In 2015, the surprise was the sudden decision by the Swiss National Bank to abandon its currency floor with the euro. In 2016, it was the UK’s vote to leave the European Union, closely followed by the election of Donald Trump as US president.
These unprecedented economic and political shocks caused gyrations in the global foreign exchange market, sending currencies into free fall and leaving some firms nursing heavy losses.
By contrast, 2017 was much more peaceful. There were no large-scale shocks leading to sudden intra-day moves and bleary-eyed traders pulling all-nighters. One could be forgiven for thinking that concerns over the market’s fragility can now be laid to rest.
But scratch below the surface and questions remain over whether or not the industry has really dealt with the structural issues that led to the shocks of recent years. Big risk events and flash crashes may happen rarely, but they are an important test of a market’s resilience to stress. When currencies swing very sharply, a certain depth of liquidity is needed to absorb those moves and allow firms to unwind positions.
The FX industry has been through some structural changes over the last five years that have affected liquidity not just during times of high volatility but also day-to-day in certain currencies and products. Tougher capital requirements have constrained banks’ risk-taking capacity, while the benchmark scandal and subsequent introduction of the FX Global Code have introduced a new era of heightened transparency and surveillance.
Non-bank market makers such as Citadel Securities, XTX Markets and Jump Trading have stepped up to operate alongside the dealers that once dominated liquidity provision, but buy-side firms are finding that prices are not always as firm as they might seem. Some platforms boast about their reliable provision of prices on both a disclosed and anonymous basis, but market makers cannot always be relied upon to make good on their quotes.
“At first glance, quoted spreads in the spot market appear to be extremely tight, but the extent to which the apparent liquidity is available when one needs to access it is more limited,” says James Wood-Collins, chief executive of Record Currency Management. “The main risk this creates for participants is that bids are pulled very quickly and there isn’t the depth of liquidity at the prices being quoted.”
The issue of non-firm pricing is something the Global Foreign Exchange Committee might have hoped to tackle through the execution principles of the code of conduct, but it remains an issue that the buy side cannot always control. If volatile market conditions in particular currencies drive market makers to pull their interest, liquidity immediately falls away.
“When you only have one trade to do, spreads are as tight as they ever have been and costs haven’t increased; but if we were to do sequential trades, it would become much harder and we would be more wary about how our counterparties are filling the order,” observes Nathan Vurgest, senior trader at Record Currency Management. “Cable has been particularly challenging recently for depth of liquidity as it trades almost like an emerging-market currency pair.”
Given the volume of flow that is now internalized by the largest dealers – some reckon the proportion could be as high as 85% – the business that runs through the big trading platforms is not representative of the whole market, but it remains the best available monthly barometer of trading volume and liquidity.
Thomson Reuters saw a marked fall in FX spot volumes on its platforms last year, with average daily volume dropping 10%, from $99.8 billion in 2016 to $89.8 billion, during the year to October 2017.
Spot volume on the EBS platforms has fallen less abruptly, with NEX Markets reporting average daily volume for the year to November 2017 at $84.2 billion, down marginally from $85.8 billion in 2016. In some months, including August, September and October, its volume grew quite a lot on the year.
“We have had some busy days over the past year, but not on the scale of the market dislocations of 2015 and 2016,” says Tim Cartledge, global head of FX and head of product at NEX Markets. “As we return to a more predictable macro environment, with central banks stepping back from quantitative easing and raising interest rates, that should create opportunities for carry plays and more portfolio rotation, which will boost market activity.”
While the EBS and Thomson Reuters platforms have delivered innovations in recent years in a bid to hold onto market share in changing market conditions, new platforms have also appeared. It is now becoming clear which ones look most likely to stand the test of time.
FastMatch, an FX electronic communication network (ECN) that was acquired by Euronext in 2017, achieved an average daily volume of $12.7 billion in 2016, with a particularly busy day after the Brexit vote when its volume rose to $39.8 billion. In the year to November 2017, average daily volume increased to $18.6 billion, highlighting the potential for new platforms to grow market share even during times of low market activity.
