However, one new trading venue, Betfair’s LMAX Exchange, has set itself apart with a unique business model that could give it that needed edge, combined with a well-established pedigree for innovation and a canny ability for market positioning. Betfair revolutionized the sports betting industry in the early 2000s. It took horse racing from being a market dominated by on-course bookies – with their leather money satchels, hung off metal sheets that registered the odds – and created an electronic exchange with hundreds of thousands of members.
It was not long before in-race betting was introduced, and sports gambling came of age. It then started to resemble a real market, with depth and liquidity.
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| “On LMAX Exchange, the price you see is the price you get.” David Mercer, CEO, LMAX. |
Betfair then turned its attention to the retail foreign exchange market, and created a new electronic exchange, called LMAX Exchange, only to stumble at the early hurdles. What it quickly realized about retail FX was that without a massive sales and marketing network, it could not gain critical mass in trading volumes to create a profitable business. The firm needed to focus on its strengths. One of those was its state-of-the-art trading technology, which at its core contained a component called the disruptor. In its early days, LMAX Exchange had harnessed open-source collaboration to enhance the idea that lay behind disruptor.
Disruptor was a low-level component that increased the speed and therefore the number of operations that the system could process per second. With that, LMAX Exchange wanted to create considerably more capacity on the exchange, which it hoped would enable it to accommodate a five-to-six-figure number of trading accounts.
LMAX Exchange sought to redirect its business strategy, and it realized it could apply such a high-performance piece of technology to the institutional end of the FX markets by creating an order-driven exchange.
However, rather than give up on retail FX altogether, LMAX Exchange refocused its attention on the retail aggregators, as well as targeting hedge funds, money managers and other investors looking for quick order-driven execution, while also positioning itself as the only FX exchange in the OTC markets, outside the interdealer space.
LMAX Exchange now operates an open order book, where orders are matched to streamed limit orders, as is similar on exchanges such as the CME and the LSE.
| LMAX exchange trading screen |
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To further set itself apart in the liquidity provider-to-buy-side market place, the exchange did not offer last look to liquidity providers, unlike many of the ECN marketplaces.
David Mercer, the chief executive of LMAX Exchange, says this gives the business an advantage over multi-dealer platform competitors, such as State Street’s Currenex and Knight Capital Group’s Hotspot FX – although Hotspot FX does offer a no-last-look service to clients on request – because it allows for consistency of trade execution.
“On LMAX Exchange, the price you see is the price you get,” says Mercer. “You don’t sometimes get filled in three milliseconds and sometimes in 100 milliseconds. You always get filled in three milliseconds.”
He also adds that because the order is resting in the exchange, if a customer matches that order they are immediately filled, meaning there is no need for messages to go back to the trade server to ask if the price quote is still good.
Mercer joined LMAX as CEO in April 2011, having held senior roles at IFX Markets and Saxo Bank, in London, Geneva and Sydney.
No last look
While the no last look might be favoured by the buy-side clients, market makers are likely to compensate for that loss of flexibility by streaming wider bid offer spreads to the exchange.
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| “LMAX Exchange brings a fresh perspective,” Tim Carrington, global head of FX, RBS. |
Mercer concedes this could be true, but he maintains that LMAX Exchange has enough liquidity providers – it has eight and it says it will have 11 by the end of the year – so that the spread will be “as tight as, or tighter than, every other venue that is price and not order driven”. Indeed, Mercer says, in October, LMAX Exchange quoted a choice price on EURUSD for over 30 minutes a day.
For Mercer, the proof is in the pudding that the exchange model works.
“Yes, they may have given away some control [with no last look], but every single bank, every market maker makes more quotes, streams more orders today than they did six months ago,” he says. “Nobody has left us and everyone streams more orders and captures more flow.”
With no last look, the exchange is, in theory, open to predatory pricing behaviour too, which LMAX Exchange says it seeks to eliminate by vetting clients and their trading strategy before they join. To date, LMAX Exchange says it has had no complaints from general members on the type of flow they see on the exchange.
JPMorgan, Goldman Sachs and Dutch proprietary trading firm Optiver are the three publicly disclosed LMAX Exchange market makers. There are two more banks and three proprietary trading firms, with another two banks and prop firm expected to join by year end.
“LMAX Exchange brings a fresh perspective,” says Tim Carrington, global head of FX at Royal Bank of Scotland. “With the Betfair background, and the flow that they will bring to the table, it has the chance to differentiate itself from ECNs that have evolved from within the FX industry.”
Target market
The flow that LMAX Exchange will bring to the table will depend on the success it has in attracting the institutional marketplace to trade on the exchange. It is clear that, given the speed of its operations, LMAX Exchange is well suited to systematic traders who connect into their API, but Mercer says its core market is broker dealers.
