For a long time the foreign exchange market boasted a depth of liquidity that few other asset classes could claim. Steadily rising trading volume and a resilient market structure meant regulators didn’t really need to worry about the potential for a flash crash or liquidity event in FX.
Not any more, warns Paul Chappell, founder and chief investment officer at C-View, a currency management firm that has been operating in the UK since 1996. A confluence of factors, including the increasing constraints on the ability of banks to warehouse risk and devote balance sheet to market making, means liquidity in some currency pairs can turn out to be much shallower than it used to be.
“Many banks are now almost entirely precluded from taking and managing proprietary risk of their own, which leaves the market vulnerable to a situation where there is a very limited number of price makers of last resort that will warehouse risk,” says Chappell.
Some have claimed the rise of non-bank market makers could plug the hole that might be left by banks in times of stress, but Chappell is unconvinced: “Non-banks really have less responsibility towards the market and its clients. If for a period of time it suits them to make markets, they will do so, but if volatility gets too high, they will effectively just switch off their machines.”
The reality in current market conditions, says Chappell, is that there are times when the FX market is flooded with liquidity, but at other times markets can be exceptionally quiet. “Liquidity can and does evaporate very quickly and then takes a while to reestablish itself, which creates a challenging market environment,” he says.
In the meantime it has to be business as usual for currency managers, and for C-View that has meant largely electronic trading for many years. In some ways, a preference for trading electronically means the firm has been less affected by the cost rationalisation and scaling back of resources on the sell side, but a cut to ancillary services has become apparent.
“Core execution has not changed very much. We are seeing some slimming down of the capabilities a number of the banks have with regards to things like research and providing market colour – things that are deemed to be perhaps slightly more peripheral rather than core to their businesses,” says Chappell.
As to the execution channel itself, C-View has for some time been gravitating away from single-dealer platforms, with a preference for liquidity aggregation technology and multi-dealer platforms where prices can be sourced from several providers and best execution can be proven.
“We are making more extensive use of aggregators and multibank venues as opposed to single-bank venues for execution, because of improved net pricing and the onus of responsibility on us to show best execution. If you want to sharpen your competences, there’s no question that executing on an aggregator makes it easier to show that you dealt at the best price available at the time.”