Last month, many of the leading foreign exchange banks gave their support to the launch of a new spot FX trading platform. Built and delivered by interdealer broker Tradition, ParFXwill compete with EBS and Thomson Reuters, the two venues with the biggest market share in the wholesale FX market, where the biggest participants make markets to each other. The new platform was born out of frustration among the big banks at being picked off by high-frequency traders employing latency arbitrage, notably on EBS. It was designed to hold all participants to the same rules in maintaining firm two-way prices to each other. It is striking that the 11 founding banks, including three of the top four in Euromoney’s 2013 foreign exchange survey, carried on with the venture even after EBS bowed to their pressure to reform its rules.
Banks now say that what began as a stick to beat EBS into submission over facilitating latency arbitrage for the high-frequency traders has become something else: a means to prevent EBS and Thomson Reuters exerting duopoly pricing power. Leading banks talk up the price-and-efficiency benefits from a dose of healthy competition in the marketplace for wholesale venues. Tradition stresses the low costs of hooking up to ParFX, as well as the low costs per trade, as much as its usefulness for ensuring a level playing field for liquidity providers.
What’s most striking about all this is the banks’ apparent lack of self-awareness in decrying the dominance of EBS and Reuters, when Euromoney’s annual survey shows that end-user customers for FX – corporations, central banks, investors – now face a highly consolidated market themselves.
The widespread expectation is that before long Citi, the only one of the top-four FX banks by market share of customer volume not in the founding group behind ParFX, will join its peers – Deutsche, Barclays and UBS – on the new platform. These four banks have over 50% of the market between them, while Citi and Deutsche, the top two banks, have 30%. That’s not quite the same level of market share EBS and Thomson Reuters command of the inter-professional liquidity marketplace, but it’s not far off.
The leading FX banks’ customers should take note of the banks’ evident aversion to submitting to the potential pricing power of such dominant providers. Regulators should take a look too. The vast FX market, so essential to the functioning of so many other financial markets and a key underpinning of the global financial system, looks set to become even more dependent on a small handful of banks whose failure might pose systemic consequences. The banks themselves are even worried about this, especially in the FX derivatives markets, where regulatory and IT costs are rising, competitors are withdrawing and volumes rising as volatility returns.
In the financial crisis five years ago, the FX market performed resiliently. Would it still do so under conditions of extreme stress, say a euro break-up coinciding with a bank-funding panic? Would the diminishing number of wholesale liquidity providers in spot and FX derivatives be capable of committing the risk capital to absorb risk in a high-volume, volatile currency market?
Press them on this privately and many sources at the leading FX banks express their doubts. Of course, they won’t say so too loudly or publicly. Concentration of market share isn’t something to be discouraged when your bank is the beneficiary.