Dealers face tough test on FX costs

The trading environment for foreign exchange businesses over the past 18 months has been categorised by ever-tightening spreads. Transaction costs for buy-side firms have largely gone down across FX instruments, as banks compete intensely for flow in an increasingly commoditised sector of the market. Sometimes, banks are willing to trade at a cost to themselves if it means they make money elsewhere with the same client.

Price is first, second and third of mind for an asset manager, pension fund or corporate selecting an FX trading counterparty. The head of currency trading at a large US asset manager explains that if someone was to start charging wider spreads, the liquidity provider would naturally fall to the bottom of their pool and the manager would instead go with those that offered better prices.

This is why US banks fear the impact that the standardised approached to counterparty credit risk (SA-CCR) could have on their FX businesses. The new framework punishes uncollateralised, directional swaps and forwards trades, and will require banks to put up more capital towards them. What this could mean is that running an FX swaps business, with the added cost of capital, could become a loss-making operation if pricing continues to trend downwards. 

There is perhaps a growing realisation that banks need to actively manage their SA-CCR exposures

If it becomes too expensive to deal with certain clients, banks face the inevitable choice of either raising prices or cutting that client if they cannot cover the increased cost of capital. 

But when and by how much is unknown. Many banks do not have any concrete data on potential price increases – or at least don’t want to share them just yet – and the jury is out on whether they eat the cost and keep spreads as they are. 

Some European banks are in a wait-and-see mode on what the US banks do first, while others believe that widening spreads could become more apparent after the first quarter of 2022. There also seems to be an unequal impact geographically, and European banks that are less restricted by capital constraints – for instance by not having a capital floor in place – could come out on top. 

Any FX dealer that chooses to exit the swaps and forwards market will not be good for anyone, the head currency trader at the large US asset manager warns, adding that less competition will mean price increases anyway. 

There is perhaps a growing realisation that banks need to actively manage their SA-CCR exposures, whether that is by using optimisation vendors, clearing trades, using futures, or even restructuring portfolios with buy-side clients. These are all complex choices, yet banks may have to get these projects over the line if it means avoiding uncomfortable conversations with clients in the new year.