Consolidation, fragmentation and segmentation
The advent and growing sophistication of algorithms means that the pooling of liquidity can be done virtually, so why bother concentrating it on a venue that is widely loathed and could develop into a monopoly?
A few years ago I wrote what I thought was a clever article about the fragmentation of a consolidating market. In it, I tried to explain the contradiction of how more trading venues were springing up in the FX market at the same time as widespread consolidation was reducing the number of banks active in it. I argued that fragmentation was a major reason why the FX market revived and started to grow after a period of what appeared to many as almost terminal decline around the turn of the millennium.
Looking back, it now seems clear that the predictions of many – that the market would move towards an exchange model – were and remain wrong. The FX market has refused to centralise and it has continued to thrive in an extremely fragmented structure. Now, there seems to be a growing consensus that the market will never move on to a single exchange; but rather than talk of fragmentation, participants are starting to describe the market as being segmented. In other words, the numerous venues that already exist and which have yet to see much of the light of day may well continue to thrive because they all provide slightly distinct services tailored to meet the needs of a particular market segment.
The acceptance of segmentation was perhaps the main theme to emerge at a recent seminar I attended in London hosted by BT Radianz. It was meant to be about the impact of algorithmic trading in FX. It had a well-balanced panel consisting of Deutsche Bank’s Ian O’Flaherty, FXall’s Mark Warms, the CME’s Derek Sammann, EBS’s Steve Toland and Damian Mitchell, an old mate of mine from Midland Bank who has gone on to better things and is now running Dsquare, his own trading boutique. I did joke after the event that I taught him everything he doesn’t know.
The seminar was good but sadly it developed into what I can only describe as a ‘love-in’. The moderator was far too nice and the panel lacked a rottweiler-type character to rip things apart. Naturally, I asked a question to try and rev things up a bit, but it was pretty tame. I don’t know if my incisiveness was blunted by the superb setting at the Law Society, or whether I got caught up in the overall feeling of niceness that had pervaded the atmosphere.
Basically, I asked if there was really any room in the market for multibank portals. I was going to pose this to FXall’s Mark Warms, but for some reason he looked really unwell and I thought that if I picked on him too much, he’d have a heart attack. So I took a circuitous approach and asked Ian O’Flaherty if, given the fact that the banks are trying to drive client business on to their own portals, he saw the need for the likes of FXall.
Ian had earlier explained at some length how difficult it is to define liquidity and he admitted that pricing it properly was even harder. I was hoping that he’d say that the only way the banks would be able to do this would be to limit where they streamed their prices to. But he is far too savvy to fall for such a blatant attempt to stir things up and he fended the question off easily – and offered Mark a pretty easy way out of it too. Horses for courses was the conclusion, which is a colloquial way of explaining segmentation.
Afterwards Mark asked me why I was always so nasty about FXall. Me, nasty? Surely not? I think he was joking, but by this time I had begun to think his ruddy complexion was caused by anger, so I beat a swift retreat to find myself a tonic water.
FX and the equity model
Naturally, if you’re going to a talk about algos, you will hear about the impact they have had in FX. But as ClientKnowledge stated in the paper, e-FX at critical speed, it produced for the seminar, there are a couple of couple of ‘facts’ that people seem to have accepted about FX that are not necessarily true. These are that banks are about to be disintermediated and that FX is about to embrace an equity-type model and move on to an exchange.
I agree with ClientKnowledge’s rebuttal of these facts and think it is worth making a few more key distinctions about the equity and FX markets. First, the equity market is minute in comparison, and what liquidity there is split between thousands of issues. It is a fallacy to argue that the market is more efficient than FX. Spreads are much wider, liquidity is shallower and dealing costs are far higher, even though activity is often concentrated on a single trading venue.
