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Many pundits will offer their views on the reasons of FXCM’s unfortunate fate. Focus will incorrectly point to market abuse, misleading customers and despicable FX desk practices.

Not that any of this didn’t happen, but we believe it is necessary to go deeper to the root of the problem. And like often the case, the problem connects to cash (or lack thereof).

One will remember that FXCM got wounded by counterparty defaults over the Swiss National Bank shock in 2015 (and other minor ones in 2016). To keep afloat, FXCM accepted a loan they could not refuse which weighed heavily on the business ever since. That included taking undue legal and regulatory risks to try to extract every last dollar from their customer flow.

As Bobby Womack expresses in “Jackie Brown”:

Doing whatever I had to do to survive

I’m not saying what I did was alright

Trying to break out of the ghetto was a day to day fight

…/…

You don’t know what you’ll do until you’re put under pressure

Across 110th Street is a hell of a tester

This sad story is a perfect template for any firm that, for a time, looks too big to fail: largest Retail FX player with 34% of the US market! Like many other institutions, and not only in FX Retail, it was happy to “self-insure”. By self-insure I mean dealing in-house with regulatory, legal, market, counterparty and probably most of all technology risks. Bet let’s focus on the market and counterparty risks which are endemic in the FX Markets.

FX is one of the last markets where it is still common belief that “credit lines” are fine means of managing risk. The thinking is that they represent a reasonable (self) assessment of both counterparty and market risks taken with a single counterparty.
“We know exactly the risk we are taking” is often put forward when the notion is challenged. But obviously… as there is no way to assess how much risk your counterparty is exposed to outside of your bilateral relationship. In addition, the “line” is seldom adjusted (no one wants to repeat a painful assessment exercise), and the financial information it is based on is usually stale in the first place.

We need Central Clearing

While the 70’s taught us about the Herstatt risk, it was nearly 30 years later that the imperfect CLS solution was created. Today, we are still left with bilateral exposure everywhere. The ice-cap-like disappearance of Prime Brokerage services is choking the FX market. Counterparty risk is an unresolved problem that is costing liquidity shortfalls to all market participants.

No matter the size of a company, the belief that it is “better” alone to assume both market and counterparty risks is obsolete. FXCM did not reach its demise with a $7M fine: it crawled under the burden of debts and the need to earn money to survive. Had they been able to “insure” against counterparty and market risk, their stock would still be trading between $15-20…

Central Clearing is the mutualisation of risk. Society organised itself and progressed due to a combination of competition and collaboration. Granted that it is wise to leverage one’s strength to compete and win. But even a big balance sheet is not enough if a volcano erupts under your house.

In FXCM’s case, the first hit that caused them to assume some debt at exorbitant conditions could have been better absorbed by a Clearing House. The SNB event is still fresh in everybody’s mind. It qualifies as the most momentous event of the past 15 years in FX. But most market participants agree that fast markets and similar shocks are going to be more – not less – frequent.

Separation of concern

Insuring against the volcano and removing it from your “I must worry about” list is a superior strategy.

Mutualisation of these risks with the community of market participants allows you to concentrate on your value-added jobs. That does not mean the risks disappear entirely, only that someone else – a specialist company – is worrying about it for you.
During a flight, you chat with your colleague or write a report instead of worrying about landing procedures. Much cheaper than a pilot licence and the lease of the jet!
A Clearing House’s purpose is to be a utility, servicing and organising risk management for the next volcanoes, and let you focus on your value-added work.

Many retail FX operations have already realised the benefit of concentrating their force on the know-how that makes them different: marketing and sales.
For position and risk management, the wise turn to Liquidity Providers. In addition to their superior financial engineering, independent Liquidity Providers remove the regulatory and legal risk of conflict of interest (CFTC – “…was taking positions opposite to customers”).

Credit intermediation–please stop calling this credit intermediation! Credit is dead.

I believe that the incredibly damaging ban by the CFTC will accelerate a healthy trend. More Retail Brokers will want to pass through the market risk of their customers and the counterparty (bilateral) risk of their professional distributors. But since Liquidity Providers will continue to be wary of taking their risk directly, we need credit intermediation.
A Clearing House comes in handy to allow Banks and electronic LP’s to trade seamlessly with this large and still growing pocket of market.
Shareholders of large retail operations will put a premium on the firms who genuinely shed away these market and counterparty risks.

The monetary benefits of a Central Clearing solution will be felt by Retail Brokers at multiple levels. Our estimate:
– Access to more counterparties –> better prices –> higher margins –> 20-30% higher revenue
– Lower risk of distributor default –> more relationships –> 25-35% more turnover
– Lower business risks –> Higher PER/capitalisation/valuation –> estimate 50-70% higher PER ratio
– Collateral –> generally less capital requirements –> hard to quantify
– Safety in case of dramatic events –> priceless

The tale of a very large retail Broker being forced out of the market should cause other financial institutions and Banks to reflect. The same benefits will ultimately apply at a larger scale in their context. Separation of concerns and avoiding self insurance for all aspects of the business needs reconsideration. Not even Apple builds manufacturing plants. Central Clearing can improve the business of all FX market participants.

The silver lining

By allowing more counterparties to trade with each other, a Clearing House for FX will gradually have a positive effect on liquidity. Instead of a reduced segment of similarly armed electronic traders battling each other for speed, the regained diversity of participants will pad the market depth with orders.

And could we see more longevity in Retail FX?