Cognizant 20/20 Insights Leveraging IT to Extend Excellence in the Forex Marketplace Executive Summary As the foreign exchange (FX) market prepares for the next wave of growth, technology has emerged as a vital enabler. Although the Top 5 banks still control 54%1 of the FX, their cumulative market share has sharply declined since 2009. Meanwhile, the next five players have seen their share edge up. As the competition intensifies and more Tier 2 players aim to increase their customer base, investments in FX technology, superior pricing tools and the ability to streamline front-to-back processes are among the key elements of a much-needed business transformation that will enable these players to capture a slice of the low-margin, high-volume-flow portion of the market, while at the same time offering high-margin, value-added services that meet the requirements of specific customer segments. In this article, we examine some of the technology focus areas many of which have been adopted by market leaders that banks need to take into consideration when building a robust FX architecture that will enable them to maximize their market share. The first decade of this millennium saw unprecedented growth in FX trading volume. Not only did FX become an established asset class, but the entire market structure also underwent a partial transformation. Among the key developments were growth in electronic trading and the emergence of a hybrid exchange-like market model due cognizant 20/20 insights december 2010 to several factors, including the establishment of several electronic communication network/multidealer platforms; growth in agency-based business, supplemented with services like prime brokerage; accessibility of the FX market to completely different customer segments (e.g., retail FX); and, above all, the widespread use of continuous linked settlement (CLS) for FX transactions, which significantly reduces settlement risk. Although 2009 saw a slight dip in FX volume growth, it is expected to bounce back in 2010, with the average daily turnover estimated to reach USD $4 trillion. Today, the FX market is a highly mature industry, much like the equities market, with a number of entities that can be broadly classified as follows: Liquidity Consumers (Buy Side): These entities include central banks and governments that manage liquidity at a country level; banks that operate in the interbank market; corporations and institutions that use FX mainly for hedging; hedge funds and asset management firms; retail (speculators, traders, individuals); and private (high net-worth) clients. Liquidity Providers (Sell Side): These are mainly the banks that not only operate in the interbank markets, but also provide liquidity to their customers via various channels, such as their proprietary single-dealer platforms or on third-party multi-bank electronic platforms. It also includes non-banking broker dealers that provide liquidity to the buy-side, primarily in an agency mode.
Third-Party Electronic Platforms: These include the large inter-dealer networks like EBS and Reuters; ECN/multi-dealer platforms like Hotspot FXi, FXAll and Currenex; and retail FX platforms (i.e., retail aggregators), such as FXCM, GAIN, OANDA, etc. All these players own FX trading platforms on which sell-side firms can provide liquidity that can be accessed using the platform GUIs. Other Players: FX Prime Brokerage has existed for several years now but has seen significant traction in the past four to five years, as FXall has emerged as an asset class and buyside firms look to source liquidity from multiple dealers but want to maintain a credit relationship with a single entity. The prime broker steps into the FX trades done by its clients with various liquidity providers and offers netting, clearing and settlement services. In that sense, they act as a pseudo central counterparty (CCP). Most large banks now have an integrated FX prime brokerage offering that caters to client segments such as hedge funds, asset managers, CTAs and, more recently, retail aggregators. Last but not least, the CLS Bank (as the central settlement entity) has been at the forefront of streamlining the FX settlement process through its payment vs. payment (PvP) settlement service and thus reducing the risk associated with settlement of FX transactions. Today, the service supports 17 major currencies and has 60 bank members and over 9,500 third-party participants. Nearly 55% of the total FX obligations are settled via CLS. 2 FX Technology Initiatives To a large extent, the growth in the FX market can be attributed to the widespread adoption of technology across the FX trade lifecycle. Although the credit crisis and the consequent shutdown of some of the largest investment banks has resulted in significant re-alignment in the FX marketplace, the Top 5 players continue to dominate in terms of market share. The key to their success has been an integrated service offering, backed by robust and cutting-edge technology. Here is a look at some of these technology initiatives. Front-Office Technology One of the main reasons FX has achieved an equities-like status is the rapid innovation and adoption of front-office technology, be it algorithmic trading, smart order routing, client and partner connectivity and client portals. Maximizing Customer Reach via a Coherent Channel Strategy: Fundamental to building a strong FX business is a robust channel strategy. The key requirements in building an effective channel include the following: Aggregation of FX flows from multiple client segments centrally, thus enabling higher internalization. Better price discovery through efficient and consistent pricing across all channels. Superior speed of execution. FX Market Participants Interbank Platforms (Reuters, EBS) Multi-Dealer Platforms Multi-Dealer Platforms (Hotspot, Currenex, FXall) Retail Aggregators/ White-Label (FXCM, OANDA, GAIN, SAXO) Trading, hedging, arbitrage Customer Segments Government/ Central Bank Hedge Funds Asset Management Trading, hedging, arbitrage Liquidity & Credit Providers Banks Provide liquidity, market making Interbank dealing Corporations/ Institutions Brokers CLS Bank Private Clients Retail Clients Trade giveup, Netting, Clearing Prime Brokers FX Settlement Figure 1 cognizant 20/20 insights 2
