Foreign exchange (FX) is the backbone of global trade: trillions of dollars are exchanged daily across global markets. FX settlement transactions are key to a functioning global financial system.

They also carry an inherent settlement risk. This can result in significant losses and high costs for market participants – and can lead to systemic consequences, too. Market participants are exposed to FX settlement risk every day: almost a third of deliverable FX turnover, or $2.2 trillion, was still at risk on any given day in April 2022 as it was not covered under Payment-versus-Payment (PvP).

Addressing this risk is essential for safeguarding the stability of the global economy. Market participants can turn to technology-driven tools, like settlement optimization services, to help reduce settlement risk and prepare to mitigate a potential problem—before it arises.

Drivers of Settlement Risk

Years ago, central banks devised a system wherein commercial banks would exchange currencies through a financial market utility (FMU), which are “multilateral systems that provide the essential infrastructure for transferring, clearing, and settling payments, securities, and other financial transactions among financial institutions or between financial institutions and within those systems.”

However, not all principal exchanges are covered on an FMU, including many currencies (e.g., Russian Ruble, Turkish Lira, Chinese Yuan), and therefore they are inherently exposed to higher settlement risk. In addition, when a country is in crisis, settlement risk is magnified by a greater likelihood of failure. Geopolitical risks, such as sanctions or political upheavals, will further exacerbate currency volatility, and increase settlement uncertainty.  

There have been seven major currency crises in the last 30 years. Most recently, we’ve seen a crisis with the Russian Ruble, where banks were overexposed to the currency and unprepared for the risk of Russia’s sudden invasion of Ukraine in 2022, which led to global sanctions and the devaluing of the Ruble.

A currency crisis is an unfortunate inevitability over a banking lifetime and can be crippling if banks are not prepared to handle the associated settlement risk.

Two Types of Viable Solutions to Mitigate Settlement Risk

• Payment vs. Payment Transactions: The most common and effective present day FMU is a Continuous Linked Settlement (CLS), an international payment system launched in September 2002 to handle FX transactions. This utility offers banks and market participants real-time gross settlement to provide protection in the over-the-counter (OTC) FX markets. The CLS operates within a specific window of time each day, during which all commercial banks can exchange currencies on a simultaneous basis. This Payment vs. Payment (PvP) process ensures that both sides of a transaction are settled simultaneously, minimizing the risk of one party defaulting before the other side settles. While CLS has provided solutions for stable currencies, it is important to note that more volatile currencies are not so easily settled through a PvP process.

• Optimization Services: If a currency isn’t covered on an FMU, or when a global crisis occurs and a currency is extremely volatile, the traditional CLS to facilitate a PvP transaction may not be a feasible risk-mitigation option. Instead, financial institutions can leverage a settlement optimization service – a technology solution that works to reduce every party’s settlement exposure in advance and avoid needing to settle any unnecessary PvP transactions. This method optimizes currency exposure by moving positions across participating banks and optimizing each pair simultaneously. In addition, the service enables financial institutions to reduce gross notional and line items to simplify their books, so they can more easily handle a sudden currency shock or crisis. In the same way one purchases a home insurance policy ahead of something happening to their home (e.g., a tree falling on it), a settlement optimization service looks to reduce exposure ahead of time, providing a unique and vital service by addressing potential settlement risks before they escalate. This creates an added layer of protection for the global banking system.

There are two types of optimization services – Bilateral Day of Settlement Netting and Multilateral Future Settlement Optimization.

Bilateral Day of Settlement Netting: A bilateral mechanism that allows for the offsetting of payment obligations between a pair of participants across multiple currencies the day the trades are due for settlement. The benefit of this service is operational risk reduction and operational efficiency.

Multilateral Future Settlement Optimization: Facilitated as a run with multiple participants looking to optimize for future settlement, this mechanism moves positions across network participants. The benefit of this service is future risk reduction while also allowing participants to reduce gross notional and line items to simplify books.

A case of leveraging Settlement Optimization to reduce volatile currency exposure just occurred via the Russian invasion of Ukraine. At the start of the crisis, many banks had large exposures to the Ruble, which became extremely volatile given sanctions, deflation of the currency, and growing uncertainty regarding what impact the war would have on the Russian economy. These banks had an immediate need to reduce their Ruble exposures. They only had a few means to do this: stop trading, roll off trades, and/or actively optimize their portfolios.

