What are the key FinTech elements of FX? We take a comprehensive look – FinanceFeeds Research

FinTech has become not only an integral part of the entire electronic financial services business, but is actually now leading the entire industry forward.

The electronic trading business, whether institutional or retail, has a number of key components which range from the Tier 1 banks which provide direct top level liquidity, through to the prime brokerages which aggregate the price feeds using very sophisticated systems, to the liquidity management and integration companies, trade clearing firms and then down to the platform providers.

Liquidity aggregation and prime brokerage

2016 in London is definitely the year of the prime brokerage.

The establishment nestles among the financial giants of the Square Mile, and has done for a substantial period of time – in some cases for decades, however this year, a torrent of newly established prime brokerages and firms offering liquidity has made its way to London.

Hardly surprising, of course, as London is the global centre for Tier 1 bank liquidity provision, as well as for non-bank aggregated liquidity delivered via electronic communication networks such as Thomson Reuters FXall, ICAP’s EBS, or Currenex.

Retail brokerages have never had so much choice with regard to order processing, liquidity management and trade execution methodology.

Many firms, including Danish FinTech and electronic trading company Saxo Bank, have designed a series of tools to optimize their flow to the market and then using that technology to benefit corporate clients which are brokerges. Companies that do this are able to show the brokerages that use their Prime of Prime service what their flow looks like and how the liquidity providers that they are accessing view their flow. Many firms in this sector have regular conversations and understand what metrics the sources of liqudity use to evaluate flow and have built similar reporting and analysis themselves so that they can show clients how their flow will be viewed and handled by liquidity providers.

A particular dynamic nowadays is that it is becoming harder to become a prime of prime, the banks require far higher capital bases. Just a few years ago, $5 million would have got a prime brokerage relationship with a bank, now it is between $50 million to $100 million, and in many cases despite the capital being high enough, banks will still not provide credit.

This lack of access to traditional prime brokers has led to a prime of prime explosion this year and the adoption of an ‘ecosystem’ model among integration and bridge providers such as oneZero, in order to foster greater non-bank prime of prime relationships and keep the execution cost to a minimum.

In London during the last year and a half, CMC Markets, ADS Securities, AFX Capital, ISPrime, a division of Lord Fink’s ISAM, and Stater Global Markets have all entered the institutional sector.

FinanceFeeds recently conducted an investigation into the global reluctance by large banks to accept retail FX firms as customers for commercial banking accounts in which they can store operating capital, and segregated client fund accounts.

In essence, Tier 1 banks in top quality jurisdictions including US, Canada, Britain, Australia, Israel and Cyprus – effectively all regions with a high level banking environment, good safety and compliance rulings and large institutions that carry corporate accounts for some of the world’s largest blue chip companies as well as being home to the lion’s share of the world’s retail FX industry – are continuing to curtail their service and are increasingly turning away FX brokerages as customers.

This means that not only do brokers have limited options as to where to store their operating capital and client funds, but also are now becoming the target of thefts from corporate bank accounts because FX brokers are being increasingly forced to use third degree banks in less than salubrious regions, which, according to our research, is causing great difficulties in security of funds.

Our research involved a case in which a retail FX brokerage have had several hundred thousand dollars stolen by fraudsters which is a point worthy of consideration for brokers considering placing their business with banks that are not structured according to Basel III liquidity ratio levels or under strict regulations in terms of data security and identity verification compliance procedures.

This research resonated with some of the large firms that provide liquidity to brokerages and have vast and solid capital bases, and this week in London, FinanceFeeds met with Saxo Bank senior executives who raised the importance of this point, especially with regard to how to find a solution.

FinanceFeeds suggests that there could be a method by which specialist firms could provide these services exclusively to FX brokerages, especially companies that develop their own end to end electronic trading solutions and are registered as a bank, such as Dukascopy, IG Bank, Swissquote or Saxo Bank, thus avoiding the pitfalls that many brokers are now exposed to by being pushed toward third tier banks.