* Better client touch in terms of access to valueadded services, such as research, sophisticated tools and up-to-date information on positions and risk. Most leading banks have addressed these requirements by implementing what is commonly known as a single-dealer platform (SDP). An SDP provides a common platform on which the firm can consolidate research, pricing, execution and other services, such as reporting at a single place to address specific customer needs across various segments. Nearly all industry leaders have built their competitive advantage on the basis of their SDP, namely Autobahn (Deutsche Bank), UBS FX (UBS), BARX (Barclays Capital) and CitiFX (Citigroup). While most banks have some form of Web channels through which they serve their clients, it is essential that they have an integrated offering brought together through an SDP. In building an SDP, banks need to decide whether a build or buy approach should be taken. A build approach can be time consuming and complex given the various systems/components, such as pricing engines, data feeds, risk systems, trading systems, etc. that need to be integrated. However, it provides the firm the flexibility to build its unique differentiator, while allowing the SDP to be extended to multiple asset classes. To do this, the firm needs to ensure that it first builds a robust SDP framework that comprises reusable components and services that can be extended as the SDP evolves. The buy approach could mean white-labeling of third-party SDP platforms (like SAXO and FXSolutions) or buying an SDP framework from an SDP vendor (such as Caplin and Trader Tools). The primary advantage of this option is that it addresses the time-to-market need; this is extremely important given the intense competition among banks. However, if the solution is build-only for FX, it might be difficult to extend the platform to other asset classes. Additionally, personalizing the whitelabeled solution to bear the firm s distinct differentiating identity is less likely to be possible. Among the focus areas critical to the channel strategy is the user experience. In the effort to provide superior user experience, rich Internet application (RIA) technologies are increasingly gaining acceptance, as they provide the ability to combine data visualization (in the form of dashboards, drill-downs, streaming data and video and online analytics) with human interaction (realtime chat) to provide a powerful customer experience. Morgan Stanley, for instance, has created waves through its RIA-based SDP offering, Morgan Matrix. However, firms that want to adopt RIA need to decide whether their entire Web channel needs to be built using RIA or whether to use this technology intelligently to address specific customer segments, while continuing to leverage their existing Web channels for other requirements. It is important to understand that the SDP is not only about providing a rich user experience, but also about providing an integrated platform that helps improve client service via access to a variety of tools, research and reports. In addition, it enables effective cross-selling opportunities to the client-facing teams and, at the same time, ensures front-to-back integration. While SDP is one of the most important technology focus areas as far as channels are concerned, firms need to ensure that their channel strategies are comprehensive and provide them with maximum customer reach via multiple channels, such as telephone, mobile connectivity and direct FX connectivity with buyside systems, as well as access to all the leading multi-dealer platforms. Finally, firms need to ensure that the liquidity from the various channels is aggregated and is either internalized, where possible, or routed to the execution venue providing the While most banks have some form of Web channels through which they serve their clients, it is essential that they have an integrated offering brought together through an SDP. Firms need to ensure that the liquidity from the various channels is aggregated and is either internalized, where possible, or routed to the execution venue providing the best price (using smart order routing) so customers get the best execution price. best price (using smart order routing) so customers get the best execution price. Addressing the Need for Low Latency: With growing volumes and reducing spreads, low latency is perhaps the most important requirement when it comes to pricing computation, price distribution and trading. The technologies that have been adopted at the highest rate are low-latency messaging and complex event processing. cognizant 20/20 insights 3
