Do the big FX banks need a new platform?

Latest updates:
The FX debate – a response from RBS March 2006

Answers to the FX Problem  January 2006 

It’s the biggest story in the foreign exchange market but nobody wants you to know about it. Six of the world’s largest forex banks are looking at a proposal to create a new spot-trading platform solely for their own use.

Beyond that, the foreign exchange market’s vow of silence kicks in, and it’s hard to find out exactly what’s going on. Some banks say they’re not interested in the proposal (at least for now). Some say they are considering it. Many point the finger at Deutsche Bank and Reuters as the driving force behind the plans (though they are not sure quite what the plan is). Deutsche strongly denies its supposed role, while Reuters won’t comment, even though some bankers say its technology is in place and ready to go.

Some things are more clear. The leading banks have played a big role in creating a system that threatens to do them more harm than good. In effect, they’ve shot themselves in the foot. The proliferation of electronic trading platforms (and no one actually knows how many exist) has increased turnover in the spot market but at the same time cut back spreads to the bone and beyond. Liquidity is poor. Clever traders are taking advantage of the system at the expense of the major liquidity providers.

This intrigue neatly sums up the current state of the foreign exchange market. It is riddled with contradictions. Its participants know this, even if they are loath to admit it. In one breath they’ll tell you forex is the largest market in the world, with a daily turnover of more than $2 trillion a day. In the next they’ll claim it has a liquidity problem. If both statements are true, the market must have deep structural faults that are adversely affecting its overall efficiency.

It’s no wonder the leading banks, having invested enormous sums of money in becoming one of a handful of true liquidity providers to this huge market, want to rectify the situation. The question is this: should they make an effort to pool their own liquidity, or will they create just another platform that has little chance of changing anything?

New solution The solution that is being touted to the perceived liquidity problem is a new platform that will only allow access to the large trading banks. In effect, this is an attempt to recreate interbank dealing, which has all but disappeared since the advent of electronic trading in 1993. Before that, most major banks traded routinely with each other in larger than market standard amounts either on the phone or via the Reuters direct dealing system. Market sources insist that Deutsche Bank is leading this initiative.

Deutsche Bank denies that it is the driving force behind any bank-only platform initiative, and a spokesman for the bank says that it continues to work closely with many vendors to improve the way that it provides and receives liquidity.

Although Deutsche would not comment more specifically, an insight into the way it, and no doubt other banks, perceive a potential problem in the spot foreign exchange market was provided by Ian O’Flaherty, Deutsche’s global head of e-commerce for global currencies and commodities, in Euromoney last month [see Winners and losers in the FX spread war, November edition].

In the article, O’Flaherty said that he envisaged the electronic market as a pendulum, where at the point of equilibrium both the buy side and the sell side receive value. But, he added: “New technology being introduced into the space could make [the pendulum] swing farther in favour of the buy side. We will have to see how sustainable that is.”

Whoever is behind it, the concept ostensibly appears to have merits; in some ways it mimics the block-trading platforms in the equity market. These act mainly as a complementary rather than a competitive service to that offered by the exchanges.

Few of the banks said to be involved are willing to say anything, at least officially. But if one breaks through the FX market’s omertà, the whispers are loud enough to suggest that the venture might be doomed as early as the concept stage.

Of the eight major banks questioned for this article, only three are prepared to go on the record about the new platform. UBS says simply that it has no plans to take part at the moment, HSBC says it is considering doing so and Deutsche denies leading it.

One of the top six-ranked FX banks according to Euromoney’s latest survey, published in May 2005, which declined to be named, offered the following comment: “We are studying a proposal made by Reuters. How it would work in practice isn’t clear, so it would be wrong to assume we’ll say yes. The proposal is to create a bank-only tier in the market, a closed user group for spot matching for six banks. The people to talk to on this are Deutsche. The idea seems to be to disintermediate EBS.”

This is an extremely powerful statement and, not surprisingly, Deutsche Bank rebuts it, saying it has no intention of trying to disintermediate EBS or any other portal that provides it with liquidity. Reuters, which is EBS’s only real competitor in the electronic broking space, also has little to say on the matter.

Its only response was as follows: “The FX market is an extremely competitive marketplace and it’s natural for participants to look for new ways to access best price and pools of liquidity. Reuters supports the development of the market and is happy to work to support its customers’ business goals. However, as a matter of policy, Reuters doesn’t comment on market rumour and cannot comment on this specific initiative.”

A senior figure at a US bank based in London says he has spoken to Reuters about the proposal and that the technology to create the platform is already in place. “It’s just a question of creating new currency codes really,” he says. Reuters, he adds, has been actively sounding out clients for their views to assess whether the venture is viable or a waste of time.