Using data from seven large global banks at the start of the Russian invasion of Ukraine through the end of the year proves the effectiveness of those means. Between March 2022 and December 2022, the aggregated exposure of those seven banks was nearly halved: from $35 billion to $18 billion.

We Must Be Prepared for Settlement Risk

In a world where trillions of dollars are exchanged daily across global markets, settlement transactions are the lifeblood of banking and as such carry monumental risks. If not accounted for, a single point of failure can trigger a cascading effect, disrupting the entire financial system. Market participants now have the tools to mitigate these risks and ensure the stability of the global economy.

Kate Weston is Head of Execution, Portfolio Optimization for Capitolis, the financial technology company creating safer and more vibrant capital markets.

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Last year saw the impact of the Standardized Approach for Counterparty Credit Risk (SA-CCR) reach new heights

In January 2022, US and UK banks joined their Australian and Canadian counterparts, who have been operating under the regulatory regime longer. This resulted in an accelerated appetite to effectively optimize under this methodology. By addressing their exposures, banks reduced record amounts [1] of SA-CCR RWA on an interbank level. Further, it became evident SA-CCR RWA may at times be dominated by those originating from buy-side client exposures, leading to new conversations and explorations on how to optimize for an enhanced liquidity partnership [2].  

At the same time, Uncleared Margin Rule (UMR) phase 6 took effect in September 2022, reducing the AANA thresholds from $50bn to $8bn, adding a large new universe of funds required to post and receive margin. This further increased the number of buy-side funds in-scope that needed to address processes for margining of uncleared derivatives. The increase was anticipated to be between 700 to 1,200 additional firms globally, a significantly larger number than the estimated 300 firms which were in-scope for Phase 5, according to the DTCC [3].  

Additionally, the effect of higher interest rate levels with elevated FX volatility, increased uncertainties across Emerging Markets (EM) currencies and less stable economies, heightened the need to manage risks including settlement risk. The latest BIS quarterly review [4] quantifies that in April 2022 $2.2 trillion of daily FX turnover was subject to settlement risk compared to an estimated $1.9 trillion in April 2019, an increase in line with general turnover change. Further, the same review highlights that nearly a third of deliverable FX turnover is subject to settlement risk according to the 2022 BIS Triennial Survey. Current market conditions aside, the need to address risk management and post-trade processing is always critical from a best practice standpoint and included in the FX Global Code [5]. 

On the back of regulatory reforms is the increased need for data and automation. For example, we have seen buy-side execution desks adopting automated execution and transaction costs analysis (TCA) alongside MiFID II (Markets in Financial Instruments Directive). The financial industry trend of seeking increased transparency, analytics, and insights has entered the post trade capital and funding space. Buy-side execution desks, operations, and portfolio managers are being bridged closer and closer together as the benefits of efficient post-trade capital optimization can be added to the bottom line of aggregated risks and costs across portfolios. By accessing on demand metrics, such as EM settlement risk and RWA drag on counterparties, portfolio managers receive increased insights to mitigate risk.

Now, some managers are starting to explore the indirect effects of SA-CCR and how to jointly enhance the liquidity partnerships with their banks under the regime. Also, banks, not yet under SA-CCR, may benefit from joining this trend now to be ready when the time comes. This is positively affecting the cost of business across participants, with an opportunity to additionally address multiple utilities and constraints. For example, an asset manager having UCITS funds can benefit from gross notional reductions to reduce leverage while also addressing their counterparty’s need.

Expect an emergence of more asset managers seeing the direct benefits for their FX businesses and client services by adopting capital optimization solutions just as banks, and hedge funds, have done for years. The utilities are multi-fold and can include metrics such as reduction of gross notional, line items, counterparty concentration, limits, settlement risk, margin, and much more. Many portfolio managers have several constraints including non-comingling of funds, where block trades are allocated back to each individual fund or sub account. Hence, utilizing technology and automation is crucial to seamlessly optimize for a large number of funds, which could be in the order of hundreds or thousands. By leveraging technologies and services, users can simplify workflows, scale, and gain a competitive edge.  

When reaching their bank counterparties on a single go-to platform, buy-side users receive not only consistent processes, but also simultaneous access to the full network of counterparties with bilateral and multilateral opportunity sets. Joining the client-to-dealer network has a scope far greater than one single utility or regulation. It allows liquidity partnerships to be manifested and glued together with technology for enhanced transparency and flexibility to quickly adapt to new emerging risks, regulations, and events of the future.   