Low Latency Messaging: As in the case of equities trading, ultra low-latency messaging is a much-desired need, almost a prerequisite for FX trading for sell-side firms. Low latency is applicable not only in real-time pricing computation and distribution A combination of low-latency messaging along with CEP can provide sell-side firms the cutting-edge technology needed to maximize trading volumes and provide the best price to their customers across multiple channels, but also for fast interaction with applications supporting real-time risk analytics, algorithmic trading and trade surveillance. A wide variety of low-latency technology options are available from market-leading niche players, such as 29West and Real Time Innovations (RTI), traditional middleware offerings from giants TIBCO and IBM (IBM MQ), as well as smaller players like Nirvana and Openslice DDS (an open source-based low-latency middleware offering) that can address specific or enterprise-wide requirements. Complex Event Processing (CEP): CEP facilitates processing of large streams of data/feeds, and based on pre-defined rules, it enables accurate decisions on pricing and trading. Hence, it finds use in various aspects of the FX trading lifecycle, such as price aggregation from multiple sources, pricing engines, algorithmic trading, smart order routing and trade surveillance. There are contradictory views on what CEP really includes, with purists claiming that CEP as used by sell-side firms for functions like smart order routing and algorithmic trading is more of an extension of low-latency EAI rather than pure CEP. For the sake of this white paper, however, we will go with the above definition. Leading CEP providers such as Apama, Streambase, Aleri and TIBCO have customized frameworks to specifically address needs of the FX market, and these have been widely adopted by sell-side firms. When correctly implemented, a combination of low-latency messaging along with CEP can provide sell-side firms the cutting-edge technology needed to maximize trading volumes and provide the best price to their customers. Of course, both of these technology options are expensive. Every additional unit of latency improvement (i.e., from millisecond to micro-second to nano-second) comes with a substantial increase in cost. Figure 2 (below) shows that beyond a threshold, the costs could increase exponentially. Firms need to evaluate the incremental revenue they can generate to justify the costs of building a low-latency infrastructure. Trade Processing Technology Typically, most technology innovations and spend are directed at front-office technologies, due to the focus on revenues and profit. Often, trade processing gets neglected. However, it is extremely important that the middle- and backoffice infrastructure is robust and scalable to handle the high volumes that can result from superior front-office technology. Costs for Reduced Latency $14,000 $12,000 Cost (thousands) $10,000 $8,000 $6,000 $4,000 $2,000 $0 1000 2000 3000 4000 4500 4750 4900 4935 4940 Latency Savings (microseconds) Source: TABB Group estimates Figure 2 cognizant 20/20 insights 4
Reducing the Cost per Trade: Despite the fact that the high volumes in FX trades has helped reduce the cost per trade, the reduced spreads and growth in retail transactions require firms to look at further reducing the cost per trade, which is higher for FX compared with equities, especially for Tier 2 and Tier 3 banks. The key requirements from a post-trade processing perspective include the following: Improve client service: FX clients, especially buy-side firms, expect more transparency in terms of real-time updates of their trading activity and online trade confirmations. What this means is that not only should customers be able to view their trade activity in near-realtime, but they should also be able to confirm (or reject) these trades online, and there should be a straight-through link with the back-office systems for subsequent settlement processing or exception processing. Similarly, if banks can provide buy-side customers the ability to assign settlement instructions online, they can significantly reduce settlement failures. Achieve a higher degree of straight-through processing and operational efficiency: When we talk STP, it is not just about eliminating manual intervention, but also about streamlining the front-to-back flow through increased automation, efficient processing and higher throughput. Operations is a manually-intensive activity, but the firm can look to improve technology enablement of operations through better workflow tools to streamline processes such as investigations and claims. Firms can look at integrating business activity monitoring tools with their front-to-back applications for effective transaction monitoring on parameters such as volumes, throughput and exceptions. Increase high-volume transaction processing capabilities: A factor that has a huge impact on volumes is the push to expand the customer base to hedge funds, private clients and retail aggregators that use FX as hedging or speculative asset and trade in large volumes but smaller tickets. Additionally, most banks have an integrated FX prime brokerage offering that also serves such clients. This has resulted in additional pressure on post-trade processing infrastructure, as the firm s flow business and prime brokerage business both need to be supported. The most simplistic but sub-optimal solution would be to have a separate infrastructure for the flow and prime brokerage businesses. However, this would only inflate operations cost. Hence, firms need to ensure that they use the same infrastructure to handle both their flow and prime brokerage businesses and increase processing capacity, wherever feasible, through hardware and software improvements. The best solution is to reduce the volumes that the