Increased volatility, extreme market events, the use of algos that can run out of control and ‘flash crashes’ can cause considerable losses to market participants and their underlying clients.
If not managed correctly, they can quickly join the ranks of the distressed.
When a client is under stress, it is not a given that the counterparties will have access to this information in real time and the more that clients diversify their credit providers, the more complex the situation becomes.
If the counterparty is in control of some of the assets affected, this will raise a red flag, but they don’t always have the ability to deny access in real time.
Baton Systems founder and CEO Arjun Jayaram notes that since most FX traders do not have a sufficiently large balance sheet to book their trades and therefore use the services of an FX prime broker, it is not always obvious when they are in trouble.
“However, there are a number of signs that may indicate distress,” he says. “These include large gross and net exposures and obligations; disproportionate counterparty exposures; exposures in non-CLS settled currencies – which leads to settlement risks for both broker and trader; and large positions in spots and futures in volatile markets.”
When a client’s algo starts acting erratically, some platforms have functionality to mitigate this risk. FXall, for example, offers providers last-look capabilities while its anonymous electronic communication network has a kill switch.
In either scenario, providers have the ability to ensure they are only accepting trades from acceptable counterparties.
James Sinclair, executive chairman of MarketFactory, also notes that for electronic trades, banks have kill switches using systems such as Reflector with options to permit risk-reducing trades if required.
“Complex voice trades – including exotic options – need constant monitoring and modelling,” he says. “It is noticeable that more and more banks are moving their FX prime brokerage businesses into their clearing businesses.”
One obvious explanation for this trend is that customers are using both FX prime broker and cleared products.
“Another consideration is that the skills to look at products structured by clients, to detect when these trades may be going bad and to service such customers are similar on the cleared and OTC FX sides of the business,” adds Sinclair.
However, Baton’s Jayaram says it is reasonable to assume that visibility across a number of key indicators is lower than it might be.
“Considering exposures and obligations by counterparty, currency and type of trade, the ability to monitor this in near-real time is required to identify and mitigate risks,” he says.
“While risks are building as trades are being placed by traders, it is challenging to monitor the use of balance sheet in real time, and outside of CLS currencies, settlement risk is a major issue.”
Henry Wilkes, CEO of PointFX, goes further, suggesting that the mismanagement of credit has notably contributed to mishandling clients in distress.
“How these clients are managed obviously depends on the policies and procedures of the institution involved, but it frequently results in the immediate termination of market access,” he says.
“This isn’t always the most effective way to manage the situation, because it locks the client into their loss-making position while the institution verifies and quantifies the loss. In my experience, this approach often leads to a larger loss, which can result in even more expensive litigation procedures.”
Wilkes reckons tracking and managing credit in a live environment would give the institution and the client more flexibility and protection from substantial losses and give market participants the ability to unwind their trades in an orderly fashion without increasing their risk.
“It is absolutely critical to the health of the FX market that credit-management technology catches up with electronic trading, and encouragingly we are starting to see some interesting and innovative solutions appear,” he concludes.
“The future has to be based on a live credit-management process for all market participants.”