[1] https://www.marketsmedia.com/capitolis-completes-record-sa-ccr-optimization/ 

[2] https://capitolis.com/buysidetalkingtobanksaboutcapitalcosts/ 

[3] Ready or Not: What In-Scope Firms Should Be Doing to Prepare for Phase 6 of the Uncleared Margin Rules

[4] https://www.bis.org/publ/qtrpdf/r_qt2212.pdf, page 75-77, “FX settlement risk: an unsettled issue” 

[5] https://www.globalfxc.org/fx_global_code.htm

Dr. Petra Wikstrom holds a PhD in Turbulence, Fluid Dynamics, from the Department of Mechanics at the Royal Institute of Technology (KTH) in Stockholm, Sweden, one of Europe’s leading technical and engineering universities.

Petra is currently a Business Development Executive with Capitolis. She is the former Global Head of Execution & Alpha Solutions within FXLM & Commodity Derivatives Sales and Trading at BNP Paribas in New York, NY. Previously she was the Head of QSI North America within FXEM Sales and Structuring at Morgan Stanley in New York, and the former Global Head Quant Solutions at RBS (now NatWest) in Greenwich, CT and London, England.

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The buy side is facing a paradigm-shifting year in 2022 as both the Uncleared Margin Rules (UMR) and SA-CCR (Standard Approach for Counterparty Credit Risk) increasingly impact financial institutions globally. As we highlighted in Why the Buyside Should be Talking to Banks About Capital Costs, there are solutions at hand for investors and managers to mitigate both direct and indirect effects on capital costs. What’s more, the crucial factor in achieving sizeable cost savings is easily accessible data, coupled with systems integration.

The Scope:

To grasp the magnitude of the new regulatory changes, in the UK and US alone, which make up some 60% of global FX turnover[1], non-bank financial institutions traded $570 billion per day in outright forwards, including Non-Deliverable Forwards and FX swaps. These products -in addition to options and other products across asset classes- are all subject to SA-CCR.

On top of this, the new standardized approach is different to previous capital regimes because exposures can be netted by currency pair, and do not need to be of the same tenor. The good news is that banks can now net a one-week trade against a five-year trade. On the flipside, asset managers’ rolls of positions, especially at month-end, can be large and directional. If a manager is rolling a $2 billion position for one month, this FX swap, if margined, will now attract the same regulatory costs as a six-month swap.

Beyond SA-CCR, UMR is now entering phase 6 in September 2022, and for funds entering the in-scope status, much of the reporting and systems integration is ongoing, further adding to regulatory complexity.

Banks globally have been actively utilizing capital optimization for cost savings, especially since the financial crisis. While take up on the buy-side has been more niched, it is now increasing across managers with a broader range of recognized benefits. One core driver is that capital costs are becoming more transparent and measurable with increased access to data, automation, and technology. This path is similar to what we saw with increased adoption of automated execution on the back of regulatory reforms for Best Execution.

Easy Data access:

Like all change, the implementation of new regulations bring uncertainty that needs to be worked through. Doing this in a manual setting is both time-consuming and suboptimal in terms of results. Tools, networks and leveraged learning can help facilitate and ease the transition. When a manager can easily access and view all their exposures in one place and submit their funds’ data for analysis and processing in an automated manner – the cost savings are maximized.

The need for seamless data connectivity has been an ongoing theme across the financial industry with companies leveraging external technologies to solve for internal needs. This is achieved by connecting pre-/post-trade systems through API and Cloud services with technology engines. At present, banks are actively optimizing to achieve significant SA-CCR savings in a multilateral interbank setting. This has accelerated efforts to streamline data systems and integrate effectively with technology service providers.

Correspondingly, there is a need for investors’ and managers’ data to be easily accessible in a dealer-to-client automated workflow. Managers need the ability to look at their entire portfolio of trades across funds, and counterparties, with their respective constraints identified (for example, the non-commingling of trades across investment strategies). The more comprehensive the data, the more opportunities for optimization and cost savings exist. Secure, direct connectivity between managers’ data and third-party optimization engines, adds another level of efficiency to the process as it allows managers to integrate seamlessly with technology providers from their own systems.

