FX Trading Efficiency In The UMR Era
Thought Leadership 03/01/2021
The success of an investment or trading decision is dictated by the market outcome, especially for those tasked with producing returns. Increasingly, however, trading firms must better understand the cost implications of the trade they are about to make – particularly if they are trying to outperform a peer group with a similar investment strategy.
This will be critical since, in September 2021, the threshold of Uncleared Margin Rules (UMR) drops to embrace firms with over $ (or EUR) 50 billion in exposures as measured by Average Aggregate Notional Amount (AANA). This is a significant change that puts many more buy-side firms in scope. Further reductions planned for September 2022 will affect smaller buy-side firms with AANA of $ (EUR) 8 billion.
As a result, in the next 18 months, a large proportion of buy-side firms will join the small group that has already started in-depth analysis of their trading portfolios with the aim of optimizing them to either stay below or minimize the impact of, the UMR threshold.
Evaluating market options
For some, clearing and the use of futures instead of OTC FX markets offers the potential for capital optimization and a solution to UMR. However, while these options reduce settlement and counterparty credit risk, they are not without their own challenges:
- Not all FX market participants want to clear, especially if their business model involves physical delivery of funds.
- The cost of clearing is now more likely to be passed through to the customer, rather than being included by the sell side into the spreads they charge. Thus, the total cost of clearing remains a little-known, potentially significant variable for the buy side that is unlikely to diminish until scale is achieved.
For many participants, perhaps the most important drawbacks are reduced liquidity and the ability to accurately hedge exposures within the futures market. In non-roll months, average daily volume in FX futures and options is around $70 billion per day, a number dwarfed by the $6.6 trillion traded in OTC FX markets every day.1 And, since futures trade to fixed settlement dates, accurate hedging is more difficult for many buy-side firms, who are often unwilling to accept basis risk.
Driving capital efficiency
For the majority of firms who prefer to trade in OTC FX markets, one solution is gaining access to compression and novation services. These services also directly reduce settlement and counterparty credit risk by allowing buy-side firms to eliminate positions via a risk or riskless compression, resulting in a cleaner book overall and a lower exposure to UMR-driven costs.
Optimizing capital can also further enhance an institution’s liquidity profile by allowing it to move exposures between counterparty institutions, expanding their network to include regional banks with strong balance sheets and appetite for balance sheet exposure with minimal market risk. This results in a reduction of concentration risk through an optimized, risk- and cost-efficient allocation process.
The twin needs for trade and counterparty optimization highlight the benefit of a network and platform solution that can identify and support optimization across a broad set of counterparties using a seamless and automated process. This creates new business efficiencies along with specific cost benefits that can help to meet regulatory requirements such as UMR. The bottom line should be a discernible improvement in net performance for trading and execution desks.
Achieving UMR readiness with better technology
In June 2020, a survey by State Street2 found that just 19% of firms likely to be in scope of the next two phases of UMR were fully prepared for compliance. This suggests that firms may still be considering a realignment of their business to meet the challenges. The good news is that the solutions outlined above would allow these firms to adopt a new technology-driven approach to fully capitalize on the benefits of compression and novation, while continuing to operate existing business models with minimal disruption.
For buy-side trading desks, the challenge of UMR also offers an opportunity to leverage the advances in technology and data services from recent years. Solutions designed to improve execution performance can now be tuned to include capital optimization.
With smaller books but the same market risk profile, firms will immediately benefit from a portfolio perspective. However, there are also opportunities to incorporate the expected capital impact of a trade into the smart order router to drive additional efficiencies.
The next generation of trading efficiency combines the skill of the traders with innovative technology and overlays it with operational – specifically capital – optimization. Smart order routers have changed the face of some trading desks; smart capital optimization will further accelerate that change. With optimization solutions already available and data highlighting the benefits of such an approach, the impact of any change will be minimal to the buy-side trader. However, the benefits – in terms of improved bottom-line performance – could be significant.
1https://www.bis.org/statistics/rpfx19.htm
2https://www.statestreet.com/content/dam/statestreet/documents/Articles/UMR%20Infographic.pdf