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10.12.18
10.12.18

Back Office Operations: What’s the Future?

As the Bretton Woods system broke down in the 1970’s and the new world of floating exchange rates fueled explosive growth to $80B in settlements per day in 1980, this uptick in the market was only the beginning. With settlements topping over $5 trillion on a daily basis today after passing the $1 trillion mark in the early 1990s, the growth has been unrelenting, save a brief downturn as a result of the introduction of the euro.

How has the middle and back office kept up? How is it doing? Where can it go from here? It is instructive to look at the world of operations in the late 1970s and how the fledgling market operated. FX trading was supported by two main technological innovations to “automate” the back office in the early days:

  • Telex Machine

  • Telephone

In 1978 there were 123,298 telex connections, many of them in FX trading rooms and “wire rooms” moving funds around the world. Parties would exchange “test keys” and wire funds in these early days. Maybe in some ways the timing was good to develop an automated FX operations infrastructure of the future – cumbersome legacy applications and the effort to pry them out and replace with modern technology did not need to be addressed in a significant way. At the same time, the Information Age was taking hold – EFT funds transfers and the inception of SWIFT, both game changers and both coming on the scene in the 1970s, and then of course, the first commercial application of the internet in 1980. These events laid the ground-work for the new mantra for the back office – STP (straight through processing).

Foreign exchange operations were ripe for serious automation and with standardization of SWIFT messages, vendor supplied FX applications and internally developed offerings were implemented around the world. Improvements in confirmation matching, payment processing, and nostro reconciliation have resulted to support the exploding volume growth. Operational efficiency and effectiveness were clearly on the rise.

With growth comes risk and increased management oversight as FX revenues were no longer a footnote for many global banks. The concept of delivery risk or Herstatt risk had increased focus as it was increasing as massive flows were resulting from FX trade volume growth. Banks poured millions into credit and market risk systems to measure and monitor risk, often at the expense of funding additional STP initiatives in the back office. Out of these risk concerns came the concept of netting to reduce the magnitude of funds flowing through the payment systems, and in turn, the delivery risk between counterparties. Bilateral netting agreements and supporting technology improvements led to reduced risks and in many cases reduced costs. Executing netting agreements one by one is time consuming and expensive so the industry came together and launched a netting utility in 2002 – CLS (continuous linked settlement) that has been successful in pushing delivery risk levels down significantly.

Faster processing cycles, lower transaction costs, higher STP rates, better risk measurement, lower levels of delivery risk have all been realized steadily since the early days of the 1970s even while absorbing double digit CAGR over the last four decades. BUT, diminishing returns have set in as efforts to reach 100% STP rates and continued efforts to lower processing costs have tapered off. A 2018 EY study shows that increasing operational efficiency remains a priority at most financial institutions.

Continuous improvement efforts are admirable, but not transformative. Transformation and the successful outcomes that can result require that the process be re-imagined. FX spot trades settle two business days from the date the trade is negotiated. Besides historical tradition – why is the delay required? - it certainly adds risk. First, traders making markets in currencies normally work within position and credit counterparty limits without regard to whether they have the currency on hand to deliver – they worry about that later. So even with the most state of the art technology, one cannot deliver what one does not have. How can this be solved? The simple answer is to make liquidity readily available – more on that in a bit. With the issue of funding resolved (or set aside for now), it’s time to look at the operational process to see where inefficiencies exist and question how they can be eliminated.

Once a trade is executed, the trade passes to the middle offices to confirm trade and payment details with the counterparties. SWIFT has designed messages to automate this process and STP rates have risen to the ninety percent range, but that 100% goal remains elusive. Looking at the reasons for match exceptions will shed some light on the underlying reasons for these mismatches. Not all counterparties use SWIFT, especially non-financial institution customers and trade confirmation becomes more manual and labor intensive. However, even those with state of the art matching engines are not at 100% rates.

In the current paradigm, reaching 100% on a consistent basis has a major barrier. As long as a trade is booked in the separate books and records for each counterparty, the potential for discrepancies presents itself. Although technology tools are available, the concept of a mutual ledger, shared by all has not become an industry standard.

What is the way forward? Two innovations have the potential to truly transform the FX business with the result of clearing and settling trades in minutes, not days. How can this be accomplished? Technology advances in digital ledgers / blockchain allow counterparties access to the same book of record using immutable ledgers supported with smart contracts, producing a single source of the truth. While this single innovation, increases effectiveness, it must be coupled with advances in efficiency to reach the goal of near immediate settlement – the answer is to solve the liquidity issue by providing access to funding as needed. Coupling an FX trading marketplace with a lending platform to provide funding for trades on demand answers this call.

9th Gear looks to meet the challenge by delivering this innovative approach with the ability to “fund then trade”, laying the groundwork to clear and settle in minutes.

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