Bringing it all together:

Given the importance of data and connectivity, Capitolis is facilitating the integration with a range of systems, and recently entered a partnership with TradeNeXus[2] which provides direct data access and compression optimization and analytics to its users. This results in seamless access to identify optimization, to eliminate large and unnecessary positions and to free up capital. Similarly, Capitolis recently entered a partnership with Acadia[3] to process and generate a series of FX transactions that reduce capital requirements for banks and other financial institutions.

The direct benefits of capital optimization are broad and can include reductions in gross notional, line items, and counterparty concentration risk. It also provides margin efficiencies, frees up limits and addresses overall operational risks. Further benefits are achieved when the investor or manager takes part in an optimization framework that is also reducing the SA-CCR induced capital costs their counterparties carry from their mutual exposures.

To excel with capital optimization, managers need a consistent solution that works across participants, in a centralized network. Since managers’ numerous counterparties will be on the same schedule, there are also network effect benefits from broad participation. Client to dealer optimization has become a multilateral process in the age of SA-CCR.

[1] Semi Annual FX Turnover Report, April 2021, UK FX Joint Standing Committee (JSC) and New York Foreign Exchange Committee (FXC)

[2] Capitolis to Integrate with State Street TradeNeXus Platform

[3] Acadia and Capitolis Launch SA-CCR Optimization Service

Dr. Petra Wikstrom holds a PhD in Turbulence, Fluid Dynamics, from the Department of Mechanics at the Royal Institute of Technology (KTH) in Stockholm, Sweden, one of Europe’s leading technical and engineering universities.

Petra is currently a Business Development Executive with Capitolis. She is the former Global Head of Execution & Alpha Solutions within FXLM & Commodity Derivatives Sales and Trading at BNP Paribas in New York, NY. Previously she was the Head of QSI North America within FXEM Sales and Structuring at Morgan Stanley in New York, and the former Global Head Quant Solutions at RBS (now NatWest) in Greenwich CT, and London, England.

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Capitolis CEO and Founder Gil Mandelzis and President Justin Klug discuss the fintech firm’s past, present, future and its core mission to optimize capital markets, with GlobalTrading Host Terry Flanagan.

CLICK HERE to listen to podcast.

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The coming 12 months will see an upheaval in financial markets as the impact of two important pieces of regulation is felt by more buy side firms.

The Uncleared Margin Rules (UMR) and the Standard Approach for Counterparty Credit Risk (SA-CCR) will have a direct and indirect impact, respectively, on the largest asset managers. Although some managers may still be out of scope of UMR, the trickle-down effect of these regulations on their bank suppliers means they too should be preparing now.

Put simply, capital and margin are getting more expensive for banks. Consequently, the cost of servicing clients in the age of SA-CCR and UMR will increase, sometimes dramatically, if no additional measures are taken. Reducing these effects requires a joint buy- and sell-side effort to maintain an optimal, or even in some cases sustainable, service model for the benefit of all participants. Capital optimization opportunities will be at the heart of solving for this.

There is much to establish on the final impact of SA-CCR, but a significant impact is likely to be in directional, uncollateralized portfolios. For managers who fit this profile one may need to expand the network beyond the bilateral dealer to client and work across the panel of the manager’s counterparties. Finding solutions to address SA-CCR impact clearly has mutual benefits such as maximizing market accessibility and liquidity for the buy-side and opportunities for the sell-side.

An example of how asset managers are likely to be affected can be found in the knock-on effect of the G-SIB (Globally Systemically Important Banks) regulation in the forward FX market. A 2020[1] White Paper from the Bank for International Settlements found that at quarter-end, when banks are most focused on their G-SIB rating, – and as normal market practice, asset managers also re-evaluate and rebalance portfolios -, there is a discernible reduction in liquidity levels in FX swaps markets and spreads widen.

As the focus on capital efficiency and usage intensifies, it may well transpire that these particular liquidity phenomena don’t appear only at quarter-end, and managers could find their panel of banks less able or willing to price them as aggressively as they once had. Therefore, the starting point for many managers is having conversations with their providers to explore what they mutually could do to help the banks’ positions, and vice versa, and finding technology solutions enabling access to a broad centralized network of participants.

There are naturally multi-fold additional optimization benefits to be had for the buy-side. Such technologies with novation and compression solutions that are tailored across their needs – including the management of counterparty concentration risks, limits, and gross notional levels – further reduce capital costs and increase operational efficiencies.

