Special Feature: Have Reuters and EBS lost control of FX?
The limited effects of a system breakdown at EBS suggest the two interdealer brokers no longer dominate FX price discovery. They had better watch out, there’s a new market paradigm on the block and it is hungry for their lunch. Lee Oliver reports.
IN A RECENT article for Euromoney’s weeklyFiX, Mark Warms, general manager of FXall’s European operations, highlighted the fact that many participants in the foreign exchange market believe that a new trading paradigm is starting to emerge. Does this mean that Reuters and EBS are losing their dominance in price discovery?
Until recently such a suggestion would have been summarily dismissed. The consensus was that although numerous viable trading platforms exist, ultimately they all depend on Reuters and EBS. The two electronic interdealer brokers have been routinely described as the market’s hubs, with every other platform effectively spoking off them. Pricing on every other platform was little more than a variation on the rates shown by the two brokers.
But a big system outage suffered by EBS in early March is evidence that a new market model is rapidly emerging. Such an event would once have resulted in a general loss of liquidity and a widening of prices but on this occasion some platforms, including those at the retail level, carried on working as if nothing had happened.
As Tim Cartledge, co-head of Barx FX trading, says, this might well be because there are now so many viable alternatives to EBS and Reuters. “In the past, if EBS or Reuters went down, there were real problems in pricing,” he says. “I think people have looked for more protection and are connected to other platforms. If it [a system crash] happens now, it has less effect. It still has an impact, but it doesn’t take the whole market down. If a platform goes down, business switches elsewhere. There are plenty of platforms out there.”
Cliff Lewis, chief executive of Currenex, is blunter. “I’m surprised at just how small the impact of the EBS crash was earlier this year,” he says.
Not surprisingly, Dave Rutter, deputy chief executive of Icap electronic broking, of which EBS is part, disagrees, and an incident on September 23 suggests he has a solid point. A rogue order to sell €1 million in euro/Norwegian krone two big figures below the market on Reuters by an institution with a credit rating so poor that no other counterparties could take the offer affected many banks’ auto-pricing. The result was that they resorted to quoting wide euro/Norwegian krone rates. However, the impact would undoubtedly have been smaller in the major currencies and, tellingly, some banks simply screened out the bad price, underlining just how important smart technology is becoming.
Plenty of reasons have been put forward why Reuters and EBS might have lost some of their dominance of price discovery, including the fact that some banks are resentful that both brokers had opened up to a non-bank audience, especially high-frequency traders. Another issue is that while they allow credit screening, all prices on their platforms are theoretically good for everyone. Other platforms, including Currenex, are more flexible with their rules and if a bank decides it does not want to trade with a particular counterparty for reasons other than creditworthiness, it can do so whether or not that player is hiding behind a prime broker.
Cartledge says the issue is that some business is not viewed as friendly by the banks. As a result, they have reduced the amount of hedging they do through EBS and Reuters and a modern version of direct dealing now exists. “We have reciprocal agreements with other banks to show our prices. That can be in a dark pool or through a stream over an ECN [electronic communications network]. But to do that, you have to be able too chose who you can deal with,” he says.
Rutter feels such criticism is harsh. “It’s not fair to say that high frequency traders spoil a market – they can provide valuable liquidity and many of these high frequency traders are actually units of the banks. When we opened the system weworked in close collaboration with the banks when we opened the system up.. We’ve made changes on the system to address any issues and the need for balance between manual and high frequency traders.“
Another issue is that Reuters and EBS do not, as yet, offer fractional pricing, once regarded as a gimmick. According to Lewis that has now changed. “For a long time, the dealers thought that the introduction of decimals was horrible,” he says. “But then they realized that they could jump to the top of the order queue far more cheaply.”
Although these issues are important, the main issue would appear to be the way that many banks are able to internalize their flow. “Internalization has totally transformed the market – that’s the real story,” says Lewis. “It’s inevitable that volumes will be challenged on certain platforms. The inter-bank venues no longer control price discovery.”
The ability to match up buyers and sellers internally has allowed banks to rediscover the art of market-making. “We internalize the vast bulk of our flow,” says Cartledge. “We show tighter prices than the platforms, so it makes sense for us to do that. That impacts on the likes of EBS and Reuters, which have sought liquidity from other participants.”
Rutter recognizes the development. “I think some of the banks have become more astute at internalising their flow and the market has fragmented as a result. The challenge for EBS is responding to this new paradigm. But the question I ask is whether it (the new paradigm) is good for the market in the long run,” he says. “A lot of flow goes through the aggregation engines built by the banks. However we remain at the centre of the FX market and our prices are the benchmark. Perhaps the real question is whether the centre is getting bigger or smaller. When the market is volatile, we see a spike in dealing activity.”
Jas Singh, global head of treasury at Thomson Reuters, expresses similar sentiments. “The big banks are now internalizing a lot of their flow and when the markets are stable, it’s easy to do that,” he says. “When they start to move though it becomes far more difficult. The banks still need to dissipate risk. Our overall volumes have gone down over the past year, but we don’t believe there’s been any change in our market share. We remain a core venue for the market, which is underpinned by our huge footprint and rich history.”
Lewis puts it more bluntly. “There is a completely new market paradigm and it was invented by the banks,” he says. “Where the market goes from here will be led by those same banks. There are now three choices for platform providers: operate as an IT company; work as a cooperative or mutual; or compete with the banks.” He adds that if you want to know what the market’s structure will look like, you need to ask its main liquidity providers.
“Banks are internalizing flow by using robots and then something like 20% of their business goes to a hedging outlet that’s no longer necessarily the interdealer broking platform,” Lewis says. “The robot wants to know its fills and it wants rapid information as well. The big banks are in the exchange business and compete with Reuters, EBS and Currenex.”
Another senior market figure is even more forthright, and although he declines to have his comments attributed, they will no doubt strike a chord with many FX players. “The brokers have failed to realize that the banks are eating their lunch. Their typical solution is to say: ‘Let’s organize a piss-up’.”
This is harsh. It suggests that it is not just the technology of Reuters and EBS that may be stuck in the past. But history has shown that, when challenged, the incumbents in any market fight back, at least once they realize they are under threat. And Rutter is under no illusions. “We’re not immune to the fact that the markets are changing,” he says. “We have invested in our technology and we’re no longer a closed system. The platform is much faster, it shows the order book and in some ways this has made it easier for the other platforms to exist. We’re in interesting times but we won’t be pushed into reacting to every development. We have to remember that we are there for the benefit of the whole market. We have to operate a fair, equitable market.”
Although it is too early to report the demise of Reuters and EBS and the emergence of a totally new market paradigm, the two brokers are clearly facing a degree of competitive pressure that was unimaginable until recently.
“We’re certainly in a different place now than where we were three or four years ago,” says Cartledge. “Back then, EBS and Reuters could both say they were the market. But to get a correct view of the overall market now, you can’t just look at those two venues. We’re on a journey where we could end up with eight or so major trading venues that are all as important as each other. These could be a mixture of ECNs and bank platforms.
“You can’t say any more that there’s just one ECN for the whole market. There’s not going to be one dominant player any more and platforms have to work out which niche they are catering for.”