At one of the world’s largest FX banks – housed in a Canary Wharf tower block – the feeling of tradition and convention begins with the lengthy check-in and security procedures on the ground floor. Six floors up, in an airless meeting room, senior FX traders are talking up their business. It’s all about innovation, client service and efficient business models, they say, but the shadow of recent scandal-ridden years lurks like a silent elephant in the room.
Seven miles to the west, in London’s hip King’s Cross district, startup market maker XTX Markets is keen to show off its fashionable new digs. From a life-size replica of the Apollo 11 landing capsule to its airy trading floor and dazzling designer furniture, everything about this modern office screams of the company’s intention to get as far away as possible from a tired old world of banking.
Are these the true fault lines around which the reinvented foreign exchange industry is being drawn in 2018? As it enters a new era, seeking to consign the benchmark scandal and remediation measures to history, is global FX now about the plucky, tech-driven upstarts fighting the conventional, cash-strapped banks for market share?
The reality, says XTX co-chief executive Zar Amrolia, is more nuanced than this. The number of banks and non-banks that can provide liquidity across a broad range of currencies, products and geographies is shrinking. Some of the non-bank liquidity providers that had threatened to overturn the status quo have already scaled back their ambitions, while many banks are retreating to their core competencies.
“The distinction between banks and non-banks is superficial,” says Amrolia. “There are banks that provide valuable liquidity and banks that don’t, just as there are non-banks that won’t hold risk and those that will. We believe a speed-driven business model will be shown to be unsustainable because of the high investment in technology that is required, rather than what we have done in building our alpha capabilities and our capacity to hold risk.”
The banks, too, will freely admit that it is becoming much harder to be an all-singing, all-dancing FX powerhouse with dominant market share. Rising regulatory burdens, conduct risk, increased transparency and shrinking balance sheet capacity have all contributed to the growing pressure on banks, which has in turn reduced the number of full-scale FX houses making markets across all currencies, products and geographies.
“Revenues, rather than volumes, have concentrated in the top-tier banks,” says Frederic Boillereau, head of global FX and commodities at HSBC. “Margins have been compressed, pricing is more transparent and it has become increasingly challenging to run a large FX business. You have to do massive volume to make significant revenue, while also ensuring you deliver a consistent and efficient service to clients everywhere.”
For those banks without the capacity to maintain a full-scale FX business, there has been a gradual retrenchment to core competencies. Those banks that have historically specialized in particular areas – a certain currency, region or client type, for example – are narrowing their focus to that particular area, while others may seek to carve out new niches.
“Beyond the top 10, regional banks are focusing on their home markets and doing what they do well. The focus at Deutsche Bank continues to be quality over quantity and ensuring we add value for clients through our strengths in electronic trading and derivatives,” says Russell Lascala, co-head of FX at Deutsche Bank.
Consolidation of market makers may not be a bad thing for the industry, of course. It might reduce the profit banks can make from their FX franchises, but it does not necessarily reduce the overall depth of liquidity or the quality of pricing.
And while buy-side firms benefit from a competitive sell side, it may be easier for them to navigate an industry in which liquidity providers have clear specialties rather than claiming to support every type of flow.
More broadly, however, the industry is still struggling to shake off the burden of recent challenges. Following years of crisis, scandal, regulation and remediation, it had seemed that 2018 might mark a turning point.
The FX Global Code is now a year old and has been widely adopted on the sell side, while the recast Markets in Financial Instruments Directive (Mifid II) is finally in force, ending a chapter of intense work on conduct and regulation.
But even with some punchier price moves and an uptick in volatility at the start of the year, the industry is not yet out of the woods.
Fines for market manipulation continue to trickle in – HSBC agreed to pay $101.5 million in January to settle a US Department of Justice investigation, while former trading chief Mark Johnson was jailed in the US for two years in April after being found guilty of fraud. Such developments have cast a fresh shadow and dampened morale in the FX industry, which is still struggling to get back on its feet.
“It would be great to put the challenges of recent years behind us, but we are not there yet,” says Geoff Kot, head of FX cash Asia at Standard Chartered. “Mifid II remains a large and complex regulation that the industry is still struggling to implement; conduct issues are being tackled differently across the world; and realized volatility in FX remains relatively muted by historical standards, which has exacerbated the decline in volume.”
Over the course of recent years there has been a clear pattern of declining market turnover, punctuated by sporadic high-volume days after large risk events.
Average daily volume globally fell from $5.36 trillion to $5.07 trillion between 2013 and 2016, according to the Bank for International Settlements triennial survey. But notable volume spikes took place after the Swiss National Bank’s removal of the euro/Swiss franc floor in January 2015, the Brexit vote in June 2016 and the US elections in November 2016.
During 2017, however, there were no such big-ticket days, and many banks battled with scarce resources as they prepared for Mifid II. Average daily spot volume on EBS, now part of NEX Markets, fell to its lowest level on record in 2017 at $82.6 billion, while Thomson Reuters’ average daily spot volume fell from nearly $100 billion in 2016 to $90 billion in 2017. These volumes do not represent the entire FX market of course, but they are a strong indicator of a broader decline in turnover.
