Noble Bank International recently launched with a new business model aimed at alleviating the current credit constraints in the FX market. Will it be a “game changer” for the industry? Galen Stops takes a look.

If every new product or service launch that claimed to be “game changing” actually was, the FX industry would be a dizzying place to work in, such is the popularity of this phrase and its variant forms.

As a result, it was hardly surprising to see Noble Bank International (Noble) hail its new real-time, post-trade FX service as “industry changing”, when its official launch was announced last month. And yet, if the Noble model manages to gain significant traction within the FX industry, it could have a significant impact on how the market operates.

One key problem that the FX industry is grappling with right now is that credit constraints are limiting the amount of counterparties that can transact with one another. It has been well-documented that since the SNB debacle, traditional FX prime brokers (FXPBs) have been re-assessing the risk/reward profile of their customers, while new regulatory requirements have continued to squeeze their margins. 

The end result of this has been that FXPBs have been reducing the number of clients to which they are willing to extend credit, forcing many firms to look for new ways to access the wholesale FX market and reducing the number of counterparties that market makers can face.

Thus far, the most popular solution to this problem has been to use prime-of-primes (PoPs). But given that the PoP model still ultimately relies on credit from traditional FXPBs, this arguably alleviates the problem of credit constriction in FX rather than solving it.

By contrast, the Noble model seeks to alter the dependence on credit from the FXPBs altogether. This is why the most obvious initial target client types for Noble are the non-bank market makers, which have access to credit but want to be able to trade with firms that are currently credit constrained, as well as firms that are struggling to access the credit that they need. In particular, there appears to be an emphasis on connecting the non-bank participants.

For a detailed rundown of exactly how the Noble model works, it’s best to read the initial report published by Profit & Loss when the service launched.

Real-time clearing and settlement 

In short, Noble acquired a US-regulated, non-fractional reserve bank, now branded as Noble Bank International (NBI), which means that the bank does not lend, does not re-hypothecate and does not earn a spread from client assets. It simply holds assets on behalf of clients in legally segregated, bankruptcy-remote accounts.

On this bank platform, Noble runs an FX service, where it provides real-time clearing, netting and settlement for FX transactions. Currently, Noble enables firms to clear bilaterally in private “pools”, but it also has plans to launch a public pool that will enable firms to access third-party trading venues.

Firms in the private pools self-post collateral but, because Noble’s netting and settlement happens on a T+0 basis, the amount of collateral that they have to post is substantially less than compared to when firms trade via traditional FXPBs, which operate on a T+2 basis.

“If you think about how the T+2 world works today, when two firms trade they build up settlement queues, and although there is some netting that happens, cost and risk are largely based on the gross notional traded and settled by the two institutions. In our model, because we are netting in real-time, the residual is really what goes to settlement. This leads to significant capital efficiencies, with no T+2 credit lines,” explains John Betts, CEO of Noble.

However, some argue that introducing T+0 settlement in a T+2 world is not without complications. For example, the head of FX at one non-bank market maker says that even if their firm uses the Noble service, the majority of its flow will still go through an FXPB. This could create cash imbalances, the FX head says, because if their firm must real-time settle a short position with Noble, but isn’t going to get funded to cover that position by its PB for another two days, this creates operational challenges.

Betts acknowledges that this is a concern that has been raised by prospective clients, but claims that in reality this disparity between T+0 and T+2 settlement is not a major issue.

“Certain traders might have concerns about how being T+0 versus T+2 might impact their cash management, but when we speak to staff in clearing or treasury at these firms, they understand that this is less of an issue. Because these staff live and breathe operational workflows, they understand that the size of this problem is small compared to netting efficiencies and counterparty risk reduction that we offer,” says Betts.

Similarly, one non-bank market maker explains that the T+0 versus T+2 issue “is not really problematic, because none of us are taking settlement”. The market maker concedes that, because these firms can’t take their cash out until a deal settles, it could prove slightly problematic, but insists that it is not a major concern for the firm.

Bad optics?

Another early concern voiced by a range of market participants ahead of Noble’s official launch was the fact that its bank, NBI, is licensed and based in Puerto Rico, where the government is struggling with more than $70 billion in outstanding debt and has since filed for bankruptcy.

The response from Noble is that NBI is completely uncorrelated, and not impacted by government financial issues in Puerto Rico. NBI client assets are in fact held in bankruptcy-remote accounts in the US. Noble has addressed these early concerns though, and has added BNY Mellon as the global custodian for the client funds it holds to further re-assure potential users of its service. 

“Once you explain to people that the cash sits with BNY Mellon, which is the custodian for our segregated accounts, they realise the issues in Puerto Rico are unrelated,” says Marc Asch, chief strategy officer at Noble.

