“The one unchangeable certainty is that nothing is certain or unchangeable.” Those words were uttered by former US president John F Kennedy in a State of the Union address before Congress in 1962. Nothing could be truer of today’s financial markets, where market participants across the spectrum are faced with new challenges and opportunities to reform and reshape how their business is run in order to prepare now and for the future.
There are numerous roadblocks to navigate. From a regulatory perspective, that is primarily in the shape of the European Union’s revised Markets in Financial Instruments Directive II (Mifid II), which aims to take transparency of trading decisions, fairer pricing and governance to a whole new level by January 2018. Margin rules for non-cleared foreign exchange derivatives could also potentially impact how firms trade certain FX products.
Technological changes are also revolutionising the way FX execution is conducted in the market. Where clients source their liquidity and how they trade with different counterparties is changing in ways that could ultimately help clients better comply with those regulatory changes under Mifid II, particularly around transparency and best execution for institutional firms and end-investors.
Through the Dealing Room of Tomorrow programme and strategic investments, HSBC has prepared itself to meet these challenges head on, and is ready to help clients meet the challenges they face.
“The risks that present themselves in the FX market are not new, but the environment for all institutional investors is one of low yields, low volatility, cost pressures, increased transparency and regulatory compliance. All of these factors have implications on how a company does its FX business. Change needs to have been made now and continually in order to stay ahead of the game,” says Marc Tuehl, global head of FX overlay at HSBC in London.
Staying ahead of the game – Transparency and best execution
Hedging currency positions has been a mainstay of financial markets for many years, but it has often been difficult for clients to explain the costs of those transactions to investors. Measuring this cost is a central pillar of Mifid II and important for clients to get right. New technological developments in the form of transaction cost analysis (TCA) are helping clients gain a greater understanding of the FX transactions they execute.
“Clients are looking at the actual hedging transaction as a cost, rather than just as a part of doing business. Many now want to see the breakdown of that individual cost from the carry between currency pairs, the impact from their own liquidity profile that those hedging strategies bring, to the transaction costs of entering and exiting trades positions. Bringing those costs down, particularly as profits are squeezed, has become a key consideration for many clients,” says Tuehl.
To help with this client effort, HSBC has partnered with an independent start-up company called BestX, founded on the principle of bringing TCA to the FX market. For clients trading with HSBC and using algorithms, this allows them to see time stamps, comparable price sources at the time of dealing and allows clients to fulfil their governance needs internally.
There is also a substantial trend among clients to consider outsourcing currency risk management, where the complete front-to-end workflow and process chain is managed by service providers to gain access to a robust, traceable and transparent currency programme. Many HSBC clients are outsourcing these types of rebalancing and roll-over activities from maturing hedges but still need stable, transparent pricing.
“Given this trend, the major factor in Mifid II affecting clients is best execution, so in an over-the-counter market like FX, we need to consider all available options to satisfy the clients’ needs and to protect their interest by navigating the potential conflicts of interest, helping them achieve the highest transparency in their trades,” says Tuehl.
Best execution and increased transparency is having a big impact on the custody FX business too. Historically, clients refinanced certain FX transactions only once their securities settled, which comes with multiple days of price uncertainty of the overall trade. To help reduce this time lag and the market risk overall, HSBC has launched Accelerated FX, which helps clients trade this risk much faster by executing the risk at the same time as the securities trade, reducing price uncertainty in the process.
Intuitive technology to bring value to risk management
Much of this change might be happening right now and in the future, but providing these solutions would not be possible without sustained investment in technology. Over the past three years, HSBC has invested strongly in technology, systems and risk architecture to help facilitate those services to clients.
This includes client dialogue to help identify the kinds of solutions clients need, but also investment in the technology that brings those solutions to life. A key attribute of HSBC is that it focuses on tailored, individual solutions that often use technology to enable clients to save time, money and reduce operational risk.
As an example, HSBC started pursuing this approach in FX options as far back as 2010, placing it as a priority and reflecting the need to operate a trading desk fit for changing times.
“We are focused on increasing automation and reducing human intervention,” says Giles Jewitt, head of FX options automated trading and e-risk at HSBC in London. “We want our traders to add value by focusing on tasks that cannot be successfully automated, such as understanding our clients’ needs in detail, creating interesting, bespoke solutions and trade ideas for them.”
