Why digitization of legal agreements is the key to unlocking the challenges of FX credit

  • 30 Apr 2021
  • By Igor Zubkov
  • Topics: Traiana

Over the past few years, credit departments in investment banks have been demanding the implementation of better risk controls to manage credit. FX prime brokers (PBs) have placed an even greater emphasis on defining exactly which instruments, currencies, and tenors can be traded by their clients. Due to the scope, volume, and frequency of the different FX instruments being traded, it has become much harder for PBs and executing brokers (EBs) to be fully confident that they are aligned in their management of client risk.

Broadly speaking, the FX PB model has not fundamentally changed in recent years, with buy-side clients utilizing multiple PBs, who in turn face off against multiple EBs. PBs execute legally binding agreements with these EBs, thereby enabling clients the freedom to trade with the counterparty of their choice. It is not uncommon to have dozens of EBs trading with one buy-side firm, with the PB in the middle. With this flexibility comes complexity, however, and PBs and EBs must ensure that they are fully aligned in their management of each client’s credit profile.

Credit line pile up

That is an awful lot of credit lines for the PB and EB to manage, particularly when all a PB wants is a single line of credit with the buy-side client to effectively manage credit risk. However, due to the way the FX market is structured, the PB must also manage the limits and trade restrictions with each EB. As for the EBs, they need to adjust to any changes of the limit scope made by the PB in real time in both the front office and credit departments. These changes could vary from PBs reducing tri-party limits to new developments in the scope of authorized products, currencies, tenors for trading, or even specific relationships being terminated. Because the process of updating credit limits is so manual, it can take hours for these updates to synchronize from the credit department to the EBs’ front-office risk systems.

Taking back control of limits

The industry established a mechanism to manage this complex web of limits using designation notice (DN) agreements established between EB, PB, and buy-side client that outlines the counterparties, limits, and specific authorizations explaining what can be traded.

Today, in 2021, we would expect all FX market participants to have adopted an electronic solution that organises and manages changes to these designation notices in real time. But the reality is that, in some cases, the process remains manual and error prone. Some FX market participants continue to sign and post these legal agreements by email and store them in filing cabinets. Digging through a mountain of paper-based legal documents to find out if clients are about to breach their limits and manually updating changes in trade authorisation scope and limits are unsuitable in today’s fast-paced markets. And in a world where trades often carry the risk of theoretically unlimited losses client credit usage can spiral far beyond pre-agreed thresholds in the blink of an eye.

Driving efficiencies

In conjunction with leading FX market participants, Traiana undertook the challenge of identifying and solving inefficiencies in the documentation process for FX prime brokerage. A smarter, centralised, designation notice storage and management solution ensures that EBs are using the same source of information as PBs and that their client credit risk profiles are fully synchronized. As a central electronic repository of designation notices, our Designation Notice Management (DNM) solution enables PBs and EBs to streamline the creation and amendment of client credit lines. Due to the ongoing digitization of contracts, it also allows PBs to terminate agreements and EBs to consume this critical information much more quickly in the case of a fund manager defaulting. As a result, EBs can always ensure their systems are up to date with the latest limit classifications that PBs impose on them.

Traiana’s Designation Notice Management service has been successful in reducing risk and increasing operational efficiencies between PBs, EBs, and their mutual clients. However, we understand that in order to provide optimal support for the industry, a centralized service has to offer more than just electronification of designation notices if it is to be adopted by all market participants and ultimately generate the golden-source credit profile for all downstream processes.

The future of Credit Risk Management

Our ongoing discussions with the industry have enabled us to create a road map for the future that expands the depth and breadth of our existing solution. We are working to support additional types of documentation, including FXPB legal agreements, Master Give Up Agreements, three-ways, four-ways, and more. We are re-engineering the components that comprise our credit-risk suite to provide a seamless, end-to-end process from creation of designation notice, through credit monitoring, kill switch, and dynamic distribution of credit in collaboration with a growing number of ECNs.

As part of the enhancement program for the core Designation Notice Management service, we are delivering a new user interface and associated user experience that will enable clients to build new documents from scratch using an intuitive template approach. We are building APIs to support the uploading and extraction of limits and client credit profiles in an automatic way. The service will also support documentation pertaining to bi-lateral FX trading relationships as well as additional asset classes. Together, these enhancements will drive a significant improvement in the management of credit risk controls on a cross-asset class basis.

Enhancements of this nature are key, in this day and age with markets in a constant state of flux. No firm wants to sift through sheets of paper or depend on manual updates to figure out if they are in control of the credit risk.

Traiana

CME Group’s Traiana operates the leading market infrastructure for post-trade processing and risk management across asset classes and provides client service and risk management technology across the financial sector. Global banks, broker/dealers, buy-side firms and trading platforms use our cross-asset class services to automate risk management and pre-trade/post-trade processing of listed and over the counter transactions. Traiana’s network is comprised of the global financial community’s leading voices – providing insight, thought leadership and connectivity.

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