The Cutting Edge of FX Hedge: Rethinking Liquidity
The buy side is challenging the need to bundle credit with liquidity for FX forwards and swaps, and banks have an opportunity to rise to the occasion.
When it comes to the execution of FX hedging programs, and specifically the systematic roll requirements of maintaining forward positions, the buy side doesn’t have a lot of options.
For the most part, the buy side is beholden to the banks for accessing forward liquidity simply because that is where they’ve got credit relationships. Forward liquidity is tied to credit, which is why the top 20 banks in the world basically control the market. A buy-side participant may have a relationship with, for example, four of those 20 banks, which means its liquidity is limited to those four banks, which get to dictate price.
Price making comes at a premium these days. Institutional investors are left paying the costs that arise surrounding their need for liquidity. These costs include the credit impact to their counterparty banks for holding the forwards as well as numerous costs related to transferring the position risk. Not only do banks need to overcome the various technology, connectivity and staffing costs, they must also manage their newly acquired positions as a principal counterparty. Protecting themselves from adverse market movements and covering costs while meeting their required return on capital hurdles inevitably translates to a drag on investor performance, in the form of bid/offer spreads, market impact or tracking error.
The real question is: Is it a sustainable situation for either side, and is there a better way to approach trading FX forwards and swaps? Here are a few factors that both sides should be considering.
Do Banks Really Need to Be the Only Providers of Forward Liquidity?
With continued pressures for transparency, performance and best execution, many investors are thinking outside of the box and looking for alternative ways to source liquidity.
As spot trades require little to no credit, it’s no surprise that we’ve seen various non-bank liquidity providers emerge to offer the buy side alternatives to the traditional bank route. With more choices available, the banks’ dominance in this space has diminished and the market has benefited from higher levels of transparency, deeper liquidity and tighter pricing.
However, when it comes to FX forwards and swaps, the credit element has deterred innovation, allowing the banks to remain in the driver’s seat.
While it’s understood that credit will always be a central requirement for forward trading and that there will always be costs associated with that, why must it be that liquidity is tied to credit?
The buy side is demanding evolution, and the banks that respond will rise to the top.
Long-Term, Sustainable Margins
While banks are losing share of wallet in the spot space to non-bank disruptors, there’s an opportunity in the forward market for banks to secure long-term, annuity-like revenue streams via credit provision. Banks are getting more and more pressure to be competitive, and markets businesses globally are facing shrinking margins while fighting for every dollar of additional volume. At the same time, the buy side is armed with better tools for TCA and has a lower tolerance to pass unnecessary costs to investors.
Moreover, the banks are competing for the lower-margin roll transactions related to passive hedging programs with the hope of increasing the likelihood for winning higher-margin intra-month rebalance and transaction settlement volumes.
To create harmony between market evolution and sustainable revenues, what if banks offered credit services and were paid accordingly for their balance sheet usage from holding forward positions? In doing so, banks can offer the buy side the ability to disentangle credit from the search for liquidity, enhancing relationships and supporting the buy side’s ability to explore alternative liquidity – including the possibility for peer-to-peer matching.
Best Execution & Flexibility
The reality is that we’re living in an increasingly regulated world where the banks have been feeling the brunt of the costs. On the flip side, there is increasing pressure surrounding best execution policies for the buy-side community as a whole, forcing innovation.
It’s time to consider flexible alternatives to forward FX and credit pricing. In the short term, this may cost banks, but surely it’s worth it if they can increase volumes on a consistent basis while reducing risk and cost – especially if it means they can shift focus to higher-margin trades and ultimately build the foundations that will foster more optimal balance sheet usage and enhanced customer relationships.
One way or another, banks need to re-evaluate their role in the forward FX space. There will always be those banks that resist change to preserve short-term gains; however, forward-thinking banks that embrace change may find themselves at the forefront of innovation and sustainable revenues. In the near future, banks will have to choose between simply doing things the way they’ve always been done or adapting to the needs of their customers.