middle- and back-office systems need to handle. This can be done through trade compression of small-ticket trades that result due to retail flow; micro-trades conducted on retail aggregator platforms; the use of algorithms; and prime brokerage for retail aggregators. One way of achieving this is by leveraging the trade aggregation service offered by Traiana s Netlink (now offered as CLS Aggregation, a joint venture between ICAP and CLS). Using this service, firms can achieve upstream netting (i.e., pre-booking) or downstream netting (i.e., post-booking) and achieve up to 90% trade compression (as per Traiana). A solution such as this not only addresses the volume constraints to a large extent, but it also reduces the number of trades to be settled per counterparty, thus reducing the cost per ticket. If banks can provide buy-side customers the ability to assign settlement instructions online, they can significantly reduce settlement failures. Firms need to ensure that they use the same infrastructure to handle both their flow and prime brokerage businesses and increase processing capacity, wherever feasible, through hardware and software improvements. Managing Risk: While risk management has several manifestations, we look at the key risks from an FX perspective (i.e., counterparty risk and settlement risk). Moreover, we consider some of the systems-related measures that can be employed to address these risks. The proliferation of electronic trading of FX (efx) and the consequent change in customer profile means that firms need to manage trading/counterparty risk by ensuring that their traders get a realtime update of their clients positions and P&L. Also, given that a large portion of the clients to which sell-side firms cater are highly leveraged and the fact that some of the prime brokerage clients include high-risk electronic trading firms and retail aggregators firms need to put in systems cognizant 20/20 insights 5
that will enable them to perform real-time, pre-trade credit/margin checks to manage counterparty risk. How real-time this real-time margining can be is a function of the trading volumes that a firm processes, the additional latency it is willing to introduce to perform real-time checks and the processing capacity it has. While a lot depends on the capability of the margining system that the firm chooses (such as Margin Trac, Sierra and MarginMan), the least each firm can do is to ensure that the trades executed by its front office almost instantaneously hit its risk and positionkeeping and margining systems. The other major risk that needs to be addressed is settlement risk. The widespread adoption of continuous linked settlement has practically eliminated settlement risk. However, there is still a small portion of FX trades that are nonstandard and are cleared and settled bilaterally. Besides, CLS does not provide a central counterparty functionality (i.e., if a particular trade cannot be matched at the time of netting, the system simply rejects the trade; it is then up to the firm to manage the failed trades). An adequate workflow mechanism needs to be in place to resolve these failed trades with less manual intervention and in tighter timelines. This brings us to the point on internal messaging and the need to ensure that trades hit the risk systems as soon as the trades are executed. A messaging standards-based trade bus using normal latency middleware will ensure that the firm has a standardized and consistent way of updating all downstream systems. Will FX CCP be a Reality? Although the FX market has matured significantly over the past five years, and in many ways resembles the equities model, it nevertheless remains an over-the-counter market. Despite the fact that CLS now settles an estimated 75% of all FX transactions through its member and thirdparty service framework, there are still a large number of currencies and products that are not covered under CLS. There has been an ongoing debate for several years now as to whether a central counterparty model is relevant to the FX market. There have been arguments for and against, with supporters arguing that a CCP is essential, as CLS only addresses the settlement risk and not the counterparty risk. In addition, a CCP model is viewed as essential to supporting the currencies and products not covered under CLS; on the other hand, detractors argue that the CCP approach would not provide any significant benefits over the CLS model and would result in risk shifting to the CCP, which might be located in a particular Logical Architecture: Front-to-Back FX Flow Channels Front-Office Infrastructure Post-Trade Processing Infrastructure Voice Margining System Customers Banks Hedge Funds Asset Managers Corporate Retail Single Dealer Platform Mobile Gateway Direct FX Gateway Broker Network (Traiana) Multi-Dealer Platform Gateway Smart Order Routing Low Latency Messaging Middleware Internalizing Engine Algorithmic Trading Dealer Workstation Pricing Engine FX Price Aggregation Market Data Feed Handlers Give up Processing Trade Aggregation Service Trade Bus TransactionRepository Collateral Mgmt Systems Position Keeping Systems Risk Systems Settlement Systems Payment Gateway MDP/ECNs EBS, Currenex, Reuters, Hotspot FXall CLS Bank Figure 3: A logical representation of the front-to-back technology landscape for the FX business in a sell-side firm. cognizant 20/20 insights 6
