Reaping the benefits

The last few years have witnessed an unprecedented gold rush in one of the largest, and most liquid markets in the world – foreign exchange. Whether for risk management, speculation or hedging, FX has become an asset class in its own right and existing counterparties from across both developed and emerging markets are trading more frequently.

Some of the greatest demand for foreign exchange has come from the non-bank professional FX traders including hedge funds. These have been provided with measured access to trade directly in the core FX market through leased credit from prime broking banks. These prime brokerage relationships have contributed huge growth in FX, particularly on the EBS platform which has become the source for professional FX trading across the globe.

This has provided hedge funds with the autonomy to direct their own investment strategies and applications while a larger FX market-making bank absorbs the credit risk, maintaining an orderly market. So far so good, and the hedge funds have certainly added significant additional volume and liquidity to benefit the market overall by adding depth, so traders can get the price in the currency pair at the time when they need them.

The second sea change has been the growth in algorithmic or API-based trading. A strategy favoured by both bank and hedge fund alike, black box trading in FX is typically used as a complimentary trading strategy for dealing smaller currency amounts at higher frequencies. Here lies an issue. The volume of tickets processed is rising faster than the total notional dollar amounts traded, and this is putting bank back offices under pressure and adversely affecting their margins, because of the high costs associated with ticket processing.

Client servicing
The additional volume from thousands of deal tickets has put pressure on bank back offices and added cost. Those costs inevitably get passed down to the hedge fund customer and some banks are now seeing the ability to process trades more effectively as a key point of significant differentiation in client servicing. High frequency trading funds and buy-side customers are typically price sensitive and the combined costs of thousands of individually priced FX deal tickets adds up.

“Everything below existing ticket costs is a profitable trade, while everything above them can be less profitable. The most effective way for banks to encourage us to grow and maintain our business with them is to invest in a ticket netting which reduce their individual ticket costs,” says Justin Foley, Gelber Trading Group. According to a Dow Jones report from May 2007, many banks have complained that processing trades individually in a fast growing market is putting a strain on their systems and costing them too much money, a concern reflected by their clients.

The right infrastructure
One bank back office head says that ticket processing is a major issue in FX, particularly for those organisations which do not have the infrastructure in place to process heavy ticket volumes. “It’s mainly coming from clients including hedge funds who want to work through us as a prime broker and are channeling high levels of business,” says the back office manager at a large investment bank. “Demand for direct dealing though prime brokerage in FX from our buy-side customers has led to a seismic increase in FX ticket volumes. The deal tickets started to increase and then they rocketed, particularly when black box trading came in.

“If you’re prepared and have invested wisely in your FX infrastructure, you have the systems in place to handle it and can do so cost effectively for the customer. The trick is to time and focus your investment in the right way.”

The need in the market is clear. If banks want to continue to service their customer business efficiently, a netting solution is of paramount importance. A well managed back office can itself contribute to cost reductions which can then be passed onto clients. FX post-trade specialists Traiana, the provider of the Harmony network for FX prime brokers, has developed a customer ticket netting system called NetLink in partnership with the ICAP-owned EBS platform.

The system works by allowing the banks to net their customer’s FX trades by currency pair at pre-defined points throughout the day. It receives deals from a range of electronic dealing platforms and determines whether or not each deal is netting-eligible based on customer-defined parameters. The larger number of FX trades are then processed and netted by and then published to the prime broker bank’s back office either as deal tickets or simply as payment records. NetLink has already proven its worth, with a 95 percent reduction in ticket volume in some cases, netting hundreds of smaller trades into single tickets. Many funds are now asking when their bank will offer them ticket netting for their increasing number of FX business so they can reap the benefit.

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