“There is a lot more political risk driving markets now, and intellectually it is a more stimulating time to be a trader than when we mainly tracked central bank policy moves,” says James Hassett, global head of FX trading at Barclays. “There is now more impact from real world events, especially in emerging market currencies, which are becoming more idiosyncratic, but volatility hasn’t increased in 2018 in the way we might have expected.”
Deutsche Bank’s currency volatility index, which takes the daily pulse of FX volatility, had recorded a long-term average of 9.5% since 2015 but fell sharply last year and still averaged only 7.72% between January and April 2018, in spite of more positive market sentiment.
“Last year was one of the worst on record for FX,” says Chris Purves, head of FX, rates and credit strategic development lab at UBS, “with low turnover, the shadow of the FX fines and a big drain on resources from Mifid II. But 2018 feels a much more normal year, with volumes returning and greater confidence across the market. I don’t see any reason why this should slow down. We can expect FX to continue to grow from here.”
Standard Chartered’s Kot is less optimistic: “The volatility we have seen in equity and credit markets may yet creep into FX, but we are in a world where global growth has been steady, while monetary policy is generally well flagged and fairly synchronized. That doesn’t lend itself to investment opportunities. What volatility we have seen is generally driven by idiosyncratic event risk.”
As the UK edges closer towards its exit from the European Union in March 2019 and US politics continue to be unpredictable and volatile, further idiosyncratic risks are sure to unfold in the months ahead. But there does appear to have been an uptick in buy-side activity this year, perhaps driven in part by greater certainty after Mifid II, which may yet drive volumes higher.
“The year has got off to a very good start and, as the macro environment is changing, volatility is coming back to the FX market in a good way,” says Nadir Mahmud, global head of FX and local markets at Citi. “This means our clients have portfolios to restructure and rebalance and FX hedging to do. Their priority is mainly to transact in a cost-efficient and transparent way with minimum manual intervention.”
For those liquidity providers that remain committed to the FX market – whether on a global or regional basis – the priority, as ever, is to ensure a sound balance of strong technology, experienced personnel and a forward-looking strategy that takes full account of ongoing changes in market structure.
That means continuing to invest in the business, hiring the most talented traders and salespeople and developing new technology, even when costs are rising and balance-sheet resources are scarce. The race to be the fastest price maker is certainly not as acute as it once was, but liquidity providers must stay on top of their technology to remain competitive.
Only a few years ago the largest banks competed on the strength of their single-dealer platforms, but with the implementation of Mifid II and the greater quest for transparency, there has been a transition towards multi-dealer electronic communication networks (ECNs) and aggregated liquidity. As single-dealer platforms do not reveal their turnover, it is not possible to quantify this transition, but even the banks acknowledge it is happening.
“The shift from single-dealer platforms as the primary execution channel to multi-dealer ECNs started four years ago and keeps gathering momentum, driven by the need to demonstrate prices have been sourced competitively,” says Citi’s Mahmud. “Multi-dealer platforms guarantee tight pricing, which provides an economic incentive for clients.”
Citi was a bank that invested heavily in its Velocity platform in recent years, while it was not very long ago that Deutsche’s Autobahn, together with Velocity and Barx, were expected to be the platforms of the future. Mifid II has not sounded the death knell for these single-dealer platforms altogether; most practitioners recognize they still have a part to play in FX trading, though it will be in a more limited way.
“There continues to be a role for the single-dealer platform, but, as with the transition from voice to electronic, we see some clients moving to multi-dealer platforms and aggregation,” says Deutsche’s Lascala. “This does not mean they are removing the single dealer, as the functionality and benefits to the clients are still in demand.”
Much like the consolidation of market makers, reduced concentration of liquidity on single-dealer platforms could be seen as a positive development for the industry, creating a level playing field that allows newer entrants to compete.
It is not specifically the retreat of these platforms that has opened the gate to non-bank liquidity providers – some have now been operating successfully for many years – but such firms have certainly engendered a fresh approach to technology, putting it at the very heart of the FX business.
Beyond its iconic furnishings and fancy gizmos, XTX Markets has continued to gain traction over the last year, with 97 employees and an average daily volume of $120 billion across asset classes. Indeed, its transparency on turnover alone sets it aside from almost every other FX market maker.
Three or four years ago, you would not have seen TCA in FX- Russell Lascala, Deutsche Bank
While Amrolia is the first to admit there will continue to be a role for banks in the future, it is in technology that XTX has really looked to challenge the status quo.
“Great technologists want to work at technology firms, they don’t want to be sat in the back office and treated as a burdensome cost centre,” he says. “XTX is a technology firm doing finance, and our technologists are our front-office revenue generators.”
The retrenchment of banks to core competencies may ultimately lead to greater collaboration with non-banks, he adds.
“Clients will want to be serviced well and shareholders will want the cost of servicing them in low-margin products such as FX kept tight. So you will start to see some bank/non-bank partnership deals eventually emerge, as has already happened in other markets.”
But non-banks are not immune to the challenges facing the sector. While they may not face the same capital constraints or regulatory pressures as the banks, substantial investment in technology is still required to compete on an equal footing.