The first electronic trade may have happened in the equity market before it did in FX – I’ll have to look that up some day – but it did not embrace this new paradigm as early or as whole-heartedly as the spot FX market did. In fact, in many cases the equity market has remained anachronistic and many exchanges have had to be dragged kicking and screaming into the 21st century. Maybe the reason why algos have had such an impact in equity markets is because they were needed in such an inefficient environment – users have had to search out often hidden liquidity to get a better fill. FX, in comparison, is a relative model of efficiency. It’s not perfect, but it’s not bad.
As for FX imitating equities in the future; in Europe at least there is a very real chance that the opposite is going to happen. The talk is all about the equity markets fragmenting, not consolidating, in the post-MiFID market place, because the bigger sell-side players are not happy with how the markets developed after the incumbent exchanges became for-profit organisations. Of course, there is also the odd moan and groan about various trading venues in FX, but it all seems to be handled so much more amicably. The advent and growing sophistication of algorithms means that the pooling of liquidity can be done virtually, so why bother concentrating it on a venue that is widely loathed and could develop into a monopoly?
FXMarketSpace launches not with a bang but a whimper
FXMarketSpace officially went live this week after its soft launch a few weeks back. Most of the market’s great and the good have officially signed up to play in what the company itself describes as: “The world’s first centrally cleared, global foreign exchange platform for the over-the-counter market.” Much has been made about this “major evolution in the FX industry.”
Of course, it is far too early to judge if FXMarketSpace is going to be a success and revolutionise the market. So far, the company is declining to release its volume figures, which I did think was a little opaque for an organisation that is busy trumpeting transparency. In all honesty though, this is really me just nitpicking and looking for a cheap shot.
“Volumes are increasing day by day, but obviously we recognise that we have only just launched and it is still early days. We have always supported transparency and we plan to provide volumes to the market in the next few months,” Jake Smith, its VP and head of marketing, told me on Wednesday.
“At this point we are not disclosing the number of customers trading, but obviously we had what we believed was a critical mass for launch. Already this week we have added six more live customers,” he added.
FXMarketSpace’s management team are not the sort to go shouting from the rooftops, so I’m not surprised by the low-key approach it’s taken for its launch. Of course, it would have been more fun if it had hired the walls of Big Ben at Westminster for the day and run up slogans like: “EBS, your time is up,” or something similar.
But that was never going to happen. Both the CME and Reuters, FXMarketSpaces 50/50 owners, have indicated that they are in it for the long haul, and business projections have claimed that the platform will only have to capture a modest market share to be viable. Other trading venues will be keeping a very close eye on things, no doubt.
Any new platform launched now has to have a unique offering if it is to have any chance of success. By using a genuine central counterparty (CCP), FXMarketSpace arguably does, although I’m no longer sure of what particular segment it is targeting.
The platform has had a few difficulties getting its full value proposition established, most notably the refusal of CLS to accept pre-netted trades. This may change and the use of a CCP could become increasingly important in the Basle II environment, but how the big players will react to having so much money tied-up in a single, US-owned and -based CCP remains to be seen. If the CCP concept does prove a winner – which at the moment is a very big if – it will force other platforms to rapidly adopt the same model. This is not an impossibility. There are other CCPs out there who would love to get a chunk of the FX pie and who will have had at least preliminary discussions with the likes of EBS.
We do what it says on the tin
There was I thinking that the end of voting in this year’s Euromoney FX poll would lead to a natural reduction in the stupid requests we receive from the hapless PRs that scavenge a lucrative living on the periphery of the business. But no.
Many have noticed that Euromoney’s May issue will have a feature on FX, funnily enough to coincide with the publication of the results. I will probably do something about how market participants see the FX industry developing. Naturally, we will also have a write up of the poll itself. Surprisingly – for some people – it will be about the poll.
“Could you please send me the synopsis for the feature you are doing in May on ‘Foreign exchange poll results’. Any further information you could provide would be great,” one poor thing wrote in an e-mail to my esteemed editor. Here’s a very big clue, Susie: it will be about the poll. This could be the winner of our ’mare of the month' award, if it existed.
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Lee Oliver can be contacted at firstname.lastname@example.org.
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