Betts adds: “This issue comes up in meetings and we tackle it head on. We walk people through why we’re a non-fractional reserve bank, explain that the cash sits in segregated accounts, that we have no exposure to Puerto Rican debt and, in fact, we can’t even service Puerto Rican clients. We’re a state-chartered bank and fall under US federal law, which means that we’re more highly regulated than any of our clients right now.”

Although leaving funds with Noble might be the safest thing in the world, some market participants argue that just the very fact that its business model is underpinned by owning a Puerto Rican bank means that it is fundamentally problematic for them to trade via its infrastructure.

“I honestly don’t know if it makes a difference, but just from an optics perspective, the fact that your money is with a Puerto Rican bank – where the commonwealth is currently in bankruptcy proceedings – it just doesn’t give you a good feeling in case something goes wrong,” says a senior figure at another non-bank market maker. 

Similarly, the head of operations for FX at a major bank suggested that the Puerto Rican license alone might deter potential users of the Noble service, adding that it would “set off alarm bells” with their compliance department if they were to try and interact with such an entity to facilitate FX trading. 

However, Betts refutes this point, stating that it has yet to truly be an issue beyond a simple conversation with clients and their risk teams. 

“Once they understand the model, this is a moot point for clients, who now span US, Europe and Asia,” he says.

Slow and steady

These are not the only concerns mentioned by market participants regarding the Noble business model, however.

“Even if you’re putting your money with BNY rather than a Puerto Rican bank, the challenge continues to be the credit intermediation piece. If we want to face a retail broker who lost their prime because they’re difficult credit, if we were to face them on Noble, we’re still taking that credit risk. But we can just face that broker directly as well, so I’m not entirely certain what – other than some post-trade processing – that they’ve really solved,” says the non-bank head of FX.

Betts argues that this shows an incomplete understanding of the business model. He says that “one of the main reasons we decided to start Noble is that it truly doesn’t matter who your counterparty is. Every trade is confirmed because of a real-time check of available collateral posted at Noble. You are not exposed to your counterparty’s credit, because they have pre-funded the settlement risk.”

A source at another non-bank market maker comments that their biggest issue with the Noble business model is that when trading via their service, the trading firm’s Noble book of business would be stuck at Noble. This means that if they’re trading with someone at Noble but offsetting that trade elsewhere, then they would end up with positions that they can’t collapse.

They claim that this could force them to carry balances in two different books, which they say can be an issue both from a carrying cost and also from a line cost. 

“My main concern is having offsetting imbalances and no methodology by which to close these positions out, other than skewing into a price, which isn’t the most efficient way for us to do it,” they conclude.

In response to this concern, Asch comments: “We always knew this would be a feature customers wanted, especially agency desks and certain market makers. That’s why we’re now adding a solution to flatten Noble customers at their current FXPB.”

Despite these concerns, some sources have indicated to Profit & Loss that their firm intends to use the Noble service, but state that they plan to only put a small amount of flow through its system to begin with.

Betts and Asch say that, not only are they comfortable with this slow approach to firms adopting their service, but that they actively encourage that approach as part of the pitch to prospective clients.

They claim that there are many services in the financial industry that need to build a critical mass of participants before they begin adding value to clients. In contrast, they argue that it is free to sign up to the Noble platform, it only takes a week to onboard and that users of the service only need to do one trade with one counterparty to prove the value proposition that it offers.

“It’s not like we’re an exchange, where you need to bring a whole market in to have an order book with enough liquidity to trade. We’re facilitating peer-to-peer transactions, the service is low cost and low risk, and so if clients do a transaction and find that it adds value to their business, then we encourage them to keep doing more transactions,” says Betts.

The next step

In terms of the overall corporate growth strategy, the firm is being aided by Seabury Global Markets (SGM), which announced in May that it had entered into a strategic partnership with Noble and that it had participated in Noble’s Series A funding round. As part of this agreement, SGM is working with Noble as a global sales and distribution partner.

Meanwhile, Betts and Asch say that the public pool is being finalised shortly, and that once it is launched it will enable true all-to-all functionality.

The public pool relies on a back-stop fund, which takes capital from third-party investors and holds it in reserve in case the capital put up by counterparties using Noble proves insufficient due to losses. 

Betts and Asch claim that this fund provides the ability to completely remove counterparty risk from the equation, enabling a true all-to-all model. In addition, Noble is working to add novation partners, that are rated entities, to provide additional assurance.

The first question that inevitably springs to mind when considering this model is: who are the third-parties that are going to stand behind the guarantee fund?

More than one potential Noble customer says that it is important for them to know the investors that are putting capital into the guarantee fund, with one pointing out that these investors might not be any better from a counterparty perspective than the retail brokers that their firms might be trying to trade against in the public pool.