This means that FX capital optimization is going to become a much more ingrained part of an asset manager’s toolkit, with in-depth analytics and well-presented data that is easy to interpret and action. This further implies a need for technology solutions dedicated to providing managers with the most up-to-date information and the ability to partake in optimization at the click of a button.

Initially, dealer-to-client SA-CCR optimization will likely be more post-trade based, with the manager retaining access to its same panel of liquidity and trades can be re-papered to the most appropriate and capital-effective counterparties. In the future, one can further envision a process where the impact of capital optimization is embedded in FX TCA (Transaction Cost Analysis) for instruments such as FX Forwards and Swaps. Ultimately, capital optimization is one component of many that can be incorporated into best execution processes to manage costs for the benefit of the end investor.

The clock is ticking on UMR and SA-CCR and although the costs on banks have not necessarily cascaded to the buy side so far, their impact is becoming more quantified. This will not be a ‘big bang’ moment since banks sit at different stages of their understanding of SA-CCR’s impact and is yet to be fully assessed. However further down the road, the overall benefits of addressing these capital costs with counterparties will become impossible to ignore.

[1] https://www.bis.org/publ/work836.pdf

Dr. Petra Wikstrom holds a PhD in Turbulence, Fluid Dynamics, from the Department of Mechanics at the Royal Institute of Technology (KTH) in Stockholm, Sweden, one of Europe’s leading technical and engineering universities.

Petra is currently a Business Development Executive with Capitolis. She is the former Global Head of Execution & Alpha Solutions within FXLM & Commodity Derivatives Sales and Trading at BNP Paribas in New York, NY. Previously she was the Head of QSI North America within FXEM Sales and Structuring at Morgan Stanley in New York, and the former Global Head Quant Solutions at RBS (now NatWest) in Greenwich CT and London, England.

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It is easy to think of best execution in simple terms, such as was best price hit.

But in reality, the subject is much more complex and involves market impact, signaling risk, and of course benchmark. Those are all front office metrics, but true best execution takes in the total cost of the trade, meaning a look across the entire lifecycle. Nowhere is the cost of trading more critical than in the use of capital, especially in the age of Uncleared Margin Rules (UMR). Learn more about how capital optimization is the next generation of best execution.

CLICK HERE to read the full article in e-Forex Magazine.

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Although SA-CCR (the Standardized Approach for Counterparty Credit Risk) will not impact every financial institution active in the FX markets, the roll out by the Basel Committee highlights the opportunity for all banks to streamline their use of capital, no matter what calculation methodology they use.

With SA-CCR’s roll out a staggered affair around the globe, market participants in some jurisdictions are fully au fait with the requirements while it is newly on the radar for others. Regardless of your level of awareness or preparedness, you should be focused on some basic questions:

• How much capital are the various parts of my business consuming?
• What can my business do to reduce consumption levels?

These questions are relevant not just under SA-CCR but across all capital requirement regulations and mechanisms. Even with SA-CCR replacing the Current Exposure Method (CEM) and the Standardized Method (SM) for banks, some larger banks will be able to continue using the Internal Models Method (IMM). Regardless of the regime or model, however, institutions of all sizes should be looking to optimize how they consume and allocate capital. Capital costs affect everyone, even when SA-CCR does not, so it’s crucial to access solutions and processes that allow for optimization.

If you are not already thinking about how you can flatten delta positions and reduce currency pair exposures, you should be. With the SA-CCR implementation clock already ticking, this lets you leverage opportunities under both SA-CCR and IMM.

To achieve optimum capital efficiency in FX markets, a level of flexibility and dynamism is required. With SA-CCR enabling currency pair netting, no matter the tenor of the exposures, the opportunity to compress and reduce capital consumption arises much more dynamically than before.

Accessing these opportunities requires having dedicated technology that can provide that up-to-the-minute view of a bank’s risk positions and counterparty exposures. Just as important, the technology needs to have a broad reach and offer multiple solutions to the same problem – capital efficiency – while meeting the needs of a range of institutions, all of which are potentially taking a different path to achieve the same end result.

To fully benefit from a range of solutions, however, the network effect has to play a key role. The more participants use the same service, analyze the same data, and access the same solutions, the more they can take advantage of opportunities – even before critical mass is achieved. Having access to the right information in a timely manner is critical to any institution seeking to reduce their capital footprint.