RegTech is the new FinTech

As the need for advancement of technology and use of granular and big data is becoming vital in today’s regulatory environment owing to the largely electronic global markets, strategic partnerships between specialists in this sector are important indeed.

Earlier this year, Corvil, a company that provides network data analytics company for today’s modern, real-time digital industry, concentrating on MiFID II, market infrastructure, security, trading systems and big data, forged a strategic partnership with Abide Financial, which develops automated regulatory reporting systems for EMIR and MiFID II.

With regard to background, FinanceFeeds spoke in detail to David Murray, Corvil Chief Business Development Officer at Corvil, who explained “We have been established around for 15 years, and are very heavily utilized across banks, hedge funds, exchanges, major trading firms and some outside of financial markets.”

Mr. Murray then began to explain the ethos behind Corvil’s systems. “We utilize analytics technology that enables us to see all of the trade flows and it is asset class independent. We use this to instrument the entire end to end business, including trading and algo businesses to optimize how they perform in terms of quality of execution and technological performance.”

“We also enable them to maintain a forensic record and history of all that has happened, as well as detect threats and conduct cyber security, then we stream that data into BI systems including our own” he said.

“That’s the technology and it is widely deployed. We have caught on aggressively in financial markets. Information , precision, accuracy of analytics are all integrated, and the system can perform all of these functions in real time” explained Mr. Murray.

Speaking today to FinanceFeeds, Chris Bates, Chief Commercial Officer at Abide Financial explained “Regulatory reporting is effectively a tax on firms, and therefore the value is in getting it right first time, an helping firms avoid investigation, fines and getting publicized for transgressions.”

Taking a look at how technologically advanced the regulatory reporting sector is these days, Mr. Bates said “It has been mentioned more than a few times that regtech is the new fintech.”

Mr. Bates then comprehensively explained Abide Financial’s direction toward establishing its own repository, as the size of its business requires more self-determination. “We are currently handling 2.5 billion messages per year, therefore we are launching our own repository because we have got to the size where we have got to use our own repository. There is a lot of benefit with regard to owning the hub in the middle and therefore being able to independently manage the client relationship. Doing this on a field by field level can provide quality reconciliation across all clients.”

“With regard to MiFID, we were licensed in November 2011 to become an Approved Reporting Mechanism (ARM) and are now processing more than 20% of all MiFID transactions. As soon as the window opens we will be applying for ARM2 status which is the MiFID II ARM approval status. There is currently a lot of onus on ARM2 to make sure that everything that we are processing is correct before it gets to the FCA, or other regulatory jurisdiction that a firm may be licensed by. Abide also processes approximately 50% of all EMIR FX transactions.” – Chris Bates, Co-Founder, Abide Financial.

Many regulatory reporting technology companies have recently sprung up in major jurisdictions, those being Cyprus (MAP S Platis), Israel (Cappitech), London (Abide Financial) and New York (Corvil). Corvil is an established technology firm but regtech is a new theme for them.

Bitcoin: From the villains, anarchists and mavericks to the leaders of institutions.

Nobody cares one jot about Bitcoin or any virtual currencies anymore. The days of the mavericks which attempt to go up against the traditional central banking system are long gone, with exchange demises, e-wallet hacks and imprisonments littering the history of the virtual currency, however blockchain, ironically, is now the darling of the large financial institutions and management consultancies, which are pouring millions into its development.

Morgan Stanley, Barclays, Goldman Sachs and PriceWaterhouse Coopers are just some of the large firms investing millions into blockchain development, and venture capital rounds have reached record levels – 21 Inc received an unprecedented $116 million in seed funding just two years ago to develop blockchain. It is hard enough getting VC funding for established enterprises, let alone startups, therefore this is remarkable.

One area of massive interest is automated ledger. This is where Blockchain and Bitcoin meet institutional trade clearing and reporting.

The European Central Bank (ECB) recently published a working paper to analyze distributed ledger technologies in securities post-trading. Studying its various specifications, unrestricted and restricted DLTs, validation methods, blockchain as database, consensus ledgers, and smart contracts, the official document then examines whether the adoption of DLTs is an evolution or revolution to the current post-trade landscape.

