In a report on FX liquidity in the Americas, which drew many conclusions that are broadly applicable in the global FX markets, the Bank for International Settlements (BIS) says that “for the first time since 2001, global FX trading has declined between two consecutive [BIS triennial] surveys.
“The fall in total FX turnover is due mainly to the drop in spot trading, for which the average daily volume declined by $0.3 trillion between 2013 and 2016. However, global trading in FX derivatives continued to grow.”
This was backed up by a Bank of England survey, referenced by the BIS, which showed that transactions per day in the London FX spot market fell from a peak of 1.3 million in October 2014 to 981,000 in October 2015.
In the Americas, specifically, growth in FX derivatives markets has outpaced that of spot markets since the mid-2000s, largely driven by the hedging demand of banks and corporates, adds the BIS.
“The growth in FX derivatives markets turnover in Latin American currencies has outpaced that of spot markets, and FX derivatives volumes exceed spot volumes for all currencies except the Argentine peso,” it states.
Dan Marcus, CEO at ParFX, says: “I would not be surprised to see spot levels come back up in the future, given their lower capital and margin requirements, but this market is nothing if not unpredictable.”
The BIS report made four main conclusions: that structural changes in FX markets have reduced the usefulness of some conventional FX liquidity metrics, making it difficult to form a complete picture of market liquidity; that FX market liquidity appears to fall during periods of market stress; that technological innovation has lowered transaction costs and thereby increased FX market participation, but also contributed to market fragmentation; and that the impact of post-crisis regulatory change on FX market liquidity remains unclear.
Of course, market structure is constantly evolving in response to many factors, including regulation, new platforms, consolidation and changing volatility characteristics – while market sentiment and trading volume is also itself cyclical. And the idea that markets become less liquid in periods of stress is hardly controversial.
Liquidity still evades definition
What is less obvious, despite the BIS findings, is whether market liquidity is now in retreat.
David Puth, CEO at CLS – which does not settle LatAm currencies, but does have a good view of global FX markets – says: “Generally speaking, we have not seen anything to suggest material declines in liquidity for North America.”
ParFX’s Marcus elaborates: “What is liquidity? Is it trading volume, or is it the ability to execute an order at a given price at a given time? We would say the latter.
“So yes, it may be the case that volumes are down from where they were, but they are ‘more real’ — on ParFX we do not see evidence of a problem with market depth or the ability for traders, who need to trade, fill orders.”
The BIS cited 16 metrics for FX market liquidity, including the bid-ask spread, number of trades, price impact of trade and volatility. And though each has its own advantages, none is a generally accepted and perfect measure of liquidity.
The suggestion is that as the technology around the FX market, and the traders active in it, become more sophisticated, these traditional measures of liquidity are increasingly insufficient. Improvements in trade cost analytics, for example, only accentuate the need for more precise and granular market pricing data.
This is all the more important as the number of trading venues grows, leading to market fragmentation and increasing the chances of price differences between venues – especially in times of stress.
There are many examples of such dislocations, but the fall in sterling after the Brexit vote is a particularly good one.
David Puth, CLS
“In October, sterling fell from £1.25 against the dollar by anywhere from 10% to 15% before recovering,” says Puth at CLS. “There were wide discrepancies between banks and venues regarding the actual reported low for the currency.”
“Various platforms reported the low to be around £1.18, though we are aware that transactions took place all the way down to £1.10 to the dollar, with the low prints in very small amounts.”
As fragmented as it gets?
For some, the solution is the creation of a centralized tape to aggregate FX prices from various locations, something FastMatch was working on last year. That effort has not yet borne fruit, but if it could be delivered it might offset some of the problems caused by fragmentation.
David Mechner, CEO at Pragma Securities, says: “It would be enormously useful to have a consolidated tape, or a more comprehensive record of post-trade data, and this is perfectly feasible from a technical perspective.
“The real challenge is providing the right incentives to ensure platforms provide the data and the right framework to ensure there is no information leakage, for example creating a delay on reported data. We’ll get there eventually, but it doesn’t have to be all or nothing – we can move in steps.”
Dan Marcus, ParFX
Until then, Marcus argues the market is probably as fragmented now as it is going to get, meaning the problem will at least probably not get worse.
“I remember when former [Commodity Futures Trading Commission] chairman Gary Gensler predicted there would be somewhere between 100 and 200 [swap execution facilities],” he says. “In reality, we have 23 currently registered, but only around nine that could be considered active.
“It shows there is actually a limit to the number of trading venues that is sustainable and we may have reached that in the FX market.”
And there are always solutions to the problem of illiquidity. Where it is caused by fragmentation, aggregators are available that put liquidity back together again – at least in normal market conditions.
Where it is caused by banks gravitating to smaller trades, and charging more for larger trades, due to the increasing cost of risk, “buy-side traders have responded by turning to algorithms and taking on more execution risk themselves”, says Pragma’s Mechner.
Overall, Puth says, CLS data shows liquidity in most currencies is at or near historically high levels.
“There is a tendency for market participants to believe that liquidity was better in the past,” he adds. “From what we see at CLS, liquidity appears to be very strong. It is, however, different, with liquidity widely dispersed over a number of different trading venues.”