The right technology, data, and analytics democratizes capital optimization: it enables banks outside the very top group to streamline their Markets businesses without negatively impacting their position in the industry, or, importantly, the level of service they can provide to customers. Achieving this, though, means bringing a lot of moving parts together and embedding SA-CCR across the business:

• Individual traders need to be aware of the potential cost of each new trade and, critically, where potential capital exposures can be reduced.
• The trading manager should be looking at SA-CCR exposures in the pre-trade environment, working out where and with whom netting opportunities exist.
• The front office sales and relationship team needs to be armed with the appropriate data to approach specific counterparties.
• At a more senior level, managers need to understand how they can reduce capital consumption without negatively impacting business operation, by either eliminating or moving positions.

If nothing else, managers at all levels of the business should be able to better understand how their valuable capital resources are consumed and measure individual units against this critical metric. Increasingly, business units are being judged against a metric of capital consumption rather than just top-level performance. Particularly under SA-CCR, every dollar saved offers value.

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Capitolis has just secured $90m from investors including Index Ventures, Andreessen Horowitz, Sequoia and Spark. Index Ventures partner Jan Hammer, who led Capitolis’ Series A in 2018 and has been working with the team ever since, speaks to founder and CEO Gil Mandelzis. He asks him how the Capitolis fintech platform changes the dynamics in the market, what the regulators make of it, and why we need it in the first place.

CLICK HERE to watch the video.

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Uncleared margin rules, or UMR, will dominate the conversation of buy-side firms in the same way that transaction cost analysis (TCA) and best execution gained prominence leading into and following the advent of MiFID II in 2018.

In September 2021, the steady creep of UMR into financial markets takes another step forward. The threshold drops to $ (or EUR) 50 billion as measured by Average Aggregate Notional Amount (AANA). This is a sizeable drop from the current $ (EUR) 750 billion and 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.

UMR will increase focus on AANA, creating incentives to monitor limits and maximize efficiency to enhance performance to the greatest degree possible. In short, capital optimization will become the next generation of best execution.

The search for opportunity
TCA helps buy-side dealing and execution desks optimize and streamline their trading processes by adding, or saving, crucial performance points for investors. Technologies and systems have been explored and integrated into the buy side, achieving cost savings, and supporting regulatory compliance.

Now, that same potential exists to enhance performance and realize cost savings by efficiently using the capital resources allocated to trading. The sell side, which has been subject to regulatory changes for some time, has largely embraced this concept. As more and more buy-side firms come into scope for UMR, it is their turn to focus on better workflow processes to help optimize the use of capital.

The business case for capital optimization extends beyond regulation, however. Although these firms have improved execution processes, these can be enhanced further to provide better access to deeper liquidity and reduce the actual cost of doing business – both for the firm and their counterparties. They can do this by reducing their gross or net notional outstanding, reducing settlement risk, and easing concentration risk among counterparties using techniques such as novation and compression.

Most importantly, embracing better workflow processes around the use of capital sees the firm reduce the line items in portfolios while maintaining market risk levels. The opportunity for returns is undiminished, but the cost of achieving them is mitigated by reducing the capital costs assessed against the desk.

Optimization becomes a pre-trade imperative
The good news for investment firms is that much of the optimization framework is already in place and available for adoption. Once manual and onerous, the process is now automated, proven and easy to implement. In fact, the technology is already being used by a large swathe of the sell side who represent a large proportion of any fund’s major counterparties. Adoption by the buy side creates further significant optimization benefits.

At many firms, operational efficiency has historically been viewed as a post-trade objective, but technological innovation creates opportunity for the trading business to embrace it in the pre-trade space. Where funds previously may have asked about the robustness of a liquidity stream or the ability to straight-through process after the trade, now they can ask about capital optimization before dealing.

Capital management and concentration risk remain critical
Technology can also help with the growing issue of concentration risk given the shrinking number of counterparties available to buy-side firms. Workflow solutions enable these firms to broaden their counterparty “panel” and alleviate the pressures of concentration risk; however, this can only be done in a collaborative fashion and requires a central ‘marketplace’ for sell- and buy-side firms to connect to help each other reduce their capital footprint. Whether through compression or by shifting exposures to regional banks with strong balance sheets and spare capacity, optimizing capital will be a significant focus for the buy side in 2021.