The global head of FX at another major player says: “This all came about because EBS opened up and allowed hedge funds on to the system. It pissed off people, notably Deutsche Bank.”

He adds, somewhat scathingly, that the perceived liquidity problem in the market arose not because EBS had opened up its platform to the buy side through its EBS Prime initiative, but because Deutsche was not discerning enough about whom it streamed its prices to. “The situation [liquidity mirage] arose because Deutsche supported too many platforms – it didn’t think about what it was doing. It let the genie out of the bottle and now it’s trying to put it back in.”

There is no doubt that Deutsche has been vocal in its opposition to EBS Prime, but it states firmly that it has a good relationship with the broker. “We work closely with EBS to provide EBS Prime if our clients request it,” the spokesman says.

Even so, market sources are adamant that the bank dislikes anonymous FX trading; it is not alone in this, but seems to be the only major bank prepared to take a stand. Although full anonymity works well on regulated exchanges, credit has long played a big role in the FX market in controlling prices. Even if the top banks recognize that anonymity is coming, it would appear that they are intent on delaying the process.

The problem for FX is that the market is stuck in a limbo land, where some participants can trade anonymously on the main platforms while others, notably the actual liquidity providers, cannot. But putting all the blame on EBS seems unfair. “Deutsche doesn’t seem to recognize that EBS has competition from other platforms and needs to respond to threats,” says the chief dealer at one UK bank, referring specifically to the strong growth at the CME, as well as the threat from electronic communication networks, such as Hotspot.

EBS has at least partly opened up its platform to the buy side; some of these are seen as acting extremely aggressively. The feeling is that, as a result, the buy side has been given an edge. “Anonymity shouldn’t be selective. It’s giving an unfair advantage to certain hedge funds. If we put a price in the system for a large amount, someone can hit it for a buck or a euro, see it’s us, and if they think we have directional power, turn around and push the market away. Hedge funds don’t face that problem. And they’re not market makers – they don’t stream support prices out.”

Justyn Trenner, chief executive and principal at wholesale financial services sector consultancy ClientKnowledge, expresses similar views. “There’s a very specific buy-side interest in participating on market-style platforms,” he says. “Some of these buy-siders are acting very aggressively. They’re not market makers. I think inviting them on to EBS has very real implications. The buy-side business that is coming through EBS may be too difficult for the sell side to handle.”

This might be true, but the real issue seems to be that the market can be accessed through multiple entry points. Banks will try to internalize that flow; when they cannot, it will spill out on to the market’s hubs, possibly causing prices to gap. The answer to this is not to have more platforms but fewer. The market’s liquidity problem should not exist, given its vast size. If it does, it is only because the market has created it itself.

The answer appears obvious – liquidity needs to be pooled. But that is unlikely to materialize at the moment. So smart order routing technology is being touted as another possible solution.

“The introduction of new electronic trading technology would be very beneficial to the foreign exchange marketplace and could address the many gaps in efficiencies that currently exist,” says David Ogg, head of Lava FX, an aggregating platform. “For example, banks would be able to benefit from cutting-edge solutions to alleviate the effects of liquidity gaps. The platforms that are the most forward thinking and inventive will be well positioned to address the technology needs of the foreign exchange trading community.”

Looking at US equity markets, Ogg’s prognosis might be accurate. But, given the current climate in FX, there are some who feel that aggregators might actually exacerbate the problem because it will make it even easier for the more aggressive participants to hit multiple platforms.

This is a view Deutsche shares. “The market has to be careful that new technology does not exacerbate the liquidity mirage issue. Hooking up many outlets that are providing the same price from the same liquidity provider will make risk management of the flow extremely tough for the liquidity providers in the future,” says the spokesman.

A $2.5 trillion market How can a market which, according to the most recent triennial survey from the Bank for International Settlements, had total daily turnover in the foreign exchange market in April 2004 of more than $1.9 trillion, have these problems? And how come they are getting worse as the market gets bigger?

Both the UK’s Foreign Exchange Joint Standing Committee and the US’s Foreign Exchange Committee, which meet under the auspices of the Bank of England and the Federal Reserve Bank of New York respectively, recently published data showing that the market grew by a further 17% in London and 20% in New York in the six months between October 2004 and April 2005. Market participants state that similar growth rates were experienced in the previous six months, suggesting that daily turnover in the FX market now exceeds $2.5 trillion.

