FinTech in FX: An Evolutionary Process

Although fintech solutions are likely to change how FX operates throughout the trade lifecycle, expect these changes to be evolutionary rather than revolutionary, explained speakers during a recent Profit & Loss webinar. 

The word “disruption” has become synonymous with fintech in recent years, with numerous articles, whitepapers and analyst reports warning that fintech upstarts are looking to upset the applecart in financial services.

Yet speakers on a recent Profit & Loss webinar, FinTech in FX: Getting Beyond the Hype, which was sponsored by IHS Markit, preferred to talk in terms of innovation rather than disruption when discussing the impact of fintech in the FX markets.

Vikas Shah, managing director, investment banking, at Rosenblatt Securities, said that fintech is unlikely to produce any major disruptions to the FX market in the next 12-24 months, but said that there is plenty of innovation occurring all the way across the front, middle and back office.

In the front office, he specifically highlighted how new technologies are being harnessed to extract more powerful signals that can be used to generate trade ideas.

“The technologies that we’re talking about here are really about the evolution of big data into alternative data – alternative data being where you’re not only using traditional market data to formulate trading strategies and make trading decisions, but also incorporating newer sets of data. That data can be very varied, it can stem from macro data to a lot more company-specific data to things like, for example, how much oil is sitting in certain barges around the world, or what is the port of entry bill of lading data. You can mesh a number of these data sets together to create very powerful signals that can help you when trading,” said Shah.

Isaac Lieberman, CEO of Aston Capital Management, was quick to agree that new and more sophisticated ways of mining data is having an impact with regards to how firms trade FX. Giving his own firm as an example, Lieberman revealed that he is currently building a neural network to track data going back 30 years down to the millisecond in order to identify patterns that can then be linked to quantitative strategies as well as algorithms in order to start making them adaptable.

“In the first generation of financial engineering, what we’ve seen is monolithic technologies which simply allowed participants direct market access and to use algorithms to source liquidity and bring down the costs of the liquidity premium that they pay as consumers of liquidity. But now we’re starting to look at how we can make these algorithms that are adaptive to the actual market profile that it’s trading in, so that the strategy can change and adjust in real time,” he added.

Lieberman also emphasised that it’s not just spot FX trading that is being changed by fintech innovations. Forwards, swaps, NDFs and options markets are still significantly far behind the spot market in terms of technological innovation, but Lieberman maintained that there is plenty of scope for fintech solutions to reduce this gap and said that if these markets are integrated into the trading algorithms, then it could open them up to new market participants, something that he predicted would be well received by the buy side community.

Despite the potential for fintech solutions to change front office trading, Stuart Crooks, director, FX business development, EMEA, at IHS Markit, maintained that it is actually the middle and back office that is “ripe for change”, partially because of the inefficiencies that exist within the legacy infrastructure currently in place.

“If you look at back office systems, it’s not just one system this feeds into, but it can be up to a hundred of different systems,” he explained. “[FX] is a very manually intensive product when it comes to settlements, to clearing and finalising that trade. So now what we’re looking at is a consolidation of process.”

Crooks went on to comment that, when thinking about fintech innovation within the middle and back office, it’s important to recognise that while the technology available has become both cheaper and more powerful, it is still a costly experience in terms of both money and time, to change the processes and workflows inside an institution.

However, Lieberman sounded a note of caution regarding new fintech applications in mission critical infrastructure: “We can’t allow back and middle office systems to be exposed to the introduction of any new risks just for the sake of innovation or the concept of disruption.”

He argued that these systems work well in processing trillions of dollars in FX transactions per day at a decent price point, and therefore firms should be “very cautious” when making any technology changes to them.

There is also the question about how regulators would feel about systemically critical infrastructure potentially being outsourced to unregulated fintech firms. Justin Slaughter, a partner at Mercury Strategies, said that there has been some discussion around this by regulators, but added that “it’s probably not even a tertiary issue right now”.

Ultimately, he said that this infrastructure is likely to be the last part of the FX market to be impacted by fintech.

“The amount of time, effort, money and the risk involved in bringing onboard that mission critical infrastructure into a fintech space seems a higher barrier than just building your own system or doing something that’s more tailored and narrow,” explained Slaughter.

On this point, Shah agreed that he doesn’t see core infrastructures that help process trillions of dollars per day being disrupted in the near future, but insisted that there are significant innovations taking place in the middle and back office. In particular, he highlighted central clearing as one area where fintech solutions could have a major effect on the FX market.

“On a post-trade basis, a real-time clearing solution which really integrates with prime brokers where all the requirements go down – that has not been tried. But now, blockchain and distributed ledger companies are actually working with the CME and other exchanges to come up with a central clearing solution that can fundamentally alter the margin requirements for FX,” said Shah.

Another area he pointed to where fintech solutions are being developed in the back and middle office is around surveillance of trading and operations within financial institutions. Increasingly, he said that firms are looking to fintech solutions to monitor for possible cases of collusion or fraud.

Towards the end of the end of the webinar, the panellists were asked to give a view on how they expect the development of fintech solutions within financial services to change behaviour within FX.

Crooks picked out the development of platform-as-a-service, data consolidation, and the use of distributed ledger technology, as three areas where he predicts fintech will induce a change in the FX markets.

For Shah, the two big themes in this respect are transparency and security. As a result, he pointed to new innovations that will create that transparency, whether on the trading side by measuring best execution or on the post-trade side, with a clearing and settlement solution that utilises blockchain technology.

“Also, using AI and machine learning to create more insights into your operations and data that the trading firms can use to develop their strategies. That’s where we’re definitely going to see a lot more action this year,” he said.

Slaughter said that he sees a lot of demand for fintechs that can offer back and middle office support and that solutions in these areas will change market behaviour by simply improving or upgrading current analytics or analysis. He stressed once again though that this change is likely to be evolutionary.

“I don’t think there’s going to be any new explosion so that we’re all suddenly two years from now operating in a totally different market, but it is probable that a lot of the processes will change. Things will get more efficient and we’ll notice, based on how the P&L numbers change, that fintech has had an impact,” he commented.

Finally, Lieberman said that he expects fintech to influence behaviour both on the buy and sell sides, as artificial intelligence and neural networks are used to make smarter decisions about how to source liquidity and fair value models, and as forwards, options and derivatives are integrated into those execution models.

“Consumers are going to become smarter about how they price liquidity and consume it, which will ultimately lead to spread compression. And as you have spread compression and the liquidity premium becomes smaller, the institutions that can provide liquidity and still produce healthy yields, return on equity in the tightest spreads, are going to require better systems for producing this liquidity, processing it, managing it, warehousing it. So the players who are going to become more successful are going to be ones that can integrate this for better execution, and then the ones who can trade on tighter spreads and still retain healthy yields to remain competitive,” he said.

A full recording of the webinar can be accessed here.

Galen Stops

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