Tectonic Shifts

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The provision and consumption of liquidity in the FX market has evolved in recent years, with new participants and distribution mechanisms, but concerns have been raised about the market’s resilience at times of stress.

Movements in the gigantic tectonic plates beneath the earth’s surface are slow and imperceptible to the human eye. But over the course of millions of years, it is those gradual shifts that form the world’s highest mountains and its deepest ocean trenches.

Similarly in the foreign exchange market, subtle changes over the past seven years are contributing to a major transformation in the ecology of the industry. As regulation bears down on the banking sector and technology plays an ever more important role in the provision, distribution and consumption of liquidity, a new market structure is emerging.

"It used to be that buy-side firms would hand their orders to banks and trust them to take it from there, but the industry has changed and the buy side is now taking much greater control. The challenge is that there are fewer banks with sufficient capital to respond to sudden currency moves, which can lead to patchy liquidity and air pockets at times of market stress," says Phil Weisberg, global head of FX at Thomson Reuters.

 TECTONIC-SHIFTS


A reduction in liquidity is a serious concern for all participants in a market that has always been credited as being very liquid, allowing end users to transact as and when they need. But as the role of banks and alternative market makers in the provision of liquidity has changed, buy-side firms are finding that the FX market is not quite as reliable as it has been historically, particularly during times of stress.

In the event of a major move in a particular currency, some warn that market makers are now more risk averse and more likely to react in the same way, making sharp one-way moves much more common. That has created concerns that the market’s resilience to sudden moves may be declining.

This became particularly apparent on January 15, when the Swiss National Bank (SNB) suddenly removed the currency floor it had maintained for more than three years on the EUR/CHF exchange rate. The surprise policy decision triggered chaotic market conditions as the value of the Swiss franc soared and participants scrambled to protect their positions and prevent losses. It also led to an unnerving shortage of liquidity at a time when participants needed it most.

"The institutional Swiss franc market was effectively closed for about an hour after the SNB announcement, which was to be expected, but liquidity in the forward market was disrupted for several business days. That suggests traditional liquidity providers may have had less ability to warehouse risk as a result of regulation, and were therefore less committed to the market during that period," says James Wood-Collins, chief executive of Record Currency Management.

"To make prices in currencies, market makers have to be willing to risk trading capital, and in volatile market conditions they would need much more capital to be available, so liquidity tends to get thinner at times of high volatility," says Neill Penney, head of workflow management proposition at Thomson Reuters.To some extent this kind of scenario is inevitable in a world in which Basel III is forcing banks to hold a much greater quality and quantity of shock-absorbing capital, which incentivises less risk-taking across business lines. While FX trading consumes less capital than some asset classes, a sudden risk-on environment might make banks more likely to step back.

The growing capital burden is one of a number of pressures banks are facing in the FX market today; they are also dealing with the impact of the benchmark investigation and subsequent market review. While not all banks were fined for market manipulation, most are now having to manage the changes that have been made to the fixing process, including the widening of the calculation window for the WM/Reuters 4pm fix from one minute to five minutes.

"As end users have demanded more choice and better prices, we now have many more ways of delivering our prices to them."
Douglas Cifu, Virtu Financial

More fundamentally, the conflicts of interest that have been exposed by the investigations have led to greater scrutiny of business models, and a need for more robust internal controls and disclosure to clients. Getting that right requires banks to create a whole new layer of infrastructure that didn’t previously exist, raising barriers to entry that were already fairly high.

"Large banks need to have processes and procedures in place to manage the inherent conflicts that exist when they are making prices to the buy side but are also a principal in the same business. That ramps up the fixed costs of operating as a market maker, and the investment now has to be made in internal processes rather than product innovation," says Weisberg.

Meanwhile the prospect of further regulation of some FX products, including mandatory clearing and trading on swap execution facilities, requires additional investment in infrastructure and connectivity to ensure client trades can be processed in compliance with the regulations.

As banks deal with the sharp rise in operating costs that has played out in recent years, fierce competition for market share has been replaced by a simpler fight for profitability. Some believe concentration is inevitable, particularly among mid-tier banks that might not have a particular regional focus but previously aspired to compete in the top tier of the market.

"It used to be the case that a big investment could allow any type of bank to build an electronic FX franchise, but it is now more than just technology that is needed. Natural liquidity flow and the connectivity and scale that come from it are also critical, but that is much harder for smaller entities to generate, so I believe we will see some concentration in the number of banks active in the market," says Eddie Wen, global head of electronic trading for rates, FX, commodities and emerging markets at JP Morgan.

In some ways, this might seem the ideal opportunity for non-bank market makers to step up to the plate. Free from the constraints of bank capital requirements and propelled by smart and fast technology, a host of non-banks have carved out a significant role in liquidity provision to the FX market in recent years.

Also known as high-frequency traders, this relatively new breed of market participants have often been the subject of negative publicity, particularly in the equity market where they have been accused of front-running orders and rigging markets. But it is now generally accepted that alternative market makers have a positive contribution to make to FX market liquidity.

"Alternative market makers are very good at tightening the top of book in liquid markets," says Weisberg. "That has shifted the balance so that people who have small amounts to trade are served more consistently by alternative market makers at times of normal or low volatility. Those trading larger orders in stressed market conditions may still be better served by banks."

