New FX technology resolves phantom liquidity

Peter Lee
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Fragmentation and phantom liquidity bedevil the foreign exchange market with its proliferation of trading venues. Investors and corporates want to see the true depth of the market and what amounts they can really trade at the enticing prices being flashed at them. In a low-return world, these end-users are getting rigorous on trading cost analysis. Banks are developing new technology to respond.

How many electronic trading venues are there for foreign exchange, including all the retail aggregators, all the multi-bank platforms aimed at different customer groups, specializing in different combinations of spot and FX derivatives? Euromoney asks each head of foreign exchange at the leading banks and gets different answers. But it’s a lot: anywhere from 40 to 50 in total, of which at least 10 and maybe as many as 20 are quite important to the wholesale banks.

David Fotheringhame, director at Barclays, reflects on how the barriers to entry in the foreign exchange ECN business have come right down. “When EBS and Reuters were being built, it was like building the space shuttle,” he says. “Today, it’s a lot easier to get the technology in place to set up a new ECN and attract some reflected liquidity onto it.

“But I would question whether liquidity has actually improved in foreign exchange as a result. I would argue that, if anything, it has got worse.”

The rules of the leading trading venues, their choices as to whether or not to display volumes, are far from uniform. They also change regularly, which in turn impacts which users put volume through the venues, and the depth of markets and reliability of the pricing they show.

This is aggravating for end-users who, given their own regulatory requirements, operational risk budgets and tightness of IT resources, would much prefer a uniformity of trade processes.

The biggest problem is phantom liquidity, as many venues display tight pricing while relying on just a handful of large market-making banks to provide it.

“In FX liquidity, it’s all down to the firmness of quotes published and whether the price you see is even close to the price you can get in meaningful size,” says Fotheringhame. Last-look rules in certain venues allow them to reject orders even when participants have hit an apparently valid displayed price.

“A lot of the apparent liquidity is actually spurious,” says Fotheringhame. “That makes it very difficult for customers to achieve optimal execution in the FX market. Just because you see a tight price in $20 million on one venue and $20 million on another doesn’t mean you’ll actually be able to get $40 million done at that price. You might not even get $10 million done.”

Barclays has been a pioneer in electronic foreign exchange with its Barx system. Its latest upgrade to this is called Gator. It was designed as an aggregator across the various venues for the bank’s own traders, built on algorithms developed from constantly submitting small and large orders across all the venues at various times of the day, testing the true depth of market and reliability of price.

It now allows Barclays to make a very good estimate – not it insists, an absolute guarantee – of the best actual price a client could fill a certain sized trade at, splitting it across the various venues. It intelligently gauges that actual depth of the market.

The calculations behind this are not static. Barclays refines them as it continues to submit orders and execute trades across all the venues.

The bank has decided it should roll this out to clients, on a fixed-fee basis, charging a commission per trade. This is built into the customers’ spread rather than paid later as a separate cheque.

Mike Bagguley, head of foreign exchange and commodities at Barclays, says: “We operate in a market where customers can demand the tightest pricing but also top-quality service.

“The solution is certainly to be a volume player but also to run a business with a high intellectual property component, whether it be in relative value trade ideas, insight around trade flows or IT related, as our new aggregator system is.

“If Barx 1.0 was streaming two-way prices and Barx 2.0 was the order book, Gator is Barx 3.0. It is a profound change to the marketplace and one that should sustain us for the next two or three years.”

As well as doing the job for clients of second-guessing actual price and depth of market versus that being displayed across all the many venues, Gator aims to reduce operational complexity.

If a client submits a $20 million order through the system, that might result in multiple trades across various venues that finally leaves it with an unfilled stub of say $0.5 million. Barclays will complete that as principal to ensure the fill and deliver the multiple underlying trades as one order.

Fotheringhame says: “We call it a hybrid liquidity model, consisting mainly of external liquidity that we execute against on an agency basis but with some principal as well.”