Overcoming Fragmentation in the FX Market (By Matthew Hill, Markit)
By Matthew Hill, Director of FX Business Development, Markit
Over the last decade fragmentation has become the defining characteristic in the global FX market. While most of the focus has been on fragmentation at the point of price discovery and trade execution, the industry faces fragmentation on several levels:
- Fragmented sources for liquidity
- Diversification of customer types
- Low levels of adoption of standardized protocols for messaging
- Lack of centralized post-trade systems
This structure creates challenges for both banks and buyside firms. Like other OTC markets in which standardization is low and regulatory oversight growing, one would expect post trade processing to be a challenge. In FX, however, the post trade challenge is exacerbated by fragmentation in liquidity pools and the diversity of the market.
At the same time, growing volumes in the market, changing regulation and radically lower thresholds for risk elevate the need for participants to optimise post trade technology infrastructure.
Specifically, fragmentation creates the following post trade challenges:
- The number of venues fragments the network and makes consuming notices of execution and other messaging a challenge
- Consolidating activity and a view of risk is an STP challenge at the banks
- Regulatory compliance is complex in a fragmented world. Clearing and trade reporting become easier when assisted by a certain level of centralization
- Multiple manual processes typically required for trade confirmation and subsequent lifecycle management create operational risk
To cope, the industry, especially large banks, looked to solution providers to connect to multiple execution venues, help support trade notification and develop bridges between banks and their clients. Ironically, dispersed approaches to managing fragmentation gave rise to competing communication protocols and standards as well as market silos.
The root of the problem is that back-office procedures and platforms were designed to handle voice-driven, manual trading. As a result, simply adding a Band-Aid on existing infrastructure will fall far short of achieving STP in the FX market.
The next step for the industry is to integrate with new centralised infrastructure that makes trade lifecycle management more efficient.
Transacting in FX options is one example of how the market is migrating in this direction to streamline operations, reduce cost and mitigate risks. Recently, Citi and J.P. Morgan became the first to electronically confirm FX options trades with a new venue-neutral system which also standardises and centralises how the industry communicates exercise decisions.
Putting functions like trade confirmation and exercise management on a central network removes complexity from the market, standardizes processes to reduce operational risk and mutualises cost across the industry. It also standardizes data protocols for complex workflows.
Modernising post trade systems and migrating to industry wide networks creates a competitive edge. Firms become more nimble and are able to increase their capacity without sacrificing control. This is key as high frequency and algorithmic trading continue to accelerate the increase in market volume. It is also critical for satisfying the growing number of regulatory requirements under Dodd-Frank, Emir, Mifid and other regimes.
Despite the challenges, one can argue that increased market competition and the resulting fragmentation fueled by widespread adoption of electronic trading has been largely positive in the evolution of the global FX market, leading to innovation in technology, providing transparency and generating substantial increase in trading volume. However, in order to support the continued growth of a vibrant FX market and better manage risk and compliance requirements, the industry must evolve.
We must acknowledge that the current state in FX post trade is unsustainable. The industry needs to look at other OTC asset classes which have improved operational efficiency and resiliency by migrating functions such as trade confirmation and lifecycle management to shared networks. For FX, it will be all about the network and the industry must begin to envision the day when scalable services connect major participants, standardise data exchange and facilitate communication for the key components of the FX lifecycle.
Algorithms have become more prevalent in the spot FX market.
Global Foreign Exchange Committee has made recommendations on Last Look.
There is a growing demand for transparency in FX trading by regulators.
CLS has also enhanced its existing suite of alternative FX data products.
FX Global Code sets out good practice for last look and provides illustrative examples.