Commerzbank discusses regulation and co-operation in FX market

How is Market Services structured, and when was it set up? What is its main aim?
Eugene Stanfield (ES): We've been working on the blueprints for Market Services for a few years, as the pace of new regulatory developments has quickened, and clients are looking for a partner to help them through these changes. The business line is made up of two basic components – derivatives, execution and clearing, under myself, and custody and collateral solutions, which is Rob's domain. Commerzbank has of course always operated these functions, but this is the first time they've been placed under one roof. A detailed business plan setting out the desired structure was presented to the board in early 2013. It was approved, and was launched in June 2013.

Rob Scott (RS): Market Services was established for two fundamental reasons: to support clients through the implementation of regulatory changes; and to assist clients in reducing the huge cost base that has built up as volume and product has grown. For those banks having investment banks and transaction-type banks that have operated for years as quite separate internal structures, they are trying to quickly combine business lines to offer clients co-ordinated solutions. This isn't easy to do, as culture, sales/product cycles and operating separate IT platforms presents numerous challenges. But we think we've solved it. The most important thing is to have a fully integrated product offering that leads clients all the way from execution to clearing, settlement and custody, so the front-office execution systems are completely linked and integrated into the rest of the bank.

What is it about the recent regulatory changes that make this type of internal structure so important?
ES: It's important to recognise the sheer scale of new rule-making we're talking about. It is absolutely vast. We have Dodd-Frank in the US, the European Markets Infrastructure Regulation (Emir) and the Markets in Financial Instruments Directive in the European Union, and Basel III at a global level. These reforms affect every single one of our clients in some way. They have to be aware of implementation timelines, which constantly change, and the content of the rules themselves. They have to prepare their internal systems for reporting, clearing and collateral management, which takes a lot of time and money. Having a single business line that can answer all those questions and offer solutions makes things a lot easier.

What is the general standard of preparedness among your clients? Has the industry really got to grips with the scale of the change, and is there frustration that clarity is still missing on many important regulatory reforms?
ES: Preparedness varies across client types. A lot of our work with clients has been about education, rather than implementation. Take clearing, for example – our early conversations with many were focused around the very basic concepts, how the process works, etc. Now we're tackling more advanced issues such as default management, legal documentation and collateral management.

RS: Market participants tend to sit on the fence in advance of regulatory changes, because often the exact details of the new standards are unclear until late in the day. We saw this with trade reporting under Emir, which presented many challenges when it was implemented in February this year. We see again challenges with the August inclusion of collateral valuations. Some participants are still not reporting correctly and need help resolving this.

ES: The current situation with FX clearing isn't ideal, in terms of clarity over both the timeline and content of the rules. The Commodity Futures Trading Commission indicated earlier this year the clearing standards for non-deliverable forwards (NDFs) would be released by the end of summer. There's still no sign of them. I wouldn't say this was a significant problem for our clients, though. Much of the regulatory focus, particularly with regard to clearing and collateralisation, has so far been on rates and credit.

Clearing and trade collateralisation pose significant challenges for buy-side firms. Many do not have the ready reserves of cash or securities to post as variation margin to cover mark-to-market movement of derivatives trades, and fixed initial margin costs will be high. What can banks do to ease this burden?
RS: As part of Market Services we have a collateral advisory team to help clients. We also have tailored solutions that provide full portfolio valuation and optimisation, helping clients optimise and move collateral in the most efficient manner. Savings that can be achieved with efficient collateral use are quite impressive. If we look at the recent Eurex launch of cross margining for over-the-counter and listed activities, where we were one of the first to implement for clients, savings of 40-60% can be achieved. From a cash management perspective, we have an array of products available outside of Market Services that help clients pool their assets and cash and provide efficiency surrounding their supply of collateral. All this is integrated within the bank to quite a high degree.

FX prime brokerage (FXPB) services at banks have, at times, been severely dislocated by the impact of new regulation. How has the FXPB desk at Commerzbank fared under the changes?
ES: Our FXPB is focused on the spot market, and has to date been exempt from much of the regulation. Our FXPB client base consists of participants with very specific spot FX requirements – electronic communication networks (ECNs), small to medium-sized banks, and asset managers, for instance. As we look to extend our product offering to forwards, options and precious metals, we will start to encounter some of the new requirements, such as trade reporting and clearing. But, for now, our FXPB clients are largely free to continue with their business without being impacted, at least not by all, of the current regulatory initiatives.

What is your take on the state of the FX market at the moment, with low volumes and low volatility having made life difficult for many banks and currency managers in recent years?
Nick Downes (ND): Overall FX market volumes are lower than a few years ago, but it's not all gloom and doom. Our core clients still have FX business to transact, and we are helping more clients to do more business, albeit in a very competitive environment. When I hear other people talk about significant decline in volumes at banks and ECNs, I'm happy we've had a different experience.

There seems to be a growing feeling in the market that there will be an uptick in volatility towards the end of the year, after it has been in the doldrums for so long. Do you think this will happen, and if so, will it last long enough for the FX market to return to its ‘normal' state?
ND: We have certainly seen a pickup in overall client volumes in the past few weeks, given the background of increasing geopolitical risk and diverging interest rate and quantitative easing expectations in the major economies. This has already led to some relatively large moves in the FX markets, so it will be interesting to see if the recent USD uptrend continues. FX vols are off the lows, but still way below long-term averages, so I'd be cautious of getting too far ahead of ourselves in declaring a return to normal...whatever that may mean.

What opportunities do you see emerging in the market in the years ahead? How will Market Services help you grasp these?
ES: Opportunities arise out of challenges, and regulations are creating most of the challenges at the moment. There is a big opportunity for us to entrench our problem-solving service with clients by continuing our FXPB growth, and our expanding clearing and collateral management expertise.

The biggest problem to solve is cost. Unfortunately, regulations are still a cost driver for us and clients, and will be for some time. We will continue to focus on minimising these costs as much as possible, through initiatives such as cross margining at the clearing house, for instance.

RS: We believe there will be a renewed focus, both among banks and their clients as well as non-bank financial institutions, on what operations are considered proprietary to their respective franchises and what functions are more commoditised and can be dealt with by another provider, or some sort of strategic alliance or better co-operation. Given back-office costs are largely fixed and growing under new regulation, there is a need to move to more of a variable cost structure to survive and remain competitive. Banks no longer differentiate themselves on those functions, they differentiate themselves in the front-office functions of trading, execution and research-type activities. Let's assume volumes remain static, and that margins continue to tighten. No-one wants to be stuck with low margins and massive fixed-cost blocks.

What does that mean in practice? Will we see multiple banks pooling their entire back-office functions, as has been rumoured?
RS: I don't think it will go that far. It would take too much time, negotiation and effort to set up. However, smaller, more focused solutions are more likely. We could see banks co-operate to standardise processing of trade reconciliations, collateral processing, messaging and settlement. That's very labour-intensive and commoditised, so it makes sense to outsource it. We already see utility type structures forming to take advantage of this trend.

ND: There is a precedent for this type of market-led initiative to happen. CLS was set up by the biggest banks in the industry as a settlement utility for the benefit of all involved. It has dramatically reduced settlement risk and delivered huge benefit to the industry. Given the potential cost savings to the industry, it's not inconceivable that something similar might happen to parts of the post-trade workflow process.

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