The good news is that such a shift involves less heavy lifting for the buy side than it might first appear. The increased automation of the trading business – most recently advanced by the increased use of algorithmic strategies and Software as a Service (SaaS) – means that often solutions are about connectivity rather than hardware. Mostly, a new mindset is required – one open to the opportunities afforded by the smarter use of capital as part of an operational shift, and willing to embrace new technology solutions to automate continuous optimization.

Traditionally this has been the domain of senior management or the back and middle office, but as sell-side traders can tell their buy-side brethren, UMR means capital charges allocated to the trading business have become something for everyone to focus on. Best execution is no longer about hitting the best bid and offer; just as smart order routers driving the algo strategies have shifted the relationship landscape for traders, so too capital optimization will change how they think and operate.

Whichever way one looks at it, the buy side is going to have to get serious about capital optimization. Fortunately, new technology solutions are available to help them

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Capitolis global head of sales Ben Tobin joined a panel of experts at TradeTech FX US to focus on Uncleared Margin Rules (UMR). He discussed why institutions should look beyond pure preparedness to optimizing and reducing the amount of margin they must exchange.

The panel examined how the September 2021 Phase 5 of UMR will impact FX prime brokerage, particularly with regards to operational costs and market access. Panelists discussed who and what is in scope as AANA thresholds drop, why pre-and post-trade optimization will become more important, and how technology can help drive efficiencies across trading and operations to maximize financial resources.

CLICK HERE to watch the full discussion.

Panel Discussion: How will UMR phase 5 impact prime brokerage, cost pressures and market access and how can you leverage innovations in technology to turn this update into your competitive advantage?

Moderator: Michael Koegler, Managing Principal, Market Alpha Advisors

Speakers:
Van Luu, Global Head of Currency, Russell Investments
Victoria Cumings, MD, Americas, Global FX Division, GFMA
Ben Tobin, SVP, Global Head of Sales, Capitolis
Basu Choudhury, Senior Director, CME Group Traiana
Vinod Jain, Senior Analyst, Aite Group

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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

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Capitolis CEO and Founder Gil Mandelzis recently participated in an engaging SALT Talks digital interview with Michael Weisz, Founder and President of YieldStreet, and Anthony Scaramucci, Founder and Managing Partner of SkyBridge.

In the interview, Gil offered his views on a variety of topics including the evolving relationship between financial institutions and technology providers, regulators’ thoughtful approach to innovation and the key role that fintech will play in the future of financial services.

With the acceleration of technological adoption driven, in part, by the COVID-19 pandemic, Gil expects financial institutions to focus on opportunities for collaboration with fintech partners and increasingly work with firms like Capitolis to become much more efficient in the way they utilize their balance sheets and other financial resources.

CLICK HERE to watch the full discussion.

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The COVID-19 pandemic has drastically changed nearly every aspect of our lives. Massive bailouts have been launched to rescue households and entire industries and economic activity – grounded to a halt by lockdowns across the globe – is just beginning to recover, due to the unprecedented nature of the global health crisis.

Reflecting on how so many people are heroically navigating these challenging times reminds me of just how often we have been faced with such turbulent periods in recent history and the need to always be ready for the next potential crisis to come.

I started my career in financial services more than 20 years ago, just before the Federal Reserve Bank of New York organized a $3.6-billion bailout to prevent Long-Term Capital Management from causing massive losses throughout the financial system. I remember vividly the shock in the system, and how many people were saying it was an extremely low probability event and “no one could have predicted that”. Since then, as the founder and chief executive of several companies over more than two decades, I have encountered many black swans – or those events that are ‘impossible to foresee’ – including the dot-com bust, the September 11 terrorist attacks, the global financial crisis and now the COVID-19 pandemic. And each time, the size of the disaster, its effect and required intervention were much larger. While each of these crises were different, in each instance, we have heard the same assessment – this is an unprecedented event, and no one could have been prepared for it.

But is that really the case? Surely, corporate executives, lawmakers and economists alike might not have predicted the exact circumstances of each unfortunate event. Yet, in reviewing the list I mentioned above, it has become evident that these types of global incidents will happen again. Black swans are not nearly as rare as we would like to think. The unprecedented event is commonplace every decade. In other words, the occurrence of the unpredictable event is highly predictable.

