That is the view of capital markets consultancy GreySpark, which believes the blurring of the lines between the inter-dealer FX market and the dealer-to-customer FX market will create an “all-to-all” trading model in which non-bank participants will trade among themselves.
The reshaping of the market structure in FX, according to GreySpark, has its roots in the aftermath of the financial crisis, which saw banks refocusing their activities away from warehousing risk from structured products and complex financial instruments towards flow businesses, such as spot FX and equities.
Indeed, banks invested heavily in their FX trading platforms after the collapse of Lehman Brothers, with many coming online in 2009 and 2010. However, that coincided with a dip in FX volumes just when banks were trying to recoup their outlay as depressed global economic activity and a central-bank inspired reduction in FX volatility combined to weigh on trading numbers.
 |
| Frederic Ponzo, managing partner at GreySpark |
“The big difference between a financial industry geared towards complex financial instruments, as opposed to being geared towards flow trading, is that flow business is less capital intensive in terms of balance-sheet usage, but a lot more capital intensive in terms of technology costs,” says Frederic Ponzo, managing partner at GreySpark. For FX banks, the problem was they invested in their platforms at the same time, and delivered extra capacity just when FX activity levels were falling.
That has led to a situation in which there is a massive amount of extra capacity in FX, which means dealers are trying to cover their fixed costs by cutting their margins through reduced spreads and fees.
This has caused a pricing war in which there is a race to the bottom to cover costs, with GreySpark estimating that for every bank making profits from their FX flow business, there are two or three that are losing money.
Other flow businesses have seen banks scale down their capacity. RBS has exited cash equities and Nomura has scaled back its activities in the sector, for example.
However, excess capacity is unlikely to be removed in FX, with no bank voluntarily leaving the market. As Ponzo notes: “Any bank that does not trade currencies is not a bank.”
Thus the problem of too much supply and not enough demand in FX will remain until volumes recover enough to allow all banks to break even, which at present appears to be a distant prospect.
Ponzo says that means, for the first time, the buy-side has the upper hand over the sell-side in the FX market.
“As a consequence, the neat separation between the inter-dealer market, in which only banks trade with each other, and the dealer to client market, in which banks resell wholesale liquidity to investors with a margin, is challenged,” he says.
Ponzo says the impetus for the rise of an all-to-all trading model can be seen in developments at Thomson Reuters and EBS, the two main inter-dealer FX platforms.
He points to Thomson Reuters’ acquisition of FXall, a leading dealer-to-client platform, which he believes is a pre-cursor to the development of one all-encompassing trading venue, while EBS’s development of trading rules to satisfy banks’ concerns over high-frequency trading will open up the platform to buy-side firms.
Meanwhile, dealer-to-customer venues are likely to move towards the all-to-all trading model, allowing banks to source, not just provide liquidity.
Ponzo admits the transition will be messy, but believes there will be a different market structure in FX by 2017, and perhaps in as little 12 to 18 months’ time, as buy-side market makers participate in the interdealer market.
“At the end, you can expect half a dozen all-to-all platforms,” he says. “Some will originate from one side, some from the other, but all of them will meet in the middle.”
In this brave new world, banks will have to fall into one of four categories to stay profitable, Ponzo believes.
There will still be room for three flow monsters, such as Deutsche, Barclays and Citi, which see enough activity to be able to live off the spread of their trading activities.
Furthermore, universal banks with large enough commercial franchises, such as HSBC, BNP Paribas and, again, Citi, will be able to “live off the skew”, matching client flows to avoid crossing the spread.
There will also be room for a third category of niche banks, trading in less-liquid markets, such as emerging-market and Scandinavian currencies.
The fourth category of banks is those vying to be in the top three. They will be forced to focus on institutional services, for example becoming an execution specialist and applying successful equities execution and clearing models to their FX businesses.
It is this last group Ponzo believes will struggle the most.
“They will be forced into an arms race in terms of functionality and technology, which will make it hard for them to stay profitable,” he says.
Some FX banks just outside of the top three might not be so upbeat about the future of the currency market.