The Current Post-Trade Landscape

Establishing many different technological hypothetical scenarios, the paper acknowledged that post-trade processes in securities are likely to disrupt. Currently, the buyer and seller instruct their respective brokers about their trading orders, which are then routed to a trading venue when they can “cross” in the order book or an alternative system.

A clearing house then reconciles orders, possibly netting them with other pending instructions, and sometimes acts as the central counterparty (CCP) when it ‘nets by novation’. The clearing house informs brokers of their obligations and brokers instruct their settlement agents.

“The settlement agent of the seller’s broker receives the securities from the seller’s custodian into its account, and credits them to the clearing house – which, for simplicity, we assume to have accounts in both the investors’ central securities depositories (CSDs). The clearing house then issues an instruction or the securities to be credited to the account of the buyer’s settlement agent, who credits them to the buyer’s custodian.”

“It may be necessary to carry out a reconciliation between the investors’ CSDs and the issuer’s CSD, e.g. to allow the execution of the notary function and of asset servicing”, the paper concludes, informing that by using internalized settlement or via consolidation among intermediaries, the process may be simplified, but consolidation may lead to anticompetitive behavior, potentially creating natural or regulatory monopolies.

The future of post-trading with distributed ledger technologies (DLTs)

Taking in account that the impact of DLTs in the post-trading processes depends on the level of post-trade value chain, the type of governance they are subject to, and the willingness and legality to implement the innovation, the ECB paper analyzes the potential impact of DLTs on three different layers: settlement, custody, and clearing.

Then, the authors evaluated three scenarios to access the outcome in the financial services industry:

The incumbent institutions embrace the new technology to improve cluster/internal efficiency, leaving business practice “as it is”, i.e. current business practice continues

Savings in reconciliation costs are estimated at $1.2 billion for 2016, with the only breakthrough being near real-time updating of any change in ownership of the security due to direct access to the same ledger by intermediaries.

Core players, such as CSDs, adopt market-wide distributed ledgers. In this “adoption model” scenario, at least some peripheral players might become redundant.

A market-wide distributed ledger would mean automatic updates of securities accounts and some layers of the industry could become redundant, potentially ousting clearing houses, custodians, central securities depositaries (CSD) and the central counterparty (CCP).

More transparency in securities executed over the counter (OTC) would be a major achievement as well, with regulators having access to the ledger.

Issuing companies, governments or fintech companies take the lead in implementing peer -to-peer systems for securities transactions, thus taking the post-trade industry into a “new world”.

If capital markets were to migrate to a peer-to-peer model, the whole chain of intermediaries would become redundant. Companies and governments would have direct access to the market and issue their own securities on the distributed ledger.

The ECB working paper argues since current validation technologies do not protect privacy, sophisticated investors could find unfair advantage against their unsophisticated counterparts by checking information such as liquidity needs. However, technical solutions using zero-knowledge proof algorithms are under development.

“Distributed ledger technologies are of relevance beyond the Bitcoin and its unrestricted blockchain model. Consensus ledgers, restricted technologies and smart contracts all represent more viable and attractive options for financial institutions, as they draw on existing business models used in the post-trade industry for securities transactions and have the potential to create safer, more reliable and efficient post-trade processes”, says the paper authored by Andrea Pinna and Wiebe Ruttenberg, that concluded that there is potential in distributed ledger technology and welcome innovations that bring safety and efficiency.

“A number of factors could, however, pose potential barriers to the widespread uptake and use of DLTs. First, the technology is not yet mature; second, the clarification of critical legal, operational and governance issues will take time; and third, even were DLTs to be adopted widely, certain post-trade functions will continue to be performed by institutions.”

“It is not yet, therefore, clear whether DLTs will cause a major revolution in mainstream financial markets or whether their use will remain limited to particular niches. It is possible that a DLT may find its way into the mainstream market, but should this happen, it is more likely to cause a gradual change in processes, rather than a revolution in the market”, concludes the paper.