One of the more surprising developments in the FX market over the past few years has been the continued strength of trading platforms. At the beginning of the decade there was a feeling that brokers were fed up of working with multiple trading venues and that the number of platforms would decline. But consolidation and retrenchment have in fact been limited.
As a result, brokers are now spending weeks or even months gathering information, conducting background checks and negotiating contracts with potential liquidity providers, while assessing them against a range of criteria including reputation, reliability, liquidity depth, technology, regulatory compliance and support.
By partnering with multiple liquidity providers, brokers are tapping into a larger liquidity pool with the hope of obtaining better pricing, tighter spreads and improved trade execution.
“Another reason to have multiple liquidity providers is to gain access to a wider range of instruments, such as exotic currency pairs or less-popular asset classes, which can be provided by specialised providers from different regions,” says Andreas Kapsos, chief executive of Match-Prime Liquidity. “Furthermore, there are differences in offerings and technological capabilities among liquidity providers, such as net open position limit levels or the ability to accept large volume orders.”
Optimum number
Lars Holst, CEO and founder of GCEX, says that years of experience have led his firm to the conclusion that the best number of liquidity providers to work with between three and five.
“This approach allows us to establish meaningful relationships with each liquidity provider, ensuring that we are considered a valued client,” he says. “Moreover, having a smaller number of providers enables them to consistently win flow by expressing their interest, without being in fierce competition with a multitude of other players.”
A crucial aspect of GCEX’s selection process is evaluating a liquidity provider’s capacity to internalise a portion of the flow.
“This ensures that they can effectively handle and process the volume of trades we execute,” says Holst, “minimising the need to rely on external sources and streamlining the execution process for our clients.”
However, adding new liquidity providers can result in a liquidity pool that works less well than a pool with fewer participants but that has been more carefully put together, cautions Fatih Atalay, head of eFX and FX trading at Swissquote.
“For example, certain liquidity providers have a flow internalization process that could tip other providers into chasing the market, resulting in more costly risk transfer for all participants,” he says.
Atalay recommends using data to estimate the yield that liquidity providers can extract from a broker’s flow.
“Combining this data with additional information will allow the broker to minimise their total net risk transfer costs while staying relevant to their suppliers,” he adds.
Aggregation of liquidity providers has obvious price advantages, but what is often overlooked is the possible impact on price formation if these providers are not constantly managed and curated. This can be exacerbated if infrastructure or network routes are not optimised.
Gavin White, chief executive of 26 Degrees, says that standard metrics such as response times and fill rates need be closely analysed and monitored. Having pricing engines across the globe is also a critical factor for any serious liquidity provider.
“We undertake a detailed process of due diligence and A/B testing when onboarding new liquidity providers that can take one or two months – the main workload being the establishment of designation notices and give-up agreements to our panel of prime brokers,” he explains. “In FX, we generally work in pools of six to eight liquidity providers, depending on the product, flow quality and execution style.”
AvaTrade prefers working with listed liquidity providers for reasons of transparency, as it must meet specific regulatory and reporting requirements, explains chief market analyst Kate Leaman.
“Listed providers may offer increased transparency regarding their financial health, execution quality and adherence to regulations, which can provide brokers with more confidence in their choice,” she says.
Status
But Tal Dar, vice-president of institutional sales at Vantage Connect, reckons a liquidity provider’s listing status has become less relevant over recent years.
“The biggest worry for a broker is safety of funds, which explains why they have traditionally chosen to go with a listed liquidity provider, even when they have to pay more to set up an agreement,” he says. “Many non-listed brokers with a healthy market share are now just as well-funded. Some may even choose to segregate funds for their clients’ peace of mind when it is not a regulatory requirement.”
Although 26 Degrees is part of a listed group, White doesn’t believe that listed status is much of a driver for liquidity provider selection.
“However, transparency and adherence to the FX global code of conduct certainly are,” he says. “Disclosure documents are also valuable in our due-diligence process, although as with many aspects of financial markets, trust and relationship still count for a lot.”
Kapsos agrees that being listed is not the sole determining factor, or even the most important one.
“There are many factors beyond formal requirements that have a significant impact on broker-liquidity provider cooperation, such as liquidity depth and diverse sources, in-house technology that can be adapted to market changes, the ability to reach a compromise on disputed issues, or even cost efficiency,” he concludes.
