While a single bank may offer a less competitive price than an ECN (electronic communication network) for any given pair at any given time, taken as a group banks overwhelmingly and consistently offer a better price for liquidity, Pragma says.
Pragma reported having found only three instances of multiple banks ceasing quoting during periods of high volatility in 2015 and 2016: the de-pegging of the Swiss Franc in January 2015; the extreme volatility of theNew Zealand dollar in August 2015; and the sterling flash crash in October 2016.
For a market that is open 24 hours a day, for five and a half days per week, and in a period that has been characterised by significant political turbulence – especially in Europe and the US – that is surprisingly consistent.
Pragma concluded that events in which banks actually stop providing liquidity are exceedingly rare, and tend to be “due to operational and technical issues that do not reflect an intentional withdrawal of liquidity.”
The depegging of the Swiss franc was by far the most extreme of the three instances and it took six months before liquidity provisioning by banks returned to normal levels, says Pragma. In the other two instances, liquidity was only affected for around a week.
Mark Meredith, global head of FXLM electronic trading at Citi, describes the Swiss franc de-pegging as “a paradigm shift for the FX industry,” forcing market participants to consider the most extreme risk scenarios.
“Against that background, the Brexit vote was a good illustration of changes in the market in the intervening 18 months: prices did not gap and liquidity providers serviced clients continuously throughout the event,” says Meredith.
But another way of looking at these events is to measure how well they were signalled in advance. The three episodes cited by Pragma all took the market by surprise, whereas subsequent shocks like Brexit and the US elections were events institutions had time to prepare for. The real test will therefore be how liquidity holds up in the face of the next unexpected shock.
Curtis Pfeiffer, Pragma
Bank for International Settlements figures show that banks still account for 43% of spot turnover in US dollars in 2016. While this is down from 53% in 2004, it still constitutes the lion’s share of the market, and has held steady at around 40%-45% of the market since 2007.
While there has been a narrative for some time in the market that banks are withdrawing FX liquidity due to factors like a reduced appetite for risk, increasing cost of capital and the juniorization of dealer staff, these findings show that trend has been overdone.
Kevin Kimmel, global head of eFX at Citadel Securities, says he expects the proportion of client volume being done by banks will continue to remain relatively stable. “However, if you look closer, you can see that banks are beginning to expand their partnerships with non-banks. A good example of this is in algorithmic execution, where in some cases non-banks have become significant sources of liquidity for the bank algo products,” he says.
Tough times for liquidity
Meredith argues a confluence of factors have deepened the liquidity challenge in recent times, including the move towards higher frequency market data from the primary markets and the subsequent impact on market data update frequencies on other platforms.
For FX traders, that has reinforced the need to ensure access to as many sources of liquidity as possible. No one institution consistently posts the best price, and any individual institution can be caught out by sudden bouts of volatility, depending on the bank's inventory, the nature of the market volatility in question and other factors. Plugging into a variety of liquidity providers maximises the chances that if one cannot offer a competitive price, another provider will.
Banks, meanwhile, are desperate to ensure that when such problems arise, it is their competitors, and not themselves, that are affected. Disruptions carry significant reputational risk, given that consistency is a key reason they see repeat business. Letting down clients in periods of extreme volatility – when they are most in need of orderly markets to manage their own exposures – risks damaging that business relationship.
Breaks also limit the bank's ability to manage its own exposures, which is particularly important for market makers, and insufficiently sophisticated systems can leave banks taking on greater levels of market risk than intended.
Banks therefore see stress scenarios provide a useful real-world exercise that highlights where they need to bolster safeguards – though they also stress that their systems and processes are always under review, and are not only refined in response to crises. Heightened volatility exposes any hidden technological or operational issues, such as systems built with sufficient capacity to handle a spike in orders, or reconciliation processes that are not robust.
Meredith says the challenges around providing uninterrupted liquidity span all the different types of risk that the bank looks to manage. “While market risk springs first to mind, ensuring our systems can cope with the additional operational load is also crucial. To achieve this, high quality low-latency software must be delivered to price, manage risk and book electronic flows, which can be stress-tested in advance against high-load scenarios. This is a requirement of both our risk-taking desks as well as our prime brokerage business,” he says.
The human touch
Most market-making banks have therefore invested in all aspects of their liquidity provision systems, regardless of whether they were caught out by the sterling flash crash or Swiss franc peg debacle. This may have entailed increased spending on hardware, operational risk management, quantitative risk management or all three.
It also means continuing to invest in what may be seen as “old fashioned” systems, such as voice broking.
Kevin Kimmel, Citadel
Richard Bibbey, head of FX cash trading and risk management at HSBC, says: “Banks have other avenues through which to provide pricing and liquidity to clients. When it becomes difficult to offer prices electronically we are able to fall back on our voice business. While machines have advantages over humans in some situations, humans are better than machines at dealing with these kinds of events.”
Richard Anthony, head of FX eRisk at HSBC, adds: “There is a popular misconception that activity is the same thing as liquidity. There are large non-bank traders that are prevalent, particularly in anonymous venues, but they are not necessarily providing liquidity to clients in the way a bank does. Banks tend to have larger risk appetites than non-banks and are able to internalise flow in a way they can't. HSBC for example has internalisation rates as high as 90% in some currencies.”
Meredith also stresses the importance of its voice trading desks in serving clients in periods of volatility, as well as its balance sheet that enables it to warehouse risk.
Taken together, it suggests banks remain well placed to continue dominating the spot FX market.
Curtis Pfeiffer, chief business officer at Pragma, says: “I expect the share of FX liquidity provided by banks to remain relatively stable going forward, and possibly increase as they continue to provide better trading tools to their clients. I certainly don’t expect them to lose market share. As our research shows, in aggregate, they offer tighter spreads than ECNs.”