Price to pay for liquidity in technology arms race

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Progressive investment in trading technology over the past decade has pitched banks aggressively against one another in an intensifying arms race to offer the best access to FX liquidity. It’s a race that shows no sign of abating any time soon.

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"Anyone who participates in this market has to participate in the technology arms race to some degree, and there is clearly a cost associated with that," says Richard Anthony, global head of FX electronic risk at HSBC. "I do think that if spreads continue to become more compressed and volume continues to decline, not least because of lower volatility, we may see a reduction in the number of market makers."

That reduction could be good news for the likes of HSBC, which has long been one of the largest banks in the FX market, with a vast global footprint. But like all banks, HSBC faces its own challenges in navigating the increasing complexity of the market structure. A rising number of trading venues and execution channels means provision of liquidity is becoming a far more costly and resource-intensive business in which to compete.

"One of the biggest risks for a market maker is not having access to liquidity, so as liquidity becomes more fragmented and more and more trading venues appear, we need to connect to those venues. Connectivity is an expensive process to set up and maintain," says Anthony.

But given the number of new trading venues that have sought to enter the FX market in recent years, banks have had to be discerning about whether there is sufficient unique liquidity to justify the connectivity costs. HSBC is no exception, having so far backed some new ventures but kept a watching brief on others.

"If a new venue has exactly the same participants and architecture as an existing platform, the chances of success are fairly low. What attracts us to support a venue is if the rules of engagement or policing are slightly different or the proposed participants of that venue are different, thereby giving access to genuine liquidity that doesn’t exist elsewhere," Anthony explains.

But it is not all about external liquidity, and banks have invested increasingly in their own technology in recent years, including single-dealer platforms and algorithmic execution, which is an area Anthony believes is poised for growth in the coming years.

Internalisation of flow is also an increasingly attractive way for banks to match buyers and sellers without having to take an order to the broader market, thereby offering better execution to the client. As HSBC has invested in its risk management and pricing models, and market volatility has declined over the past two years, meaning there is less urgency to clear risk in real time, the bank’s internalisation ratios have increased substantially.

"Matching off client flows internally is the most efficient way of managing the risk. This has always happened, but with automated risk management processes and the electronic distribution of prices, we can now manage the internalisation process more efficiently. That’s positive for clients because they get tighter spreads," says Anthony.