He refers to what he calls second-tier, third-tier and fourth-tier brokers who have not got their own relationship with a prime broker and therefore struggle to find liquidity directly from banks. LMAX has stepped into this space, creating a clear difference with conventional ECNs.
“LMAX Exchange is two-in-one – it is a deposit-taking institution and an exchange, which is what makes them interesting to us,” says Paul Belogour, a director at Boston Merchant Financial (BMFN), a Boston-based retail broker dealer.
For firms such as BMFN, which make markets for retail FX traders, the traditional ECN model does not allow a client to on-board business in the same way.
Belogour adds: “The typical ECN will say, ‘Look you have to get a prime broker relationship with somebody else, and then use our technology to deal with the prime broker.’ LMAX Exchange does all this for you.”
Volumes have risen strongly this year, although that is from a low base. In fiscal year 2011, LMAX Exchange saw no volume.
Since then, at its height, the company has seen more than $3 billion in daily volumes and now daily average volumes (ADVs) typically idle around $2 billion, says Mercer.
“Our monthly compounded growth rate has been over 20% since the relaunch in September 2011,” says Mercer. “What drives volumes is client funds because they trade on margin. Our funds are the highest ever, and they point toward ADVs of $4 billion to $5 billion per day within the next three to four months.”
Mercer adds that LMAX Exchange ADVs grew rapidly this year between January and May, as the company added three of its 11 current market makers. This was followed by a flat period between July and September, as volatility slipped out of the market across the board.
The company is now looking for a strong period of trading activity on its platform through to the end of November and a healthy first quarter 2013, says Mercer.
Quote fill ratios
There are relative pros and cons between the anonymous no-last-look exchange model versus those platforms that operate via full name disclosure and last look for liquidity providers.
The argument in favour of liquidity providers having last look is that it is easier for them to identify the flow that is predatory from the flow that is not.
One head of e-commerce at a large global FX bank explains: “The reason why we can provide great service to some customers is because we reject others who are trying to pick us off, and last look is a great help in managing that process.”
This then should translate in much more efficient quote-fill ratios than can be achieved on many of the multi-dealer platforms, where it is harder to monitor. For instance, the same e-commerce head says that a bank might have a quote-fill ratio of 99% on its own platform, whereas on some MDPs the ratio could be as low as 30%.
On EBS, the interdealer platform, whose trading model most closely resembles that of LMAX Exchange, leading liquidity providers say their quote-fill ratio ranges between 70% to 75%, where the platform requires a minimum quote life of 250 milliseconds.
LMAX Exchange says it does not impose any minimum-order quote life, since 95% of orders submitted by the buy-side on the exchange are at market, so by definition the fill ratio on those orders is 100%.
Optiver’s European managing director Hans Pieterse says the elimination of last look for order trade posted to the platform is not disadvantageous for his company as a market maker.
“With last look it means that one party has the upper hand in trading,” he says. “That is not beneficial for the investor. If prices are posted and people want to take them in time, then they should have the assurance that they are able to trade those prices.”
Ultimately, adds Pieterse, it will boost investor confidence in the LMAX Exchange platform to know that the prices they see are the ones they can trade on.
Positioning for possible shifts in market structure
LMAX is the first Financial Services Authority-regulated multi-lateral trading facility (MTF) for trading spot FX. Essentially, an MTF focuses on exchange execution, but not clearing. Just as on an exchange, orders are matched in price/time priority, but trading is still bi-lateral, with FX trades cleared through prime brokers.
There is a possibility LMAX Exchange’s market positioning might prove to be a canny move for the company, if not prescient when one considers the gradual shift in market structure that is occurring at a regulatory level.
According to some regulatory experts, the concept of last look could potentially be phased out, as regulators seek to push more trading down the exchange and swap execution facility (SEF) route, where the last-look principle is not seen as acceptable.
Some market participants, largely banks, are sceptical that such a move would be beneficial for the FX markets. They will argue if there is no last look and therefore no control over the client then, inevitably, spreads will on average probably widen.
“My feeling is that the regulators don’t really care and they would rather go for clarity rather than some benefiting [non-predatory] and some not benefiting [predatory],” says the head of regulation at a leading global investment bank.
For LMAX Exchange, by showing the market that it can host a competitive, open and transparent marketplace, this regulatory shift could place it in an advantageous position. What the key will be is its ability to police and vet the exchange participants. If it does that, then it has a real future.
“We would welcome any regulation change to create fairness in the marketplace for all participants,” Mercer says. “We don’t feel there’s a need for this concept in an efficient [FX] market – and it doesn’t exist in other major exchange-led asset class.”