14 October 2008 Comments

 

Comment: Co-operation in FX trade processing

Pat Leffler, Wall Street Systems

The current discussion that centres on how FX banks can lower their all-in cost per trade is nothing new. Banks (large and small) have been always been concerned on how to lower their trade processing costs, but it's just recently that this focus has had renewed emphasis. One reason for this is that as FX trade volumes have surged over the past few years, the corresponding size per ticket has dropped significantly - translating into lower and lower margins. This trend of higher volumes and falling margins is certainly not good news for FX banks. With little flexibility to affect the revenue side, banks have been forced to spend more and more of their effort addressing the cost side of the business.

From an overall industry perspective, these efforts to reduce costs have been mostly successful. Studies show that the largest FX banks can now process trades for an all-in cost of less than one dollar per trade - a significant reduction from just five years ago. Additionally, CLS Bank - the industry standard for processing payment messages for the majority of FX trades throughout the market place - has also consistently lowered the per trade costs that they charge their member banks.

Having said that, the real issue now in discussion is the wide and growing disparity in trade processing costs between the largest FX banks and some of their smaller competitors - the Tier II and Tier III banks. While the largest banks can point to significantly reduced ticket costs, these same studies show that smaller banks haven't had any where near the same success in reducing their ticket costs. If it costs the largest banks less than a dollar to process an FX trade, smaller Tier II and III banks spend anywhere between ten to twenty-five dollars to process those same FX trades. It doesn't take a genius to figure out that this trade processing cost difference represents a huge competitive advantage for the larger banks.

So why the disparity? Most of it has to do with the amount of investment dollars that have been thrown at the problem. The large FX banks have been forced to upgrade their systems for high capacity, low latency solutions to meet the high volume demands. While these upgrades are expensive, they have been successful in lowering the cost per trade because of the vast amounts of trade volume that now flow through these upgraded systems. Because the Tier II and III banks haven't experienced the same high volume demands as their larger brethren, they haven't had the need to implement these upgrades.

So how can these Tier II and III banks remain competitive in the current FX environment? While throwing additional money at the problem may seem like the obvious answer, it is certainly easier said than done - ripping out and replacing existing trade processing systems takes time, money and exposes the bank to high IT project risks. Even if the project does receive business-level approval, few banks (large or small) have the deep pockets available for this type of investment in today's troubled banking environment. These smaller banks will need to look beyond traditional solutions in order to close the trade processing cost gap between themselves and their largest competitors.

One viable solution might be in the form of co-operative processing rather than individual bank trade processing systems. Fundamentally, the concept of co-operative processing is the creation of a hosted common silo (run by an independent service provider) that processes FX trades for a number of different banks. The concept itself is not new - the different currency networks (Currenex, FXMarketSpace, etc.) already provide co-operative FX trade execution for the front-end and CLS Bank can also be thought of as a co-operative payment messaging solution for its member banks. The adoption of a pure co-operative trade processing solution would eliminate the need for banks to invest in and maintain multiple applications and associated infrastructure. Additionally, it would create huge economies of scale that would allow for significantly reduced FX trade processing costs. The cost savings that come with the elimination of existing infrastructures and the economies of scale could help Tier II and III banks better compete with their larger Tier I counterparts.

The key factor for a successful co-operative trade processing service would be the pricing model. It would need to be priced on a cost per trade basis with minimal up-front investments in time, resource and cost. These minimal up-front costs would ensure a true pay-as-you-go pricing model. This would allow participant banks to purchase trade processing capacity based on their trade volumes - in effect, purchasing as a package all the different processes (position keeping, P&L, confirmations, settlement workflow & controls, payments, payment splits, settlement netting, confirmation matching, bank account reconciliation, accounting, etc.) that make up FX trade settlement and paying on the basis of trade volume. It aligns the primary member banks' objective (reduced trade processing costs) with the actual cost structure of the solution.

The concept of co-operative trade processing is already attracting significant interest among market participants, service providers and technology vendors. If Tier II and III banks hope to compete with their larger Tier I brethren, they must act decisively to reduce the wide disparity in FX trade processing costs that currently exists. The adoption of a co-operative trade processing solution seems to be a viable solution that should be explored.

Pat Leffler, Wall Street Systems