Some non-banks have scaled back their operations over the past year, while others have sought out their own particular niches in the same way as the banks.
Citadel Securities, for example, has found it can add particular value in emerging market currencies.
|Kevin Kimmel, |
“We have really sought to expand our market-making capabilities in EM currencies where we see strong interest from clients due to thinner liquidity conditions,” says Kevin Kimmel, global head of eFX at Citadel Securities. “As some market makers have stepped back from EM, our ability to internalize and hold inventory has enabled us to grow.”
Andrew Smith, senior vice-president for markets at Virtu Financial, believes that as FX becomes a more commoditized asset class, liquidity providers without scale may struggle to survive. Having a single price-generation model that will work globally, as well as robust connectivity and distribution, is imperative, he says.
“As we saw in equities, when markets evolve to become more electronic and transparent, end users’ demands for more-competitive pricing tends to open markets to new competitors, including alternative liquidity providers,” he says. “Ultimately, this increases the efficiency of risk transfer and grows the entire market and opportunity for all service providers.”
Tech and transparency
Across asset classes, the impact of new regulations and conduct initiatives, from the FX Global Code to Mifid II, has been to increase the need for transparency throughout the transaction lifecycle. With mandates for pre-trade disclosures and post-trade reporting, as well as the more rigorous pursuit of best execution, there is a need for technology to support such transparency requirements.
Some banks that had not previously invested in algorithmic execution tools are now doing so; across the board there has been more widespread adoption of transaction cost analysis (TCA).
While it had long been difficult to bring effective TCA to foreign exchange, largely due to fragmented liquidity and scarcity of data, this is now gradually changing as banks and buy-side firms seek independent verification of execution quality.
“Three or four years ago, you would not have seen TCA in FX,” says Deutsche’s Lascala. “However, many clients now are focusing on the footprint and total cost of their trades rather than simply the bid-offer spread. The clients that measure their TCA realize that dealing with a liquidity provider that has a high percentage of internalization has the best and optimal outcome.”
Hiring into FX is much more competitive now because there are compelling opportunities to work in non-banks, cryptocurrency firms and fintechs- Nadir Mahmud, Citi
Liquidity providers face a choice between developing their own in-house TCA or sourcing it from an independent provider.
While proprietary tools are often preferred, the use of an independent service may give clients greater confidence that they are achieving best execution.
Citadel Securities last year became the first non-bank liquidity provider to sign up to BestX, a startup provider of FX TCA, highlighting its commitment to greater execution transparency.
“Minimizing market impact when executing trades is a priority for some clients,” says Kimmel. “The growth of TCA as a tool to measure this has been an important development in helping clients determine how best to construct their liquidity pools.”
Enhanced transparency in the FX market is not just about algos and TCA, however. Freed from the burden of preparing for Mifid II and with greater resources to work on key structural issues, some top-tier banks are now becoming more meticulous in tracking how their liquidity is being used.
|Chris Purves, UBS|
The concept of liquidity recycling – whereby smaller banks would take prices from larger banks and repost them onto ECNs – had become commonplace in FX, but moves are now afoot to stamp out this misleading practice. This should be positive for market transparency as it will avoid situations where liquidity appears to the buy side to be much deeper than it really is.
“As business gets back to normal after Mifid II implementation, banks are becoming much more conscious of how prices are being used and have sought to stop their liquidity from being recycled on the ECNs,” says Purves of UBS. “This reduces phantom liquidity and is good for the overall market, but it may also have led to some concentration of liquidity providers.”
In an industry still struggling to recover its mojo after a long period of turmoil, the priority for any FX business head – beyond discharging compliance requirements and investing in technology – must surely be to recruit the necessary talent that will lead the market successfully into the future.
Given the increased competition and the poor reputation that still clings to FX trading, however, recruitment may not be as straightforward as it once was. Recent changes have also forced many banks to reorganize their businesses, which means new skills may be required to land a job at a market-leading bank.
“We have rationalized our trading footprint over the last nine years and now have significantly fewer traders to service the same global market, radically improving our efficiency,” says HSBC’s Boillereau. “We have invested some of this headcount save to recruit more quants to support the electronic business. In addition, our traders are now much more engaged and connected with clients and the rest of the business than in the past.”
But unlike a decade ago, FX banks now face much greater competition to get the best people in the right seats. Faced with a choice between a Canary Wharf tower block and a place at XTX’s futuristic new home, for example, it is easy to imagine where the smartest traders and technologists may be drawn.
“Hiring into FX is much more competitive now because there are compelling opportunities to work in non-banks, cryptocurrency firms and fintechs,” says Citi’s Mahmud. “We are focused on finding people with a good mix of skill sets that will enable them to work in technology, sales and trading, so that they can rotate between functions.”
In the long term, most industry leaders believe FX still has a bright future, in spite of the challenges. Volatility may be well below average and many smaller players have had to give up on their global aspirations, but Lascala is optimistic.
“FX remains the most fundamental product in financial markets,” he says. “The business is always exciting and interesting, and as markets become more global, FX gains more importance.”