Managing risk in FX

25 January 2011

By Xavier Bellouard,
co-founder at Quartet FS

FX is the most global market in the capital markets world and also one of the most liquid - it has an average traded value that exceeds $1.9 trillion per day and includes all of the globe’s currencies. With the growth of electronic access and trading, institutional investors are increasingly looking at how they can achieve better returns by using FX as an asset. To a certain extent, the equities market provides a good blueprint for adoption. Yet, the significant differences between the FX and equities markets mean that many of the challenges the FX market faces in replicating this success are asset specific - FX will have to find its own way – especially in regards to risk management. Xavier Bellouard, co-founder at Quartet FS, considers how the FX market will need to evolve to manage risk within this changing landscape.

Although electronic trading has been around since the 1990s, its global application and acceptance has gained added momentum in recent years. This is particularly the case when it comes to FX. According to Kiyohiko G Nishimura, deputy governor of the Bank of Japan, electronic trading now makes up about 60 to 70 per cent of the currency and equity trading in the US, compared to an estimated 50 per cent in Europe and 20 to 30 per cent in Japan. The global move towards electronic trading has helped to reduce the costs of transactions, provide greater liquidity and increase competition. The recent financial crisis has added to the attractiveness of electronic trading as it supports the diversification of liquidity sources and minimises exposure to counterparty risk.

This growing adoption of e-trading has also contributed to a significant change in the FX marketplace. Only a few years ago, the FX world was dominated by a number of big banking players who owned up to 75 per cent of the market. Now, however, FX is more fragmented with new entrants such as CMC Markets, SaxoBank and ForexCash dramatically increasing competition within the space. Whether a traditional heavyweight or a new nimble player in the FX market, all organisations need to better manage their risk.

Electronic trading in FX involves a high degree of leverage and market makers must continuously monitor their risks as well as the credit risk they take on from their clients. While equity trading happens on exchanges, where credit risk is managed by the exchange, in FX, each market maker must continuously monitor collateral requirements as well as the risk taken by their clients. Furthermore, the FX market largely operates huge volumes of constantly fluctuating data which, in today’s fast moving environment, requires lightning-quick, real-time aggregation.

The increased availability of electronic FX Application Programme Interfaces (APIs) has further stimulated adoption by allowing electronic trading to connect directly to existing systems through an electronic API. APIs not only eliminate the need for a dedicated proprietary terminal but also allow end-users to monitor positions and risk in real-time. Consequently, the FX market requires solutions that offer a 360 degree view in order to ensure a full appreciation of risk at all times.

It goes without saying that the right technology and systems are crucial to managing risk well. Any risk management system worth its salt must be able to handle the huge volumes of constantly fluctuating data associated with the FX market. This also involves managing the heavy market data refreshes that continually change the data and calculations on which the front and middle office need to make fast decisions. A key factor therefore is the ability for systems to parse, load and aggregate hundreds or thousands of trades per second, while taking into account tens of thousands of market data updates per second – and all at the same time.

Moreover, to successfully compete in this market, it is critical that platforms can provide instantaneous analytics that keep pace with the rate and position volatility to support the automated trading decisions. An OLAP engine that is unique and can generate and maintain, in true real-time, multiple position screens across all money markets and foreign exchange products with full drill-down and drill-through functionality is therefore essential.

Ease of use is another important factor and technology must be flexible enough to adapt to a rapidly changing landscape. Consequently the market requires systems that are adaptable and can run on any platform. Furthermore, they must be flexible enough to plug in third party business logic at different stages of the process to tailor applications to work in a way that supports the business.

The FX landscape is incredibly complex and requires solutions specifically tailored to this market. In order to do this successfully, it is important that better parameters for risk management are put in place that meet the specific requirements of this asset class. The technology requirements for electronic trading systems in the FX space mirror this complexity and platforms and systems that meet the unique challenges of this asset class are essential. Without the right systems in place, the FX market could face the prospect of spiralling out of control. Ensuring that market players have a 360 degree view of risk and are able to manage the constantly fluctuating data and instantaneous analytics is a sound starting point. Traders need to keep these factors in mind when considering how to make the most of electronic trading in FX and managing its inherent risk.

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