Noble has thus far declined to publicly name the investors being lined up, and Betts and Asch argue that the entity providing the funds is actually irrelevant because they have to make the investment up front, with funds held by Noble. This is not a concept of introducing credit risk with a Letter of Credit. The fund sits on cash, held at Noble Bank, ready to deploy. Therefore, the identity and credit-worthiness of the investors providing capital is irrelevant, according to Betts.

Partner friendly

Whereas the private pools are designed to allow firms to bring counterparties into their pool to trade, the public pool will enable these firms to access ECN platforms.

“If you look at the current FX ecosystem, there are a lot of ECNs whose businesses are suffering right now from the same challenge that their clients are; the lack of credit is impacting the volumes on their platforms because it limits the amount of people that can participate on them,” says Asch.

However, a source at one quantitative hedge fund familiar with the Noble business model suggests that it might only be able to offer its customers connectivity and liquidity from a limited number of ECNs, claiming that these platforms might be reluctant to sign ISDAs and have the counterparty risk with Noble, even if it is US regulated.

“There are a number services a tier one FXPB offers which is not easily replicable within the secondary markets. Being able to access high-grade liquidity from a multitude of sources, whether that be on a disclosed or anonymous basis, is a value proposition that is only accessible through institutions with long-standing relationships,” the quantitative source says.

This being said, Noble is apparently already integrated with half-a-dozen ECNs, which will enable its clients to trade on these platforms via Noble. And although Betts and Asch decline to name the ECNs or detail how large they are, they say that “at least” one of them sees more than $15 billion on average per day in FX volumes.

Noble aims to be “as partner-friendly as possible across the spectrum”, according to Asch, and to this end, the firm is willing to white label its product to other firms further down the line, including to FX prime brokers.

“Big enterprises historically used their own data centres, believing it was a competitive advantage. Now everyone uses the cloud. Likewise, if you think about post-trade credit functions, custodian functions and settlement functions, owning those used to be considered a competitive advantage, but now firms that own these are finding that the cost structures are actually limiting the business they can serve,” says Asch.

He adds: “By leveraging our utility, firms can reduce that cost structure, enabling them to actually service more clients at higher margins. We’re not trying to disrupt the FXPB desks, we are a utility, not a PB. Through Noble, banks could form their own private credit pools and provide liquidity to clients that their spot desk can’t touch today because the PB desk has off-boarded them. That’s an interesting proposition.”

Although Betts and Asch say that Noble has had conversations with a number of FXPBs about potentially enabling them to use its infrastructure, they add that if such partnerships come to fruition, then it is likely to be a longer-term project and therefore it is not the main focus for the firm right now.

Pressure building

The reason why the Noble launch is interesting is that credit constraints have become a major issue in the FX industry, with some in the market suggesting that these constraints were partially responsible for the first contraction in the global FX market in 15 years, according to the most recent Bank for International Settlements’ (BIS) triennial FX turnover survey.

It is also significant because if a new credit model that doesn’t rely on FXPBs gets widely adopted in FX, it could potentially widen the number of counterparties that can trade with each other to the point where the market structure starts to look more like equities. Of course, the “equification” of FX trading has long been predicted by some industry observers, and yet the current market structure has remained largely unchanged during this period.

So could Noble really be a “game changer” in the sense of changing how FX post-trade operates and, potentially, somewhere down the line usher in a more equities-like market structure?

Most sources seem to be hedging their bets with regards to this question.

“If they can succeed, then that’s great, but I think the thought of a real money firm who doesn’t have a PB using them seems like a stretch. Attracting some of the retail firms is probably the sweet spot for them,” was the assessment of the non-bank head of FX.

Noting that the Noble offering is still a work in progress on the public pool side, the source adds: “Credit intermediation continues to be a challenge and it’s not an easy one to fix. I haven’t necessarily seen anyone who has solved it just yet.”

Another non-bank market maker says: “There’s a need for a credit solution for folks with lower credit standing and Noble does attempt to address that. But it does have some flaws and a better solution may yet show up.”

A senior figure at one trading firm says that they still view the prime-of-prime model as the best credit alternative to traditional FXPBs available in the market, but that they are waiting “with interest” to see how the Noble public pool develops.

Certainly the pressure is building for a solution to the credit challenges facing the FX market, and while it is too early to say definitively whether Noble will be the solution that firms coalesce around, it is always encouraging to see firms coming to market with new business models aimed at solving pressing industry problems.

In the press release announcing its official launch, Noble claimed that it will “empower our clients to clear and settle without the limitations of traditional credit access” and, whether or not it is setup to achieve this, one advantage that it has is that there is no shortage of market participants willing them to succeed in this aim.

Galen Stops

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