High-frequency trading liquidity goes phantom again

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Recent market volatility and the associated disappearance of FX liquidity, from hedge fund-backed algos, underscore the proliferation of new trading venues, the complexity of electronic FX trading and fears among end-users that many liquidity providers do not have their best interests at heart.

Making markets in spot FX is one of the few fixed-income trading activities that will survive the Dodd-Frank era, and investment banks are widely known to be investing resources in growing their FX footprints, particularly on single- and multi-dealer electronic trading platforms.

However, given the thin margins available in the most liquid forex markets, the business only really makes sense if it is traded in substantial volume.

Moreover, human traders employed by banks are at risk of being pushed out of the market by more efficient trading algorithms, which advocates say can trade faster, more accurately and in larger volume than traditional trading methods.

Furthermore, these traders argue that the high-frequency trading (HFT) that has come to dominate on-exchange equity markets during the past few years provides the FX market with an additional source of liquidity, which could prove vital for executing client business efficiently at a time when banks are struggling to make the volume game profitable.

Indeed, regulatory filings in association with FXCM’s purchase of London-based FX HFT firm Lucid Markets in June revealed the extent of the firm’s market footprint: during 2011 it traded an average daily spot volume of $35 billion, and $13.4 trillion total volume for 2011.

Compared against the average daily turnover on the traditional multi-dealer platforms, such as EBS, of around $100 billion, it is clear to see how HFT is growing in the foreign exchange markets.

“Overall liquidity is going up with the proliferation of trading venues, bank systems, market-making desks and now buy-side algorithms,” says a New York-based FX prop trader who recently left his position at an investment bank for a role at an independent prop firm.

“Liquidity for the buy side is there and growing – whether or not it is profitable on the other side is the challenge for banks and their need to hold on to good traders.

“Human bank traders no longer account for much of the liquidity compared with algos, including bank-run algos, and high-frequency buy-side accounts. HFTs are trading on these platforms and supply significant liquidity to the market.”

However, some participants fear the rise of the machines in foreign exchange trading, and point to a recent drop-off in quotes from HFT algos during the recent spike in volatility as evidence that HFT algos, or more specifically the hedge funds that run them, cannot be trusted to make markets when the trade is not economic for them.

This phantom liquidity, or bids and offers that mysteriously disappear when another player tries to execute, has become a particular problem during the summer, according to market sources.

“There has been less liquidity coming out of HFTs than might be hoped over the summer,” says one hedge fund manager who still uses human discretion in trading FX.

“What we’ve seen over the past year or so is that when volatility goes up, these models actually disappear – they are not really what I would call great players in supporting markets they think are dangerous.”

So where has liquidity been coming from? Banks and platforms that feed into banks continue to be the first port of call for clients seeking to trade, but they are passing that business on, either into the Street or on to buy-side players, including real-money investors, to execute.

“It appears that the interest to take risk is shifting from banks to algos and now to real-money players,” says the hedge fund manager, indicating that the largest fixed-income asset managers are beginning to flex their foreign currency reserves.

HFTs and other non-bank market makers can only access the OTC markets via prime-brokers, giving banks that cannot take the risk themselves another chance to make sure that end-users are given a minimum level of service.

Increasing cooperation between trading technology providers, dealers and ECNs to monitor and manage electronic FX trading should give end-users some comfort that there is someone there looking out for their interests amid the computerization of financial markets.