The days when large banks were the only institutions capable of delivering tier 1 liquidity to the market are long gone. In many cases, the technology and pricing that non-bank market makers use and the risk parameters they have in place are on a par with the largest financial institutions.
The extreme market dislocation that occurred in March and April 2020 caused many traditional liquidity providers to reassess their business and operating models – and be more selective.
“This allowed a number of non-bank players with significant in-house flows to be more effective as a provider of secondary liquidity to market participants who require access to the wholesale currency markets,” says Henry Wilkes, from Currency Solutions & Services. “Technology played a key role in helping the industry cope with the crisis and many non-bank providers have superior technology infrastructure.”
Market participants recognize that bank and non-bank liquidity sources are complementary and that it is essential that both groups continue to provide pricing. Different institutions have different models, serve different types of clients and specialize in specific currencies and regions.
Gavin White, CEO of Invast Global, observes that in the very earliest days of the crisis there was a huge dislocation in the gold/dollar spot market, with spreads from all liquidity providers widening more than tenfold in a matter of minutes. A few months later, oil futures went negative.
Technology played a key role in helping the industry cope with the crisis and many non-bank providers have superior technology infrastructure
Henry Wilkes, Currency Solutions & Services
“Both events severely tested liquidity in both exchange-traded and OTC [over the counter] realms, and in each case the value of non-bank liquidity was revealed,” he says. “Advances in technology have brought cost savings and performance improvements that allow various non-bank entities to compete with the banks on a level playing field.”
The loss of established prime broker relationships has been a further incentive for brokers to look to non-bank market makers. “The voluntary contraction of the tier 1 prime brokers has continued relentlessly over the past five years and disruption caused by coronavirus has only made that evolution more certain,” adds White.
As prime banks have reassessed their eligibility criteria for prime clients, prime-of-prime brokers such as FXCM have stepped in to fill the gap. But Siju Daniel, chief commercial officer at FXCM, says it is important to distinguish between the role of the broker and that of the liquidity provider.
“If a prime-of-prime broker offers a client liquidity at a favourable rate as a condition or as a benefit of signing with them, this should set off alarm bells as there is a clear conflict of interest,” he says. “Equally, a non-bank market maker should not play any role in onboarding times or the cost of accessing the FX market.”
Proxy players
A white paper published by CMC in mid-December suggested that non-bank market makers help reduce latency and play an important role as proxy wholesalers of liquidity, as their warehousing appetite and skills often exceed that of the tier 1 banks.
“Low latency is a key differentiator in the FX market and non-bank liquidity providers have played a role in being more open to the adoption of technology capable of reducing latency,” says Daniel. “On the whole, the wider market has benefited from this. For example, it has reduced the gap between the largest and smallest trading institutions and made FX more competitive.”
A proxy wholesaler of liquidity suggests an institution is recycling liquidity from another source. However, Daniel doesn’t believe that is the case for the majority of non-bank market makers, especially those that feature in the annual Euromoney FX survey.
“They provide original liquidity and actively take and hold positions in the market, just like other market makers,” he adds. “Of course, proxy market makers do exist. They can play an important role in providing liquidity to smaller clients or in niche currencies and regions where larger institutions don’t have the resources to – or don’t want to – serve that segment.”
Wilkes agrees that it is possible for non-bank market makers to help reduce latency and make the provision of liquidity more effective in the market, but also observes that not all of them are capable of fulfilling such a role. This is particularly true for non-bank players that use a business model that operates on recycling secondary liquidity, adding connectivity costs and complexity and therefore providing no real value to the market.