Against that backdrop, below are recommendations of what companies, and particularly startups, can learn from this latest crisis:

• Another global crisis will occur. It will be huge and … well … unprecedented! We will not know in advance whether this will be a health, financial event or a completely different area, but we do know an incident of some kind will occur. It’s the duty of business and government leaders to ensure that they are adequately prepared from a risk management standpoint when this day comes. Scenario planning and disaster recovery simulations of the type now mandated by central banks, should take place across industries and should be revised, particularly as business environments change.
• No one is immune from the impact of this potential event. The impact of these events is increasingly far-reaching and very real for everyone, regardless of the country where you reside or the industry in which you work. In an ever-interconnected world, we must recognize the extent to which these ‘surprising events,’ will affect all of us.
• Make sure you can sustain temporary shocks. Companies should therefore take more proactive and aggressive steps to ensure that they are able to navigate these crises when they occur. There is an old saying in Silicon Valley that companies should raise money when they can, not when they need it. During periods of expansion, companies should double or triple the cash cushions they believe they need and be mindful of the impact of hiring decisions, real estate investments, leverage and potential stock buybacks in the event of a significant downturn. Going forward, banks shouldn’t be the only types of companies that are required to maintain a stress capital buffer.
• Crises have a beginning, but more importantly, they have an end. During a crisis, it can be difficult to see the end, especially when dealing with financial difficulties that are impacting an organization, employees, and clients. However, you must remember that this situation is only temporary. It takes 2-3 years for corporations to resume growth. And while business might not return to previous levels, the immediate risk will subside. If you survive the first year, you are likely to survive, period.
• If your industry can be catastrophically affected by specific black swan events, protect and diversify. The potential for a pandemic already existed before our current crisis. Indeed, from 2002-2004, the SARS outbreak infected over 8,000 people worldwide, resulting in at least 774 deaths. Meanwhile, the Swine flu pandemic in 2009-2010 resulted in as many as 575,000 deaths. Examining the warning signs from these incidents should have been enough for business and government leaders to prepare for this type of incident. Some took notice. The All England Lawn Tennis Association, which organizes the Wimbledon tennis tournament, for instance, purchased $1.9 million per year in pandemic insurance following the SARS outbreak. This prudent decision means that the organizers are set to receive a $141 million payout. The streaming video business has become a bright spot for Walt Disney even as the entertainment company grapples with the closure of theme parks and the docking of cruise ships. Meanwhile, the strength of Apple’s services and wearables business has proved crucial even as its iPhone sales have struggled. Either through insurance, diversification or other means, companies must recognize the events that could really devastate their businesses and protect against those incidents well in advance.
• In the long term, sound business models win. Sudden catastrophes can devastate great businesses, and protections and planning can prolong weak ones. But over time, we need to make sure we have the right business models. The pandemic, while a terrible health and economic crisis, has accelerated trends – such as streaming movies, interacting with friends and customers through Zoom, and exercising on Peloton bikes in our homes – that already existed in the transition to an electronic world. There is no escape from these shifts, and we must embrace them.

The preparation for the next crisis starts now. Unfortunately, it’s coming. It will be unexpected to most of us, unprecedented and huge. At the same time, it will be predictable and survivable, if we make sure we are always prepared.

This article was originally published on LinkedIn on June 23, 2020. Click here to read the article in its original format on LinkedIn.

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Complex workflows in the capital markets, asset management and the wholesale and corporate payments space are often more difficult to tackle than the more “simplified” peer-to-peer lending, robo-advisory, crowdfunding, or other direct-to-consumer propositions.

Join Capitolis CEO Gil Mandelzis and Pascal Bouvier of MiddleGame Ventures along with other leading industry CEOs from DriveWealth and RTGS.global as they discuss disruption and innovation outside of the traditional banking sphere, looking at new business models for today’s corporate and investment banks.

This on-demand session from the 2020 Paris FinTech Forum examines how fintechs in this space approach a very different risk/return proposition, collaborate with a wide array of counterparties, manage resources and execute, and differentiate themselves as a true disruptor.

CLICK HERE to watch the session on-demand.

*Original panel filmed at the annual Paris FinTech Forum on January 29, 2020.

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Join Waters Technology editor, James Rundle, and Anthony Malakian, editor-at-large, for their weekly Wavelength podcast as they look at the fintech startup world with Capitolis Founder & CEO Gil Mandelzis. In this podcast, Gil examines the differences in the startup world today versus twenty years ago and looks at some of the challenges facing the foreign exchange market.

CLICK HERE to listen to the podcast.

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