Meanwhile FXSpotStream, a disclosed, bank-owned platform that launched in 2012, has seen average daily volume increase from $18.2 billion in 2016 to $19.4 billion in the year to November 2017. Its busiest day was after the US elections in November 2016, when it traded $49 billion.
Alan Schwarz, chief executive of FXSpotStream, believes that while liquidity used to rise on anonymous central limit order books during times of market stress, recent events show that participants now recognize the benefits of relationship-based trading.
“Since the SNB event, we have seen an unmistakable shift from non-disclosed to disclosed trading venues as market participants became more concerned with costs, risk and market impact,” says Schwarz. “Anonymous venues still have their place, but traders increasingly want to know who is on the other side of the transaction.”
It is a view shared by Yaacov Heidingsfeld, president and co-founder of TraderTools, a New York-based technology provider that specializes in relationship-based pricing and the management of aggregated liquidity.
As the buy side has become more sophisticated and liquidity has at times become scarce, he has seen a gradual shift towards disclosed trading.
“Transparent relationship-based pricing has certainly gained favour in this environment, but there is also a need to pair it with robust liquidity management,” Heidingsfeld says. “Market participants need to see where the best price is coming from and understand the decay associated to be able to sustain reliable liquidity. Dark pools from anonymous ECNs cannot provide this ability and therefore prices are worse than transparent disclosed relationship pricing.”
Incumbent platforms have not been blind to the rising popularity of relationship-based trading. EBS launched its disclosed platform, EBS Direct, as far back as 2013, amid a string of other initiatives to support its diverse user base. While NEX Markets does not publish separate volumes for its individual platforms, EBS Direct has clearly become a core component of its business, with more than 50 liquidity providers making prices in G10 and emerging-market currencies, as well as precious metals.
But NEX has also continued to invest in its anonymous central limit order book platform, EBS Market, which must strike a prudent balance in catering to the requirements of both bank and non-bank liquidity providers.
In early 2017, the new EBS Live Ultra data feed was further enhanced to deliver spot FX data at five millisecond intervals – complementing the 100 millisecond and 20 millisecond feeds. The move has been central to the investment NEX has made in the anonymous platform over the last year, which, according to Cartledge, is now beginning to pay off.
“We have seen a resurgence of interest in EBS Market and have done a lot of work to improve our technology, market data access and user experience,” he says. “Spreads on the platform are now the tightest that they’ve been in history, with no diminution at top of book. We also plan to launch last-look analytics for EBS Market to show the cost and impact of last-look rejects, so that clients can make more informed decisions on last look.”
The greatest challenge for any platform, whether a new entrant or incumbent offering disclosed or anonymous trading, is to deliver pricing upon which firms can rely in all market conditions. That is a challenge that some believe has become much more difficult over the last 12 months, despite the relatively peaceful environment.
“Both banks and non-banks are being much fussier about what prices they’re prepared to make and to whom, and liquidity is therefore much less sustainable than it was a year ago,” says Heidingsfeld. “Everybody is fighting for the same business, and everybody is having a much harder time making money. There is also much less volatility in the market today; I think we will see further contraction in volumes.”
Schwarz believes the banks continue to play an invaluable role in liquidity provision, despite the regulatory constraints. It is telling that the platform’s liquidity provider base has grown to 13 large banks in just over five years – State Street became the latest bank to join in 2017.
“All of our liquidity providers continued to price through Brexit and the US elections – the banks maintained a presence in times of stress,” says Schwarz. “The non-bank space is still in flux – several firms have found it is not as easy or cheap to be a market maker and hold inventory as they might have thought.”
Many liquidity providers are struggling not just with their own regulatory constraints and challenging market conditions but also with the increasing demands of buy-side firms for more sophisticated execution.
