Small fish, big prize: The market makers out to eat the banks' lunch

Peter Lee
Published on:

New specialist liquidity providers are nibbling away at the share of the big universal banks in more and more parts of the FICC markets. In swaps, government bonds, foreign exchange, credit, and in securities financing and repo, new entrants are on the march, stepping up to fill the gaps left by the retreating banks. Tech savvy, led by quants and data engineers rather than the expensive traders sitting on the scrap heap of most banks’ inferior tech, the new entrants now just need people with the skills to win over large numbers of customers.

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Tidjane Thiam, chief executive of Credit Suisse, stood up at an investor day in London at the end of October to outline a new strategy to revive the bank’s fortunes. Noting the collapse in customer volumes in August and September, Thiam said: "All the pressures have been on fixed income." He duly axed large swathes of his firm’s macro rates business.

Thiam wasn’t the first CEO of a bank with a big trading business to reach this conclusion, and he won’t be the last. Indeed just a week later John Cryan, recently installed as CEO of Deutsche Bank, executed what would until very recently have been a staggering U-turn for the German bank.

"In global markets, we are going to cut severely our engagement in interest-rate trading strategies," Cryan told analysts, "likewise in flow credit trading and the trading of high-risk-weighted securitized products." He added that "in global markets we expect to off-board about half of the current list of clients, because economic returns on those relationships are inadequate for us."

For them, yes. But for others, perhaps not. Eight years after the financial crisis, the new landscape of fixed income trading is starting to emerge. That landscape involves some different firms, but some very familiar names.

"A lot of what appear to be liquidity providers are engaged in back to-back hedging. It’s not immediately obvious but what they are doing is taking liquidity from one source and giving it to another. Customers may find that excluding some of these so-called liquidity providers may actually improve execution quality. Less is sometimes more in terms of quality of execution" 
- Alex Gerko, XTX Markets  Tweet this quote 

None is more familiar in global fixed income than that of Bob Diamond, the man who built Barclays Capital into a FICC powerhouse over the course of more than a decade.

Diamond, for example, has made a big investment in South Street Securities through his vehicle Atlas Merchant Capital.

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South Street, a Finra-regulated specialist broker dealer in US treasury and agency repo and securities financing, was spun out of Citigroup after the merger with Travelers in 2001 for the simple reason that the combined entity, now including Salomon Brothers, did not need two repo desks. It toiled away under the radar in the years running up to the financial crisis, struggling to make a living in a market dominated by the G-Sifi banks.

Come 2015 and its main struggle now is to do all the business customers want to do with it.

South Street has a strong niche in repo – another area the traditional bank market makers are exiting – but you sense Diamond’s ambition runs much further than that.


"It seems to us that regulation of the Sifis and G-Sifis is going to drive even more of the traditional securities business towards new entrants for a host of reasons," Diamond tells Euromoney. "The capital requirements on the biggest banks are now enormous. They comprise buffer upon buffer. Concern over too-big-to-fail remains the top issue for policymakers in the US, UK and Europe and with it comes the focus on reduction of complexity at large banks and separation of deposit taking from market risk."

Diamond continues: "So not only is more capital required, it is also ring-fenced, inflexible capital, not capital that rises and falls in line with market and business volumes. And you have the leverage ratio which constrains businesses like repo which may be low-risk because of the associated balance sheet size."

As with South Street, most of these 'new entrants’ are anything but. The firms have been trading in their markets for many years; some of the people for many years longer than that.

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Zar Amrolia, XTX Markets
Take Zar Amrolia, once one of the architects of Deutsche’s flow monster franchise, now a recent convert to new forms of market making at XTX Markets, of which he is co-CEO. XTX is a London-based trading firm spun out of the hedge fund GSA Capital Partners in July 2015 and which makes markets in cash equities, futures, commodities and in its most recent and fastest growing segment, spot foreign exchange.

"Liquidity is diminishing because the number of participants willing and able to commit risk capital is going down and the cost of providing it safely has risen," Amrolia says. "Banks may still provide this service in future but liquidity provision is going to be a specialized function and not all of the banks will be able to do it. Remember that most liquidity providers still run an inverted talent pyramid, with a few traders paid very well and a whole stack of technologists and quants paid less. In the future, it may well be the other way around."

These new entrants are good at the markets they operate in. They have state-of-the-art technology. They have limited capital. They understand and take risk.

Then there’s the most telling aspect of all. At this time of reduced liquidity in fixed income markets, the banks withdrawing their market-making capabilities are themselves starting to rely on these new, non-bank firms for access to it.

Surely it’s only a matter of time before the banks’ clients begin to do the same?

Important advantages

New non-bank market makers may lack the banks’ balance sheet size, their agglomeration of bundled services, their sales networks and bilateral credit lines with big asset managers, but the new firms have three important advantages: they have state-of-the art technology, simple and focused business models and while they are regulated, they are not burdened by regulation designed to protect against too-big-to-fail. In addition, they can move quickly, adjust their business strategies as the underlying market infrastructure evolves.

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Citadel Securities is an electronic market-making firm, owned by but legally separate from the multi-strategy hedge fund that billionaire Ken Griffin founded just over 25 years ago. Citadel, like most other electronic market makers, is best known for its US equities markets business, but it has made big strides in interest rate swaps in the past year and has now entered the cash treasury market.

Paul Hamill is managing director and global head of FICC at Citadel Institutional Solutions inside Citadel Securities, where he leads the client-facing fixed income market-making businesses, including interest rate swaps, government and corporate bonds and credit default swaps.