country and might not be acceptable to banks in other countries. Of course, there is also the fact that a CCP model (if it evolves) would impact the near-monopoly that CLS holds today, forcing it to revise its operating and revenue model, and at the same time, it could also impact the prime broker business, which currently operates as mini CCPs. First steps toward a CCP model have already been taken, as CME has launched its FX CCP through its ClearPort clearing services, and others, such as LCH.Clearnet and Singapore Exchange, are also looking to offer CCP services around certain FX asset classes. Whatever the outcome of these debates might be, banks need to be prepared to adapt to such structural changes that will ultimately introduce better efficiencies to the marketplace. Conclusion The FX marketplace is seeing a new wave of growth following a minor setback caused by the global economic downturn. Among the Top 20 sell-side players, the Top 3 are clear leaders, while intense competition remains among the next five to seven players. As previously discussed, technology plays a key role in any FX strategy through both higher revenues (by increasing the customer base, maximizing the volume flow and offering customer-segmentspecific products and services), as well as cutting the total cost of operations (through higher automation via STP, reduced risks and better operational efficiencies). Figure 4 summarizes many of the technology enablers (in most cases vendor-provided) that firms can deploy to achieve these objectives. In summary, as sell-side firms scramble to gain market share in the lucrative yet crowded FX market, they need to continually adopt and upgrade technology to address both revenue and cost drivers. Not all the options discussed here are relevant or appropriate to every firm, and each firm needs to consider various aspects, internal and external, before choosing what is appropriate for its move-forward plan. Ultimately, the responsibility of building a more efficient and competitive FX marketplace lies with each market participant. Firms need to make rational decisions with respect to finalizing their FX IT landscape and ensuring that they get the biggest bang for their buck. Technology Enablers for FX IT Strategy Front-Office Technology Trade Processing Technology Single Dealer Platform (RIA, Saxo, TraderTools, Caplin) Low Latency Messaging (29 West, Nirvana, DDS Openslice, TIBCO) Complex Event Processing (Apama, Streambase) Online Notifications and Confirmations (Omgeo OASYS, Reuters Trade Notification) Trade Aggregation (Traiana Netlink, CLS Aggregation) Real-Time Margining (Margin Trac, Sierra) Business Activity Monitoring (Systar, TIBCO, Proxima Technologies) Figure 4 cognizant 20/20 insights 7
Footnotes 1 Foreign Exchange Survey, Euromoney, 2010. 2 www.cls-group.com References Roger Aitken, Building Momentum: Flagging New CEP Initiatives within FX, e-forex Magazine, July 2009. Francis Maguire, FX Prime Brokerage: What Does it Take to be a Provider of Choice? e-forex Magazine, October 2009. FXJSC Paper on Foreign Exchange Market, FX Joint Standing Committee, September 2009, http://www.bankofengland.co.uk/markets/forex/fxjsc/fxpaper090923.pdf Faster Than a Speeding Bullet: The New Low Latency Messaging, Tabb Group, 2007. www.euromoney.com www.icap.com www.wallstreetsystems.com www.traiana.com www.cls-group.com Acknowledgments Sudhanshu Upadhyaya, for reviewing the article and providing valuable input. About The Author Arun Iyer is a Principal with Cognizant Business Consulting, working within the Banking and Financial Services Practice. He also leads the Investment Banking and Brokerage Practice in India. Arun has over 15 years of experience in the capital markets industry as a business analyst, solution architect and consultant. His areas of expertise include order management, trading, risk management, post-trade processing and investment management. He has a bachelor s degree in computer science and a master s degree in management. Arun can be reached at arun.iyer@cognizant.com. About Cognizant Cognizant (NASDAQ: CTSH) is a leading provider of information technology, consulting, and business process outsourcing services. Cognizant s single-minded passion is to dedicate our global technology and innovation know-how, our industry expertise and worldwide resources to working together with clients to make their businesses stronger. With over 50 global delivery centers and more than 95,600 employees as of September 30, 2010, we combine a unique global delivery model infused with a distinct culture of customer satisfaction. A member of the NASDAQ-100 Index and S&P 500 Index, Cognizant is a Forbes Global 2000 company and a member of the Fortune 1000 and is ranked among the top information technology companies in BusinessWeek s Hot Growth and Top 50 Performers listings. Visit us online at www.cognizant.com for more information. World Headquarters 500 Frank W. Burr Blvd. Teaneck, NJ 07666 USA Phone: +1 201 801 0233 Fax: +1 201 801 0243 Toll Free: +1 888 937 3277 Email: inquiry@cognizant.com European Headquarters Haymarket House 28-29 Haymarket London SW1Y 4SP UK Phone: +44 (0) 20 7321 4888 Fax: +44 (0) 20 7321 4890 Email: infouk@cognizant.com India Operations Headquarters #5/535, Old Mahabalipuram Road Okkiyam Pettai, Thoraipakkam Chennai, 600 096 India Phone: +91 (0) 44 4209 6000 Fax: +91 (0) 44 4209 6060 Email: inquiryindia@cognizant.com Copyright 2010, Cognizant. All rights reserved. No part of this document may be reproduced, stored in a retrieval system, transmitted in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the express written permission from Cognizant. The information contained herein is subject to change without notice. All other trademarks mentioned herein are the property of their respective owners.