As their assets continue to grow, the world’s biggest hedge funds, asset managers and pension funds have become increasingly bullish about their status in the foreign-exchange market.
But even the largest firms’ total assets under management are equivalent to only a single day’s trading on what is the world’s largest financial market. And as Euromoney has previously reported, market participants are choosy about the liquidity providers they work with.
That is good news for banks.
“We haven’t come across a lot of clients telling us that they are so big that they now see themselves as liquidity providers,” says Asif Razaq, global head of FX algo execution at BNP Paribas. “The trend we are seeing is that clients value the liquidity banks bring to them, either from the interbank market and trading on primary venues, secondary electronic communications networks (ECNs), internal bank liquidity, or seeking liquidity via the bank’s client franchise.”
There have been efforts to get peer-to-peer matching platforms up and running. However, they are a very small part of the overall market
Asif Razaq, BNP Paribas
ECNs are curated liquidity pools where clients can typically show as well as take liquidity. There has been increased use of private ECNs or mid-matching venues that create a liquidity pool for the buy side to post their interest and have another client come along, see that interest and trade on the other side of it.
“There have been efforts to get peer-to-peer matching platforms up and running,” explains Razaq. “However, they are a very small part of the overall market because that type of solution requires clients to sit on a position waiting for the other side, which could happen in a matter of minutes or at the end of the day, exposing them to market risk that few firms have the luxury of taking on.”
The alternative is to work with a bank that enables clients to trade on external venues, trade against the bank’s own liquidity, and plug into these peer-to-peer matching venues in parallel.
“We have had to gear our algorithms to allow clients to participate in these matching venues so at least they have the opportunity of being considered as a liquidity provider to other clients,” says Razaq.
Most buy-side clients must execute their order at that point in time and benchmark the performance of that order in isolation. So, if they sat on the bid and the market trended higher and they got filled at a much higher level, the trader would be held accountable for why they took so long to execute the order and exposed the firm to excessive market risk.
According to Razaq there are some interesting solutions coming to market, where some of the bigger banks are offering clients the ability to execute their flow using their franchise, showing the order to their client base.
“That could be seen as a client acting as a liquidity provider to our franchise, because when they execute in this manner the client has lower execution costs because they are not trading in the interbank marketplace, where the cost of execution could be significantly higher,” he says.
But there is still market risk involved because if there is no interest on the other side, the clients could be waiting to be filled while the market drifts higher.
Matching axes
There is of course value in natural and offsetting liquidity – and, in a world of lower margins and tighter spreads, finding ways to source liquidity efficiently and with low market impact is vital. Firms are interested in seeing and matching against axes, or even having their positions actively axed directly to other clients to attract offsetting interest.
“The larger firms know their flows and interest play a significant role in the market and want that reflected in their execution costs,” says Daniel Bowerman, global head of eFX at Bank of America. “Real-money firms understand the relative value of the products and flows they execute and where their liquidity providers can really add value for them.”
The flows executed on their behalf are often the largest seen in the market and help to generate interest and liquidity from other market participants, he adds.
One head of trading at a large FX bank acknowledged that he had come across a buy-side firm that believed it should be given preferential treatment on the basis that it was providing liquidity to the market.
But even a buy-side firm with a $1 billion order must be seen in the context of an FX market that was worth $7.5 trillion a day in April 2022, according to the latest triennial survey by the Bank for International Settlements.
Another issue is that there will probably be only a handful of clients on the opposite side of the trade who could offer them access to that liquidity.
“The client was happy to take all the market risk and all the time in the world to work its order into the market as a provider,” he explains. “It never wanted to be taking liquidity or paying the spread, and believed that the market impact over a period of time would normalise down to zero.
“The only cost of execution it saw was when it paid spread, so it was happy to post interest into the market and sit on that risk and evaluate it over a period of time.”
However, he notes, at the client in question there was a specific individual behind the approach who has since moved, and that the firm is now revisiting that methodology and looking to trade in a more conventional manner.
