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Foreign Exchange

Letter to the editor: The FX debate – a response from RBS

Our December cover story, The problem with foreign exchange, has sparked debate about the structure of today's FX market. Responses to the feature are still arriving at the Euromoney office.

Sir,

Thank you for running the article “Do the big FX banks need a new platform?” in your December 2005 issue. In it, Lee Oliver probed many of the inconsistencies of the current industry structure and the ambivalent attitudes various constituent members have to the development of the marketplace.

At RBS we cannot see the merit in such a suggestion. We do not see it succeeding and feel that it is moving in a contrary direction to that in which the new technologies and the participants who wield them are inevitably taking the market. Misguided suggestions by market participants that can be interpreted as ‘bringing back the old boys’ club’ simply lay bare the atavistic yearnings of a few alleged participants who want to roll back the clock to an easier time.

The folly of this hope can be seen not just in the development of the FX market but in the morphing structure of many of the other securities markets. Consider the US bond market, the largest securities market in the world. Technological developments continue to offer increased speed, visibility, ease of access and new models, such as TradeWeb, BrokerTec and eSpeed, all offering the customers more information, and more power.

The primary dealer community still retains many advantages, not least of which remains the ability, indeed the responsibility, to bid at government auctions. But – and this is important for the analogy to the FX markets – a significant proportion of the market-making and liquidity provision function that goes on within the government markets, on the exchanges and within the BrokerTec and eSpeed communities now happens outside the primary dealer fraternity. Borrowing on technology, analytics and engineering developed by the equities and statistical arbitrage space, a range of new participants have taken on the full-time role of providing bids and offers, at multiple liquidity depths, all day long, to all takers. These participants range from prop shops that have been set up with the express aim of providing liquidity and earning the bid-offer “rents” that attach to that economic function, to hedge funds that in an increasingly competitive return-seeking world have internal sleeves set up to capture market-making rents as alpha strategies.

These same forces are buffeting the FX markets. The proliferation of platforms and liquidity pools, the advances in technology and system engineering, the increasing ability to separate the credit provision from liquidity provision – and to provide and price those services differently – are all contributing to the rapidly gathering gale. And within this maelstrom there is no question that the old rules have been broken through a deliberate and planned exploitation of individual bank shortcomings by certain market participants who have been able to take advantage of this fluid environment, to the annoyance of the professional bank market. Clients whose activities are predatory or violate established canons of professional behaviour should and will be countered – by either their liquidity providers or their platform hosts, or both. Indeed there is significant anecdotal evidence that such market self regulation is already making itself felt.

As Lee Oliver points out, much of the problem stems from the existence of too many platforms, too many pools of liquidity, all with different processes underlying them, streamed to by the finite number of banks that have even the rudimentary technology to support such activities. The fact is that the technology and the systems engineering involved in streaming these prices, the latency rates, and proximity to pricing hubs remain a complex cocktail, the menu for which many nimble, specialist market participants have proven more adroit at mixing than many of the major banks, who remain lumbered with large legacy technology infrastructures. Those that have accomplished excellence in this will continue to sponsor fragmentation, seeking to create virtual consolidation within themselves.

This will change as banks adopt many of these superior practices, either through a build or a buy strategy, one example of which we have seen in recent weeks. Finally, the sheer numbers of pools of liquidity should begin to diminish, as the inevitable process of aggregation and roll-up among these upstarts with less than bullet-proof business plans begins to gather steam.

To properly analyse the thesis of your article, these more temporary, tactical developments should be analysed separately from some of the main structural undercurrents of market development, the most important of which is the emergence of non-bank liquidity providers. Just as has occurred in other asset classes, such as equities and fixed income, the FX market, in my view, will increasingly witness and take advantage of sources of market making and liquidity provision that originate from non-banks.

The few bad apples – snipers and latency bandits – that the market is tussling with at the moment, will weed themselves out. But it is mistaken to expect any group of banks, per se, to ever again solely own the provision of FX liquidity. History has moved on, I am afraid.

Peter Nielsen
Managing director
Global head of FX, treasury & investor products
Global banking and markets

Royal Bank of Scotland


Do the big FX banks need a new platform? December 2005

Answers to the FX Problem  January 2006



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