcing has been a big topic in FX markets for many years, although over that period the conversation has taken many different forms. I can recall being on a panel with Vikas Srivnastava, who at the time was running Citi’s e-FX franchise when he spoke of the “shades” of white labelling and in the intervening period there have been attempts at just about every colour on the spectrum, as predicted by Vikas.
Last week, consulting firm McKinsey published an interesting article on its website, you can read it here, about “trading as a service”. The basis of the article is nothing new, e-trading is squeezing margins, and the cost of regulation is going up, which means regional banks can struggle to provide the scale necessary to remain adequately profitable. The suggested solution is a partnership with a major player – who has scale – across the entire spectrum of the trade.
In principle I have few quibbles with the report, but in FX terms there are a couple of areas that would need to be addressed (the full report is about ‘flow’ markets, not just FX I should stress).
First and foremost in this day and age, what happens about best execution? The regional banks have an obligation to provide best execution for their clients, especially when dealing outside of their core currencies. Can that be fulfilled with a partnership with one player? I am not suggesting it can’t but I would imagine certain frameworks for monitoring trading will be needed.
One of the benefits of aggregation (as long as it is limited in scope in my view) is that consumers naturally have access to more axes. This is irrelevant in the majors, but the key benefit of such a relationship for a regional bank is being able to access liquidity in emerging markets for instance. Being tied to one player doesn’t seem an optimal solution, because even at the top level, there are markets where ostensibly the best LPs in the business are less competitive.
If the relationship extends to FX swaps and options, which are, in my view, on the cusp of greater electronification, then the inability to see axes from more than one player becomes even more critical to performance and the fulfillment of best ex requirements.
A second area is sustained excellence on the part of the “major” player. I have been lucky enough to be writing and studying single dealer platforms for two decades now, and there are cycles to this industry.
I need to stress I am not suggesting in any way that the following examples indicated poor levels of service, it’s all relative, but my observations over the past 20 years would be thus. In the early years of the century, UBS’ FX platform was truly outstanding, but then it went through a period where it was overtaken by its peers (paradoxically enough because it was reliant upon a third-party provider that perhaps struggled to keep up with the pace of change necessary). If you had looked at the bank’s platform in the early 2010’s, as I did, it is hard to see it in the top three or four at that time.
Tying to one provider has risks if that provider’s investment levels change
UBS was succeeded in my view (and, broadly, of the many of you who helped with the judging of the Profit & Loss Digital FX Awards) by what was Barclays Capital, but then at some stage investment in the BARX Platform slowed and cracks started appearing. Deutsche Bank’s Autobahn was another excellent concept that went through a period of under investment in my view, thanks, to a degree, to wider issues with the bank. These have been solved and investment has picked up.
Conversely, for much of the first decade of this century, the three US giants, Citi, Goldman Sachs and JP Morgan, had single dealer platforms that were, frankly, underwhelming. There were good parts, no doubt, but the overall experience wasn’t always great. Look at them now, probably the leading three platforms in the business (with more competition than three years ago I would observe, however).
My point is that tying to one provider, albeit for one part of the chain, has risks if that provider’s investment levels change. Things happen way above the FX level of the business that can impact negatively on technology investment levels and they are impossible to predict.
The final issue is related – a guarantee to stand in, with appropriate spreads and depth of liquidity, when the world goes to hell in a handbasket. Thankfully liquidity events on a massive scale happen relatively rarely in FX markets still, and LPs in particular have proven themselves adept at learning from the experience. That does not mean there are risks, however, for every time there is an event you hear stories of some major players either disappearing altogether, or quoting spreads that cover the entire range of the past 50 years of floating exchange rates.
This is, occasionally, an issue in the majors, but, again, it’s something that can happen quite often in emerging markets – can a provider actually follow through on a promise to stay in come what may? These promises will be made genuinely and with the best intentions, but take what happened this morning in Asia as an example, how many players were willing or able to offer a service (including warehousing risk if necessary) in the Turkish lira, which fell over 17% in early trading, before recovering to “only” be down 12.5% as Europe wakes up? On a different note, what happens if there is a catastrophic event that collapses the technology stack?
It strikes me, therefore, that while the idea of partnerships is a good one – I have been arguing that for some time now – they have to be re-imagined.
In some ways the McKinsey report does this by discussing how a group of regional bank providers could get together to manage costs, but again, where would this sit with monopoly laws in certain regional markets? I can only imagine the eyebrows raised if, for example, the five major Canadian banks developed such a structure. Yes, with the right framework it could ease any concerns, but are the Canadian banks the only serious players in the Funds market?
Overall, the report touts savings of around 30% for a $200 million FX business, the savings mainly coming from reducing the cost of traders from $30 million to $7 million, the level of tech spending from $25 million to $10 million, and the outsourcing of operations to the partner from $16 million to $5 million.
Regional banks have a more complex landscape to navigate, but I remain of the opinion that their best avenue is to curate a small group of providers that allow it to operate with redundancy and fulfil basic levels of best execution policies
Interestingly to me, the savings on regulatory reporting ($1 million), market risk ($2 million) are pretty marginal and the $4 million saving on market data can probably be achieved without outsourcing, rather through a better choice of how much data the institution really needs.
The nature of the FX business has changed, without doubt and the fragmentation of markets has increased costs. Back in the day, a group of traders had pretty much fixed costs thanks to brokerage ceilings and technology that did not need to be updated on a monthly basis. Now it is much more complex, especially if a customer decides they want to trade via a previously unconnected platform.
This does mean that regional banks have a more complex landscape to navigate, but I remain of the opinion that their best avenue is to curate a small group of providers that allow it to operate with redundancy and fulfil basic levels of best execution policies. The fact is, a lot of regional banks have specialities in certain currency pairs – the Scandis spring to mind where a long list of major global players have scaled back their commitment (often while licking their wounds!)
For a regional bank to remain competitive in their own core markets they still need a certain level of technology and resources – outsourcing everything to a major player is effectively handing over the client franchise and I can’t see many wanting to do that. This means that while I absolutely agree that the market structure around regional banks probably has to change, I am not buying into the unique relationship model.
An interesting side topic of this will be what happens to the multi-dealer platforms in such an environment? Clearly one of the cost benefits from the McKinsey approach would be the creation of a bespoke technology “bubble”, providing the end-to-end experience required. This is typically what the multi-dealer platforms offer, at a cost, but what the report seems to recommend is something I wrote about recently – the evolution of the single dealer platform into an FX ECN, with added workflow benefits.
Overall though, while I don’t buy in to the idea, this is another example of how the FX market structure could easily change, as I wrote just two weeks ago. What this report does is highlight how prospective change could come at all levels, not just at the top.