Kerril Burke, CEO of Meritsoft , explains why investment banks are facing a “major headache” in the form of increased FX brokerage fees right now.
A storm is brewing in the world of FX derivatives. Driven by, surprise surprise, Brexit uncertainty and Trump – there’s a sizable chunk of activity in GBP/USD options relative to the other major currency pairs.
Now the geopolitical landscape is of course backed into the price of the underlying currency pair, as opposed to the activity of the options. But the challenge is that as volumes increase, investment banks have to inevitably pay more in interdealer broker (IDB) fees. And the bigger the volume, the bigger the brokerage cost. Already under intense scrutiny to reduce costs wherever possible, this is a major headache that any desk head could do without right now.
Dealing with multiple brokers, all with different rate card structures, is very difficult, to put it mildly. Particularly when a bank is trying get a true handle on how much brokerage they will be charged at the time of trading. On a typical GBP/USD option contract, for example, there is so much to consider. For starters, there is the currency pair itself and the time-to-maturity of the asset in question. On top of this, a head of desk has to consider if it is a strategy or structured trade, whether it is being executed over the phone or electronically, before figuring out the actual rate the IDB will use to bill brokerage.
The trouble is that because the data needed to calculate brokerage on a transaction like this is typically available electronically to the desk, traders have no way of passing the cost on. After all, fees vary significantly depending on how a trade is executed and settled. As a case in point, a bank may receive a bill from their broker that has a plethora of options trades on it. How can a bank in question know which trade belongs to which client? Due to the huge disconnect between the transaction carried out and the billing, it is really difficult for a bank to accrue the appropriate charges against the appropriate book.
With volumes showing no immediate sign of decline, herein lies the root of the problem facing banks. The majority of front office trading systems do not carry all the data. This means the brokerage process is left to be reactive at the end of the month, as opposed to being proactive. Consequently, a lot of important information gets mislaid. Let’s face it, it is too late for the majority of banks to start to try and solve this issue by ripping and replacing decade-old back office systems that have cost huge amounts to build.
Instead, in order to accurately calculate how much banks should be paying their brokers, more and more heads of desks are starting to explore new ways to capture and normalise their data in a centralised system. This way, it is much easier for a bank to work out when it is underpaying, and when it is overpaying for brokerage because comparisons can be done directly. On top of this, they can also figure out if they have been executing at a sub optimal rate for an FX option or other products at a certain venue.
Ultimately, if banks are going to thrive in these times of high volumes, identifying pivotal issues surrounding brokerage spend is one major way to close the gaps in their cost base and crucially, meet the ongoing efficiency demands of the business.