By Daniel Carpenter, CEO at Meritsoft (a Cognizant company)

Investment banks face a cost dilemma when trading foreign exchange derivatives, driven by an uptick in FX swaps turnover. According to the Bank of International Settlements (BIS) preliminary tri-annual global FX survey results last month, OTC FX swaps accounted for 51% of global turnover, up from 49% in 2019. As FX swaps business rises globally, investment banks inevitably pay more in brokerage fees. Already facing intense scrutiny to reduce costs wherever possible, this is a major financial headache for any trading desk, particularly if one also considers that these costs are significant and often not entirely transparent. According to our own survey of 450 financial institutions last year, 80% of respondents claim to be paying between $250m (£214m) and $1bn on trade expenses annually.

The BIS study also found that inter-dealer trading reached $3.5 trillion (the equivalent of 46% of global turnover in April 2022), a higher share than in previous studies. Dealing with multiple brokers, all with different rate card structures, complicates the picture. 77% of market participants in our own research cited outdated rate agreements as an issue. This is even more problematic 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 swap, there is so much to consider. There is the currency pair itself and the time-to-maturity of the asset in question. On top of this, a head of desk must consider if it is a strategy or structured trade, whether it is being executed over the phone or electronically, all before figuring out the actual rate the broker will use to bill.

As a case in point, a bank may well be running a FX swaps trading strategy with two or more different elements to it. One strategy could combine a spread designed to profit from an uptick in the value of an underlying currency pair, and a spread conversely aiming to profit when the same underlying currency pair declines. The challenge is that it is very difficult for the front office to identify which broker rate to apply. Should it be the strategy rate, or should each individual transaction be charged? It may well be that by the time the trade gets into the back office, all the broker sees is one element to match off to on the other side of the market. If this trade is not booked correctly, the bank could end up paying over the odds.

The trouble is that because the information needed to calculate brokerage on a transaction like this is typically available electronically to the desk, it is not always possible to send through all the necessary data for passing on the costs. After all, fees vary significantly depending on how a trade is executed and settled. As an example, a bank may have received a bill in April from their broker that has a plethora of swaps trades on it. How can it know which trade belongs to which client? Due to the huge disconnect between the transaction carried out and the billing, it is extremely difficult for a bank to accrue the appropriate charges against the appropriate book.

However, if FX swaps turnover continues to climb, trying to figure out which trade belongs to which client is the least of a bank’s problems. The majority of front office trading systems do not carry all the data, so brokerage costs are typically processed at the end of the month, rather than proactively on a daily basis.  Consequently, a lot of key information can systematically get misplaced. Let’s face it, it’s too late for most banks to begin attempting to solve this issue by reworking decade-old back-office systems, which come with high costs of their own.

Instead, to accurately calculate how they should be paying their brokers, more and more banks are starting to explore new avenues to capture and normalise their information 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 swap contract with a certain broker. Ultimately, if banks are going to thrive as swaps turnover continues to rise year on year, identifying pivotal issues surrounding brokerage spend is one major way to plug the gaps in their cost base and, crucially, meet the ongoing efficiency demands of the business.