FX trading set to be dominated by clique of banks
A small group of top banks has been steadily increasing its dominance of FX trading, but its advantage is so great that within a few years some are predicting all but a handful of banks will have exited the market as liquidity-providing principal players.
At a time when banks are under increasing pressure to cut costs, the case for trading FX is getting harder to make.
For years, since the financial crisis and the regulatory changes that came as a result, banks have been deliberating what their core offering should be, and where their competitive advantages lie.
For some, FX trading has been part of the answer, and resources have been pumped into it, but in FX in recent years, banks have had to run quite fast just to stand still.
One FX trader at a bank still committed to the currency markets says: “FX is a very expensive business. Clients want a high volume e-trading capability and they want derivatives, and both of those things are expensive to build.
“The hardware is expensive, the footprint – being co-located in all the jurisdictions you need to be in to overcome latency issues – is expensive, having a team dedicated to maintaining the software is expensive. And then you have the level-two expenses, the compliance, legal and surveillance people. It’s a lot of resources.”
Wayne Abernathy, executive vice-president for financial institutions policy and regulatory affairs at the American Bankers Association (ABA), focuses not on the pressure to invest, but in the diminishing returns of the business.
“It is pretty well a law of business that as the margins in any product line get squeezed thin, the only way to cover costs and earn an acceptable return on capital is gain enough on volume,” he says.
“Firms that cannot achieve enough volume for the earnings to cover their costs – and I am referring particularly to the fixed costs – will have to consider leaving that line.”
One example specific to the currencies market is fixing. Here, the regulatory requirement to segregate the business has forced smaller banks to reconsider whether the returns on offer justify the effort of doing it themselves. Many are already outsourcing this function to larger banks. The same logic will apply in other parts of FX.
Adam Myers, an FX specialist and former European head of FX strategy at Crédit Agricole, says the starting point wasn’t – for once – regulation, but the emergence of Deutsche Bank’s (DB) Autobahn.
“It gave the bank a competitive advantage in the ability to price spreads faster and tighter than other banks,” he says. “Smaller banks in particular couldn’t in terms of the speed of quoting or price.”
It is arguably the speed of this platform, even more than the price level, that gave DB its competitive advantage and started the FX market on the road it is now on, he adds.
Carving a place
Autobahn was simply the first. A number of banks have responded with their own technology investments to carve a place for themselves in FX. The top-tier banks have also conducted internal reorganizations to increase efficiency, with the development of a hybrid, riskless principal model at the heart of that.
A bank’s spot FX trading desk is inundated with thousands of financial buy-side and non-financial corporate client orders for liquidity in different currency pairings over the course of any given day, notes Russell Dinnage, senior consultant at GreySpark.
Rather than relying on the dealer-to-dealer market to hedge the risk inherent in managing these flows, a bank can instead internalize or match those flows against an internal order book.
It constructs this order book by corralling all of the various internal FX flows linked to the bank’s internal divisions globally – specifically, the commercial bank, the retail bank, the private bank, the bank’s asset-management arm and its custody business – as well as with the orders received externally from its clients.
Matching off these internal flows and external client orders leaves the bank with residual long and short positions in different currencies, called the skew.
Dinnage says: “As such, an agency trading-riskless principal model is created, in which the bank exercises riskless principal to displace the need to hedge external client spot FX orders in the dealer-to-dealer market, by instead matching them within an internal order book.
“Then, through the utilization of an agency model, the bank can efficiently work the resulting skew in either the dealer-to-client or dealer-to-dealer marketplace.”
For those that have fallen behind the leading banks in implementing these changes, or have not been able to match their spending on technology, their future in FX looks bleak – especially as they are being squeezed, not only by the larger banks, but by active non-bank financial institutions as well.
Such players do not threaten the position of the biggest banks, a point even the non-banks concede.
One non-bank FX securities dealer says: “The top five or 10 banks will never stop trading FX for a select group of clients, but for the next tier of banks, as costs increase and margins get smaller, it will become a less attractive business and within the next five years or so many will leave it.”
ABA’s Abernathy points out banks have certain advantages over other FX players, saying: “If the thin margins are not a constant, but that there are notable periods of volatility, and particularly if that volatility can be rather unpredictable, that favours firms with depth, and banking, as an industry, has the best depth in the financial markets.”
The bank trader agrees. “Banks have greater inventory with which they can offset client interests,” he says. “They have more liquidity – that is the big differentiator.”
However, the non-bank FX dealer says: “Non-banks are better at risk taking and risk pricing – we can do it cheaper. Banks are better at relationships and providing clients with other services. If both sides focus on what they are best at, everyone is better off.”
In that sense, he says, the growth of non-bank activity in the FX market is good for banks, even if mid-size and smaller banks will suffer.
So far, the casualties have largely been confined to the smaller banks, but the mid-tier banks will be squeezed out over time, warns the bank trader.
This should not make much difference to the client, for whom things should look like business as usual.
Myers says: “At the front end it looked like nothing had changed because the smaller banks were still appearing to serve their clients as before. However behind the scenes many banks were simply backing out – or directly off-loading – their FX business to the top three or five FX banks, thus acting as mere agent, rather than counterparty, to the trade.”
This means while clients might perceive a large pool of FX liquidity providers in the market, in reality the FX pool is increasingly small and dominated by a technologically superior few, he adds.
However Myers warns that bankers outside FX should be taking note, with the trends currently playing out in the FX markets likely to be indicative of the future for other asset classes.
“FX is always at the coalface of technological change in financial markets,” he says. “What is happening now in FX will probably occur in equities and other asset classes eventually.”