For alternative market makers, the most positive transformation of recent years has been the proliferation of distribution channels that enable them to make prices to liquidity consumers. The growth of disclosed trading venues as well as the willingness of banks to take prices from non-banks and redistribute them to their own clients on an agency basis has created an attractive business model for alternative market makers.

One example is Virtu Financial, which successfully completed an initial public offering on NASDAQ in April and has significantly grown its presence in the FX market over the past year. The firm’s net trading income from global currencies grew from $20.7 million in the first quarter of 2014 to $42.2 million in the same period this year, according to its latest results.

Phantom liquidity: A buy-side view
Michael O’Brien, director of global trading at Eaton Vance, shares his perspective on the changing nature of liquidity in the FX market.

It is at moments of extreme market stress, such as the Swiss National Bank’s surprise policy decision in January, that weaknesses in the FX market structure are laid bare, but some buy-side firms have been finding it increasingly difficult to access liquidity in normal market conditions.

"There is often a disconnect between the tight bid-offer spreads we see quoted on the screen and the actual prices we can transact at, particularly for large orders. The market operates at a much higher speed now, so by the time we have placed a trade with a bank, the price will often have moved," says Michael O’Brien, director of global trading at Eaton Vance in Boston.

Recognising that banks’ ability to provide liquidity is also being constrained by the growing burden of regulation, O’Brien believes market participants need to come together to find alternative models for sourcing liquidity, such as peer-to-peer matching between buy-side firms, or crossing with retail flow.

"There is still very strong demand for foreign exchange from asset managers and corporates, so we need to establish where the supply is going to come from in the future, and I believe that’s a technology issue. The banks will always play a critical role in the FX market, but we may see more liquidity residing elsewhere," O’Brien explains.

Finding an alternative channel for liquidity consumption will take time, and until it happens O’Brien believes the FX market may be less resilient than it was during the financial crisis. "FX performed well in 2008, but I’m concerned that it may not be as robust if a similar crisis were to happen today, given liquidity is shallower," he says.

At Eaton Vance, electronic platforms and aggregators play a growing role in FX trading, but the firm is careful to choose execution channels that add true value to its business.

"We don’t use single-bank platforms and we’re doing less algo execution than we did in the past as we have found those tools to be less effective. Our business has evolved from a world where we used the phone almost exclusively to one where we make much greater use of electronic platforms and alternative market makers, but we’re looking for unique models rather than just another RFQ platform," says O’Brien.

Although Eaton Vance generally does not use the 4pm London fix that lay at the centre of the market manipulation scandal, the firm has been closely observing recent structural changes, including the clampdown on conduct inside banks. "We have seen use of chat-room messages and even some phone conversations being restricted. In general, banks are being more conservative in the way they interact with the market," says O’Brien.

"Virtu and firms like us have always been very good at efficient price discovery and providing attractive liquidity, but what we lacked historically was the ability to distribute those prices to the buy side. As end users have demanded more choice and better prices, we now have many more ways of delivering our prices to them," says Douglas Cifu, chief executive of Virtu.

While high-frequency traders have often been accused of using super-fast technology to exploit inefficiencies between markets and platforms to gain a competitive edge, Cifu counters that it is actually the transparency and efficiency of the FX market that has allowed Virtu to succeed. Technology plays a central role, but the model requires efficient markets, he says.

"Bid-offer spreads have significantly tightened in the FX market over the past five years and Virtu has been able to capitalise on that increased efficiency by delivering valid and robust liquidity to the market. We have reduced transaction costs in the financial ecosystem and made price discovery more efficient for end users, allowing them to move in and out of positions more easily," says Cifu.

But while alternative market makers may deliver efficiencies, the model doesn’t suit all buy-side firms. Record Currency Management, for example, runs bespoke currency programmes for clients and trades mainly in FX forwards and swaps. The firm’s choiceof counterparty is based primarily on price and creditworthiness, with the latter being much easier to assess for a bank than a non-bank.

"Every bit of risk and reward we create for a client in a currency management programme sits on the counterparty’s balance sheet until maturity, so we have to think hard about who that counterparty is and what its credit rating is. Even if alternative market makers provided significant liquidity in forwards, we would need to be able to fully assess their creditworthiness for them to be on the other side of the trade from our clients," says Wood-Collins.

For market makers, the evolution of the industry in recent years has created a more level playing field as major trading platforms have introduced new rules and controls to slow down the technology arms race. Tools such as randomised order processing aim to grant equal opportunities to market makers, regardless of how fast their systems might be, while a host of other rule changes and surveillance mechanisms have been implemented to prevent market abuse.

Against this backdrop, banks and non-banks are often considered to be vying against one another for market share, but the evolving market structure has blurred the lines between market participants, to the extent that the two groups often act as both clients and competitors to one another.

"We view banks as business partners rather than competitors, because most of them now recognise that they can take our prices for whatever purpose they want, whether it is to redistribute to their clients at their own mark-up, or to use it to hedge their own exposure. We are just another source of liquidity that complements our bank partners," says Cifu.

"The traditional dealer to client relationship has changed," adds Wen of JP Morgan. "Our clients provide us with liquidity that helps us trade better with our other clients. We also trade with alternative market makers so they, too, become a liquidity source for us. Our business model is to manage our positions and liquidity as best we can, regardless of the type of counterparty we are dealing with."

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