With the scope, volume and frequency in the trade of today’s different FX instruments, a new approach is required to align FX prime brokers and executing brokers in their risk management for each client and their credit profiles. Traiana’s Igor Zubkov sees a path forward.
By Igor Zubkov, Traiana
Over the past few years, credit departments in investment banks have been demanding the implementation of better risk controls to manage credit. FX prime brokers (PBs) have placed an even greater emphasis on defining exactly which instruments, currencies, and tenors can be traded by their clients. Due to the scope, volume, and frequency of the different FX instruments being traded, it has become much harder for PBs and executing brokers (EBs) to be fully confident that they are aligned in their management of client risk.
Broadly speaking, the FX PB model has not fundamentally changed in recent years, with buy-side clients utilizing multiple PBs, who in turn face off against multiple EBs. PBs execute legally binding agreements with these EBs, thereby enabling clients the freedom to trade with the counterparty of their choice. It is not uncommon to have dozens of EBs trading with one buy-side firm, with the PB in the middle. With this flexibility comes complexity, however, and PBs and EBs have to ensure that they are fully aligned in their management of each client’s credit profile.
Credit line pile up
That is an awful lot of credit lines for the PB and EB to manage. Particularly when all a PB really wants is a single line of credit with the buy-side client in order to effectively manage credit risk. However, because of the way the FX market is structured, the PB must also manage the limits and trade restrictions with each EB. As for the EBs, they need to adjust to any changes of the limit scope made by the PB in real time in both the front office and credit departments. These changes could vary from PBs reducing tri-party limits, to new developments in the scope of authorized products, currencies, or tenors for trading, or even specific relationships being terminated. Because the process of updating credit limits is such a manual one, it can take hours for these updates to synchronize from the credit department to the EBs’ front-office risk systems.
Taking back control of limits
The industry established a mechanism to manage this complex web of limits using designation notice (DN) agreements established between EB, PB, and buy-side client that outlines the counterparties, limits, and specific authorizations explaining what can be traded.
Today, in 2021, we would expect all FX market participants to have adopted an electronic solution that organises and manages changes to these designation notices in real-time, but the reality is that, in some cases, the process still remains manual and error prone. Some FX market participants still sign and post these legal agreements by email and store them in filing cabinets. Digging through a mountain of paper-based legal documents to ascertain whether clients may be about to breach their limits and updating the changes in trade authorisation scope and limits manually is unsuitable in today’s fast-paced markets. And in a world where trades often carry the risk of theoretically unlimited losses, the threat is that client credit usage can spiral far beyond pre-agreed thresholds in the blink of an eye.
In conjunction with leading FX market participants, Traiana undertook the challenge of identifying and solving for inefficiencies in the documentation process for FX prime brokerage. A smarter, centralised, designation notice storage and management solution ensures that EBs are using the same source of information as PBs and that their client credit risk profiles are fully synchronized. As a central and electronic repository of designation notices, our Designation Notice Management (DNM) solution enables PBs and EBs to streamline the creation and amendment of client credit lines. Also, due to the ongoing digitization of contracts, it allows PBs to terminate agreements and EBs to consume this critical information much more quickly in the case of a fund manager defaulting. As a result, EBs can always ensure their systems are up to date with the latest limit classifications that PBs impose on them.
Traiana’s Designation Notice Management service has been successful in reducing risk and increasing operational efficiencies between many PBs, EBs, and their mutual clients. However, we understand that in order to provide optimal support for the industry, a centralized service has to offer more than just the electronification of designation notices if it is to be adopted by all market participants and ultimately generate the golden-source credit profile for all downstream processes.
The future of Credit Risk Management
Our ongoing discussions with the industry have enabled us to create a road map for the future that expands the depth and breadth of our existing solution. We are working to support additional types of documentation including FXPB legal agreements, Master Give Up Agreements, 3-ways, 4-ways and more. We are re-engineering the components that comprise our credit-risk suite in order to provide a seamless end-to-end process from creation of designation notice, through credit monitoring, kill switch, and dynamic distribution of credit in collaboration with a growing number of ECNs.
As part of the enhancement program for the core Designation Notice Management service, we are delivering a new user interface and associated user experience that will enable clients to build new documents from scratch using an intuitive template approach. We are building APIs to support the uploading and extraction of limits and client credit profiles in an automatic way. The service will also be capable of supporting documentation pertaining to bi-lateral FX trading relationships as well as additional asset classes. Together, these enhancements will drive a significant improvement in the management of credit risk controls on a cross asset class basis.
Enhancements of this nature are key as let’s face it, in this day and age with markets in a constant state of flux, no firm wants to be sifting through sheets of paper or depend on manual updates to try to figure out if they are in control of the credit risk.
Igor Zubkov is director, Head of Credit and Documentation Services at Traiana, part of CME Group. With more than 20 years’ experience in the financial services and technology, Igor has ownership of credit risk and documentation services strategy. Since he joined Traiana in 2021, Igor held several roles in project and product management and he also been responsible for service delivery as head of credit professional services. Prior to that Igor worked in financial services and technology roles in Israel including at IDF, Bank Leumi and Matrix BI.
Igor holds M. Sc. in Information Systems Engineering (with Honors) and B.Sc. in Industrial Management and Engineering (with Honors) from Technion Haifa and is based in New York.
About CME Group
As the world’s leading and most diverse derivatives marketplace, CME Group (www.cmegroup.com) enables clients to trade futures, options, cash and OTC markets, optimize portfolios, and analyze data – empowering market participants worldwide to efficiently manage risk and capture opportunities. CME Group exchanges offer the widest range of global benchmark products across all major asset classes based on interest rates, equity indexes, foreign exchange, energy, agricultural products and metals. The company offers futures and options on futures trading through the CME Globex® platform, fixed income trading via BrokerTec and foreign exchange trading on the EBS platform. In addition, it operates one of the world’s leading central counterparty clearing providers, CME Clearing. With a range of pre- and post-trade products and services underpinning the entire lifecycle of a trade, CME Group also offers optimization and reconciliation services through TriOptima, and trade processing services through Traiana.
The content in this communication has been compiled by Traiana for general purposes only and is not intended to provide, and should not be construed as, advice. Although every attempt has been made to ensure the accuracy of the information within this communication as of the date of publication, Traiana assumes no responsibility for any errors or omissions and will not update it. Additionally, all examples and information in this communication are used for explanation purposes only and should not be considered investment advice or the results of actual market experience. Traiana is not a regulated entity.
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