To achieve this goal, HSBC has made collaboration a key theme internally to best combine its traditional business with new technology, particularly around how voice traders and electronic trading systems interact. The ability for traders to focus on clients’ most complex and pressing issues is strengthened by increased automation.
“In FX options, traditionally, traders manually update their volatility surfaces and bid-offer spreads, and that default pricing would have gone directly out to clients. With all the electronic market data now available, we have automated much of that process, particularly in the most liquid currency pairs, creating a more transparent, data-driven practice,” says Jewitt.
HSBC separated its electronic trading book from the voice trading book and, as a result, was able to make rapid progress developing its automated trading capabilities. Auto-quoted prices in Group of 10 (G10) currency pairs are set such that the chances of offsetting the existing inventory are increased – hence reducing risk and enabling more efficient spread capture.
“Through continual focus on the speed of each step within the price-making process, and careful use of simplifying assumptions, HSBC is able to quote prices algorithmically as quickly as the standard default neutral prices quoted by other banks. Our algorithms maximise internalisation and improve the service we give to clients, with well over half of all price requests now being quoted automatically,” says Jewitt. “They also enable us to successfully service the increasing numbers of price requests coming over electronic channels, including our own single-dealer platform, HSBC Evolve.”
Despite spending years developing the technology to trade more efficiently with clients, HSBC has not stopped there. Through close collaboration between the trading desk and technology, the bank has progressed from handling single-shot ‘request-for-quote’ price requests to streaming liquidity over multiple channels where prices update on a continuous basis as trades occur or markets move.
It is also possible to harness new technology in other complex areas of the FX workflow. HSBC is working with its clients to set up a robust risk management system to help them with dynamic currency hedging, which can potentially allow flexibility towards market developments. Clients entering into these trades follow a predetermined, quantitative hedging strategy to achieve an asymmetric risk profile while not needing to have a specific directional view on the market.
“The system is in-house proprietary technology built for HSBC clients and tailored to their specific needs that offers non-discretionary, quantitative, HSBC-developed strategies to enhance the risk-and-return profile of their currency hedging activities,” says Tuehl.
Prepare now to meet new rules in the future
Despite the developments made at HSBC to prepare itself and better serve its clients for the future, the landscape is continually evolving and all market participants need to be ready and prepared.
One key area that is set to take effect in the FX market from 2018 is the onset of margin rules for FX forwards in Europe. This could begin to impact large asset managers and institutional clients, and could result in extended margining requirements for dealing in FX. There could also be operational implications of setting up cash and asset management and how to source the liquidity needed to meet margin calls.
This is likely to be particularly impactful on funds that operate in share-class hedging, whereby margin requirements could mean excess liquidity going into the fund, which could be additionally invested and result in a performance drag. Conversely, clients could have negative liquidity flows as there is a need to meet margin calls, for example when hedging GBP/USD.
“All of this ties in with a lot of challenges hitting the fund industry – how to source cash, and how to allocate the performance effect of these transactions within the fund accounting so they don’t disadvantage anyone else. We are discussing with clients how they can mitigate these effects and they are considering their options. It’s definitely a big question mark out there, and it shows things are still continuously evolving and clients need to have the right answer by the time they need to implement their strategy,” says Tuehl.
Marc Tuehl, Global Head of FX Overlay
Marc Tuehl began his career in 1996 with Deutsche Bank Dusseldorf in a sales role covering foreign exchange and rates products. He moved to HSBC Trinkaus & Burkhardt, Dusseldorf, in 2000 to work in FX sales with a focus on structured products. Two years later, Marc became head of the German Desk at LCF Rothschild in Geneva. In this position he was responsible for the advisory of German and pan-European clients within structured rates, FX and quantitative asset management. Marc became head of currency overlay management at HSBC Trinkaus in 2004 before moving to London in 2013 as global head of FX overlay. In this position he is responsible for the global FX overlay platform of HSBC, providing passive and dynamic hedging solutions.
Giles Jewitt, Head of FX Options Automated Trading and e-Risk
Giles has worked at HSBC for his entire career, beginning in 2004 on the FX options trading desk in London – first as a quant, then as a G10 exotics trader. In 2007 he moved to Hong Kong and ran G10 FX options trading across the entire product suite,from vanillas to complex scripted risk. Giles formed the FX options e-Risk team in 2010 and moved back to London shortly thereafter. Since 2015 he has also been leading the project to build a new in-house primary trading system covering both FX cash and FX options.