The need to evidence the pursuit of best execution has given rise to more granular analytics and greater transparency on how orders are being handled, which has in turn shone a light on inefficiencies in trade execution.
“There has been a greater focus on execution quality over the past year, as liquidity takers measure their liquidity providers and try to better understand what they’re doing,” says Citadel’s Kimmel. “There is much more dialogue on execution quality and the dynamics of liquidity provision.”
While such scrutiny and dialogue may be a positive development for the market as a whole, it also means there is less tolerance for wide pricing or high costs if a better result can be achieved by slicing up an order or using an algo execution strategy.
With the advent of the recast Markets in Financial Instruments Directive (Mifid) in Europe, firms now have a legal obligation to undertake detailed execution analysis and secure the best result for investors.
“As the execution tools available to clients and dealers to take some of the execution risk become more prolific, there is less willingness to transfer risk at traditionally wide prices,” says Scott Wacker, global head of e-commerce sales and marketing at JPMorgan. “Many firms now want to work trades gradually in the market on a passive basis, which has systematically lowered execution costs and worked well with the lower volatility environment we have seen over the course of the year.”
At Record Currency Management, Wood-Collins is committed to achieving best execution, whatever the cost: “As we owe fiduciary duties for best execution to our clients, we are very sensitive to how we undertake transactions and try to leave as little market footprint as possible. If we can aggregate smaller transactions and split up larger ones to achieve better results, we always will do.”
In cases where a large order needs to be transacted in a currency pair that may be prone to illiquidity, buy-side trading desks are likely to give greater consideration to their choice of counterparty, as this could greatly impact the price and quality of execution.
In some emerging-market currencies, for example, where there may be fewer buyers and sellers than in G10 pairs, one would want a liquidity provider with a proven track record in making firm and tight prices. This is an area where Citadel Securities has been focusing on building a deeper book of business in recent times.
“In emerging market currencies, we consistently hear from clients that it can be difficult to find deep liquidity, even in normal market conditions,” says Kimmel. “Executing in larger size can be particularly difficult, which is why we see more liquidity consumers using algos that take top-of-book liquidity in small sizes throughout the course of the day.”
The provision of algo execution tools may be one value-added service that a liquidity provider can use to attract clients, but high levels of internalization could be another. While matching flow within a dealer’s own internal liquidity pool offers benefits to the dealer, it can also be a boon to currency managers that have a large order, or series of orders, and want to avoid market impact.
“Concerns over liquidity definitely affect our choice of counterparty, because if we were to have a series of sequential trades, we’d prefer not to send them to a bank that will immediately throw the flow out to the public market – that could impact the price,” says Vurgest of Record Currency Management. “A bank that is a strong internalizer and can hold the flow for longer would clearly be preferable in those circumstances where we have more volume to transact.”
Rising volumes of internalized trades may not be good news for the operators of central limit order books, however, as it threatens to erode their own business. But NEX’s Cartledge claims not to be worried.
“Larger trades still tend to go through the central limit order book, particularly during times of high volatility,” he says. “It is a greater struggle to be profitable as a market maker these days and there is not sufficient money being made to withstand big losses in stressed market conditions. Internalization is not new, but rates have certainly been growing among the major dealers.”
From the further development of internalization and the transition towards greater use of disclosed trading platforms to the rising sophistication of the buy side and a willingness to try out new execution strategies, it is clear that FX trading practices are continuing to evolve.
Whether or not these trends will help to protect market participants from the impact of further dislocations in the future remains to be seen. There is no doubt that while FX remains a relatively liquid market, it cannot be relied upon in quite the same way that it once was. Whether it happens regularly or only during extreme market conditions, firm prices will not always be available when they are needed.
“The FX market still offers unparalleled liquidity and flexibility, with very low transaction costs and reliable pricing,” says Wood-Collins. “But to access those benefits, one needs to fully understand the market dynamics and capabilities of the various price makers in different instruments and plot an execution strategy accordingly.”