PBs seek remedy for credit addiction in FX

Group set up after big Citi loss considers limit-checking hub, among other options

FX-credit-addicts

Prime brokers in the foreign exchange markets are looking for new ways to control credit risk, after a $180 million loss at Citi in 2018 attracted the attention of regulators.

A working group has been quietly exploring remedies over the past year, Risk.net can reveal, with the granting of too-generous credit limits seen as the industry’s most pressing problem. One option under discussion is the creation of a centralised limit-checking hub.

“What we wanted to do is prioritise the biggest issues facing FXPB and think about them from a self-regulatory perspective. Over-allocation was deemed to be the number one priority,” says a source at a large FX prime broker.

Many brokerage clients are currently given generous limits so they can execute across the FX market’s plethora of trading venues without running out of capacity. What’s convenient for the client is, however, potentially catastrophic for the prime broker, which becomes the counterparty to its customer’s trades.

The industry working group operates within the Global Financial Markets Association, and last month presented its initial findings to the association’s global FX division – the GFXD. The group has now been given permission to take its work further, and recommend solutions.

A spokesperson for the GFXD declined to comment.

What we wanted to do is prioritise the biggest issues facing FXPB and think about them from a self-regulatory perspective. Over-allocation was deemed to be the number one priority 
Source at a large FX prime broker

One of the group’s objectives is to head off direct regulation. Citi’s loss was the result of a complex, options-based strategy at a single client – not the kind of widespread over-allocation that is more common in the business – but prime brokers worry any fresh slip-ups would result in a broader clampdown.

“The regulators are aware FXPB is an issue post-Citi in 2018, so they are definitely keeping an eye on it because they understand it’s an extremely important part of the institutional FX market,” says a second source at a large FXPB.

“The working group is really meant to address a problem that we all understand is real and needs to be addressed, but it goes without saying that if we have another blow up like that, and if this tail risk actually were to materialise, the regulators might say, ‘OK, here’s how it’s going to be’.”

Nope to NOP

Over-allocation of credit limits is a long-standing feature of the prime brokerage business. This is largely due to the fragmented nature of the FX market, where clients are able to access liquidity via dozens of trading platforms and aggregation services, as well as trading bilaterally with dealers – known as ‘executing brokers’ in the PB business. To support this, prime brokers give many clients extra headroom so they don’t run out of capacity at a given venue.

In addition, the prime brokerage business tends to set limits on a net basis, using a metric known as net open position (NOP). This means clients, particularly high-frequency trading firms, can incur huge gross positions that net down to pass the NOP limits. If one of these firms’ trading algorithms went rogue, it could rapidly rack up exposure for its prime broker.

Pre-execution checks can be carried out through the use of so-called designation notices (DNs) – legal documents issued by PBs that lay out the type of products a client can trade with a given dealer, and the credit limits that apply. This type of check will tell a prime broker whether a client is allowed to execute a specific trade with a specific dealer, but not how a flurry of trading affects its overall net position.

“When a hedge fund client trades, for example, we do check the DN on a pre-trade basis so we always know if they are trading within the DN limit with an executing broker,” says Nat Litwak, global co-head of FXPB at BNP Paribas. “But what we don’t know until post-trade is whether that trade is going to put the client over its own NOP limit.”

Some prime brokers skip even these pre-trade checks for their HFT clients, as they can act as a drag on the customer’s rapid-fire trading strategy.

Pipes and plumbing

Among the solutions being discussed by the industry working group is the creation of a centralised credit utility, allowing FXPBs to keep track of a client’s aggregate position. 

A similar service was created for over-the-counter derivatives markets following the introduction of mandatory clearing. Operated by CME-owned Traiana, it tells parties to a trade that each side is within its credit limits at the point of execution. In theory, if all FX limits and trades were also run through a hub, brokers would be able to monitor limit consumption in something close to real time.

Sources say Traiana would be the most likely provider of a limit-checking service for FX prime brokerage.

citi-canary-wharf
Citi was exposed to painful FX losses in 2018

“The reality of a central hub is that it’s all about the pipes and the only one that has the real connectivity to almost everybody currently is Traiana,” says the global head of FXPB at a US bank. “They are not there with regards to having a solution that can do this, but they would be best placed because having the network in place is what adds much of the value.” 

Some participants take the opposite view, pointing out that Traiana’s tools are only available on a limited number of trading venues. John O’Hara, head of prime services clearing for the Americas at Societe Generale, says the market may be better served by starting fresh.

“One can’t simply assume that obvious and existing service providers represent the right mechanism to facilitate the creation of a central repository. Perhaps we should be looking outside traditional functionality and employ something that’s a little more nimble and configurable,” says O’Hara.

A spokesperson for Traiana provided a statement that outlines the firm’s existing role in OTC trading, but the firm declined to comment on whether this could be extended to FX prime brokerage.

Dynamic DNs

A limit-checking hub is not the only option that has been discussed. Another possibility would be to enable DN limits to be managed more dynamically. 

Again, the nearest equivalent in today’s market is a Traiana service that allows prime brokers to define the type of currencies, products and tenors a client is allowed to trade within its DN credit limits. FXPBs can raise or cut a client’s credit limit via the hub when needed, but the system relies heavily on manual inputs.

Some market participants envisage an automated version of this system, which might allow far tighter limits to be set. 

For example, instead of giving a client a $100 million credit line, the FXPB might only provide $10 million, based on the customer’s observed trading behaviour. If the client executed a $2 million trade, its available credit would drop to $8 million, but once the trade was confirmed by the executing broker, the FXPB would put $2 million back into the client’s pot, returning the limit to its agreed level of $10 million.

“That is going to require a very sophisticated network and you would need the participation of both the PBs and the EBs, but it’s something that’s definitely doable,” says BNP Paribas’ Litwak.

The reality of a central hub is that it’s all about the pipes and the only one that has the real connectivity to almost everybody currently is Traiana
Global head of FXPB at a US bank

But of course this needs full participation from the Street to be effective: “The problem with Traiana’s DNM is that it is only as good as the amount of EBs that are on that network, and although more and more people are on it, it’s not universal,” says the first source at a large FXPB.

Some say Traiana could address this by expanding the type of agreements that are handled by its service. But even then, the issue of over-allocation wouldn’t disappear entirely. 

“When you have a DN limit, why do you over-allocate in the first place? Because a client doesn’t know exactly how much they are going to be trading with a given bank – you give them more, because otherwise they might run out,” says Litwak. 

It’s not clear what route the working group will choose, and participants aren’t expecting a quick decision.

“This isn’t something that is meant to be done in the next couple of months and it will likely take years, but at least we are addressing it,” says a third source at a large FXPB. “Everybody is short on resources and, depending on the solutions, it’s going to require a lot of IT budget and human resources.” 

Whatever the shape these solutions take, one thing is clear: the banks will not be building them. 

“Everyone has different approval processes, different regulators, different management, different IT spend, so it can be very challenging,” says Litwak.

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