Although numerous currencies and different products are traded, activity is concentrated in the “majors”– the US dollar, euro, yen and pound sterling. According to BIS, the forward market accounts for about 50% of turnover, and spot, which is generally what most people think of when considering FX, accounts for around a third of activity. The rest of the volume is made up of outright transactions, which are a combination of spot and forward deals and options. By currency pair, euro/dollar accounts for 28% of the market, dollar/yen 17% and sterling/dollar 14%.

Each of the various FX currency segments are huge markets in their own right. Daily turnover in the spot market is now estimated to be about $800 billion a day. However, despite the market’s huge size, FX participants frequently claim that the spot market is illiquid. This seems totally inconceivable. A big reason why this claim has some merit is that FX trading is not centralized, in the way many other markets are.

Another factor is that the market has consolidated over the past seven years – 11 banks now account for 75% of the turnover in the US compared with 20 in 1998. In another contradiction, while this consolidation has occurred, the market has also fragmented considerably.

Consolidation in the banking industry is one obvious reason why market share has concentrated into fewer hands. Technology has also played a part, introducing transparency and efficiency; this has led to such a reduction in the bid-offer spread that it is now almost non-existent. The erosion of margins has effectively squeezed many banks out of the business. However, on the plus side, technology has made the market far more accessible and undoubtedly played a part in its growth.

Technology has enabled liquidity providers to distribute their prices far and wide and process smaller deal tickets cost effectively. Nobody knows the precise number of internet trading venues catering for those who want to trade FX, but estimates range between 200 and 600. At the moment there is no reason to believe that the ceiling has been reached.

This fragmentation is perhaps the real reason why market participants feel the need to speak of a liquidity problem in spot FX. The question is, why did the FX market allow this fragmentation to happen?

At least part of the reason is that as spreads narrowed with the uptake of electronic trading and broking, a new spot FX business model started to emerge. To run a viable spot business now either requires the ability to warehouse substantial risk or the capture of enough market share to allow the bid-offer spread to be earned as many times as possible. The spread might be minimal, but the size of the market means that if sufficient flow is garnered, spot FX remains a viable proposition for the sell side. Many banks, therefore, decided to provide liquidity to as many platforms as possible to attract flow.

However, the proliferation of streamed prices has resulted in a problem that Martin Mallett, chief dealer at the Bank of England, famously termed the “liquidity mirage” in a speech to the ACI Congress in London in May 2004. There are hundreds of trading platforms, but they are all essentially showing the same rate. This gives the appearance that the FX market is far deeper than it is. If several of the platforms are hit at the same time, which market participants say is happening more regularly, the sell-side liquidity provider is likely to find itself inheriting a sizeable position.

Although the FX market is not centralized on an exchange, it has at its hub two electronic brokers, EBS and Reuters. Over the past five years, the Chicago Mercantile Exchange has also reinvented itself to become a significant alternative outlet for business.

EBS is the largest of these market hubs, reporting average daily turnover of $120 billion. This is extremely impressive, but a frequent complaint is that the prices on its screens are often only for small amounts. According to the company, EBS’s average deal size is just under $3 million.

If a bank has just inherited a $50 million position, and then only gets $3 million done when it tries to exit the trade on EBS, it is no wonder that it expresses discontent. However, these complaints are not universal, and one market veteran has a slightly different slant. “There’s no liquidity problem as such, just a [liquidity] problem at specific prices,” he says. Furthermore, all traders have a habit of only remembering trades that do not go as planned.

Whatever the true situation, several of the top FX banks are checking out who they are streaming their prices to, in the belief that some of the alternative platforms are either abusing the system themselves or have clients who are. As a result, liquidity has definitely been pulled back from some venues, but there is too much competition between the banks to ever envisage spreads widening on a permanent basis. In fact, the opposite is occurring and spreads are still narrowing.

Cartel criticism The idea of establishing an alternative platform to provide the liquidity providers with liquidity might make some sense. However, at this stage it seems unlikely that it will get off the ground. It runs the risk of being labelled a cartel, although, as one dealer suggested, this will be easily got around if anyone can join, as long as they give a commitment to stream in prices in large amounts.

In addition, people are suspicious of Deutsche’s motives. These suspicions might be misplaced and inspired by a jealous response to the bank’s success in FX; Deutsche could well be acting altruistically for the market’s greater good.

But, ultimately, the real reason the venture will most likely come to nothing is precisely because market players feel they have little obvious to gain from it. “It can’t possibly work. Why would you quote five other banks in large amounts? People will be much more prepared to take their chances on EBS (to shift volume),” says the global head of FX at a US investment bank. “Why would you want to make the strong stronger?”

The FX debate – a response from RBS

Answers to the FX Problem