“The beauty of FX is that it’s so pure,” says Lucio Biase, CEO of LMRKTS, a FinTech firm founded in 2011 that focuses on providing compression technology.
“You have an asset and an offsetting liability and, when done at market, they discount each other perfectly. If you enter a swap it’s not pure, because you may discount the fix different from the floating. In a positively sloped curve you have a portion of the trade where one party may be a creditor to the other.
“In FX, it’s not like I fund cheaper or have better credit in one currency versus the other. So when you enter into an FX forward, you don’t have as many of the CSA [Credit Annex Support] concerns, because your discount rate isn’t too different in your credit in one currency versus the another. So FX is very pure and clean,” adds Biase.
This is one reason why FX compression could be very effective, and anecdotally it appears to be something that a number of major banks are currently looking at. This is also borne out in the fact that the firm was selected for the New York FinTech Innovation Lab that was sponsored by nine major dealers in 2014 and in the past year was granted a place in Rise NY, which hosts the Barclays Accelerator programme, via the USB Future of Finance Accelerator Awards.
According to Biase, the reason why there is a growing enthusiasm amongst banks for FX compression services is threefold: higher funding costs, more onerous leverage requirements and a duty to shareholders to improve their bottom line earnings by reducing their inventory costs.
“If you’re a top 20 bank then leverage is a true incentive for compression. There’s no reason to be long and short the same currency to different parties and on different days, so we consolidate those positions to net off the exposures and that’s the basic driver of leverage,” says Biase.
In terms of funding costs, he points out that banks – like any other businesses – have an inventory cost. This inventory cost is determined on the one hand by risk-based, or margin, charges and on the other by leverage, which is effectively the amount of items that the banks have on their shelves.
“We’re less focused on reducing the line items, because it doesn’t really cost that much to keep a line item open, but what does cost a lot is the gross notional associated with it, and the risk-based charges,” comments Biase.
He adds that although this inventory cost has always been a concern for the banks, when profit margins were a little higher it wasn’t as much of a priority. However, now that banks have started charging desks in line with their inventory costs, it has rapidly moved up many firms’ lists of priorities.
Given that new capital requirements mean that it will cost banks more to fund their exposures, bank profit margins are likely to come under further pressure and this in turn impacts the return on equity for investors, according to Biase. If the banks can make savings elsewhere in the business, then their earnings will improve and they can keep shareholders happy, which he says is another driver towards compression technology.
“We’ve been in development with this for years and were offering this technology to banks, but FX optimisation wasn’t as much of a priority until a couple of banks tapped us on the shoulder last spring to help them with this,” says Biase.
He adds that the firm differentiates itself from other compression service providers by being operationally very light touch. It uses the same pipes already being used by the banks; it takes their inputs in a very simple file format and doesn’t require the user to download any software.
Additionally, Biase says that the firm’s position as a neutral third party vendor is an advantage, especially when asking banks to trust it with their biggest exposures. Indeed, Biase is full of praise for the banks that have recognised the value of this approach.
“We owe a lot to the banks that supported us at the start, FX exposures aren’t small and in sharing them, they demonstrated their trust in us. To have faith in a young company breaks the mould and demonstrates that these firms are actually a lot more innovative and more willing to facilitate solutions that are in their mutual best interest than many people realise,” he says.
On the subject of shared infrastructure amongst competing financial institutions, Biase adds: “Banks are realising that pure utilities or infrastructures can be built cheaper together. Rather than everyone trying to recreate the wheel individually, it’s simply more effective to just hire a firm to build the wheel with all of their inputs and then they can all use that.”
He argues that these financial institutions are not losing a competitive edge, because “there’s a difference between the data that goes into the wheel and the design of the wheel itself”.
“With regards to input, most firms want the most bespoke wheel they can get – the banks have many different views on what they prioritise, the regulatory regime they are subject to, and whether leverage or risk is the greater concern. Making all that work together is the fun part of the puzzle,” says Biase.