In a report produced earlier this year by Oliver Wyman, an overview of non-bank liquidity providers estimated that FX market makers accounted for between 30% and 35% of non-bank liquidity provider volumes and would continue to provide stiff competition to banks.
The rise of such providers was attributed to the importing of technology and risk-management techniques from the equities markets by providers initially focused on entry into electronic inter-dealer broker channels to facilitate risk recycle from the large dealers.
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I guess it is just a few who are capable and have the risk appetite to step into this space Frank van Zegveld, |
If banks continue to be restrained in their warehousing capacity and reluctant or unable to run proprietary risk, it is likely that non-bank market makers – who are better resourced and less regulated – will increase market share, agrees Paul Chappell, founder and chief investment officer of UK currency management firm C-View.
He adds that there are “probably no more than a dozen” with genuine aspirations to become principal market makers.
“Banks can fight back if they wish, but the current situation has occurred as the banks have moved from considering the quality rather than the absolute quantity of their market making flows and there is no sign of an imminent reversal of this,” says Chappell.
Many banks are reducing their principal market making activity and taking on more of an agency role, which provides the opportunity for non-banks to play a larger part in the market, explains Bill Goodbody, senior vice-president and head of FX at BATS Global Markets.
“That said, it is worth restating that banks remain the largest players in global FX markets by a considerable distance,” he says. “So while it follows that non-bank players will become increasingly competitive, we don’t expect the balance of power to shift drastically in the short term.”
Goodbody reckons it is a little early to say how many non-banks will become major players.
“The beauty of the global FX market is the diversity of roles and regions open to market making firms,” he says. “In that respect, there is plenty of room for those players looking to take on a principal role.”
“Fewer than 10” is the response of Harpal Sandhu, CEO of Integral Development Corp, to that question. He believes the distinction between banks and non-banks will continue to diminish as a determinant of quality of liquidity.
I credit market making hedge funds with raising the bar Harpal Sandhu, Integral Development Corp |
“The providers who provide reliable liquidity at attractive levels and depth will continue to win a larger share of customer business, irrespective of whether they are a bank or non-bank,” he adds.
“It takes a combination of advanced technology, access to broad liquidity and risk-management tools to compete as a market maker – those who leverage resting liquidity from customers have better odds at this.”
Drew Izzo, chief marketing officer for Oanda, says his firm doesn’t usurp banks on price, adding: “We hedge our exposure to our banking liquidity providers. Our prices are created from aggregating many pricing feeds from most global FX banks.”
Risk appetite rather than price is the key driver, suggests Frank van Zegveld, head of business development at Solid Trading, adding: “But it all comes down to the definition of a non-bank market maker.
“A true non-bank market maker is a principal in a trade and creates his own prices. An ECN or a dark pool absorbs prices from others and STPs those prices directly or in a skewed model. In this model, which is heavily aggregated, it is quite easy to outprice a bank’s price.”
He observes that from a legal and risk perspective it is getting harder to be a principal, with huge collateral or balance-sheet requirements a prerequisite. “I guess it is just a few who are capable and have the risk appetite to step into this space,” says Van Zegveld.
As a result, he wonders whether banks have lost interest. “The operational costs and work involved are being reviewed by many banks and some have already decided to outsource their market making activities completely,” he says.
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Paul Chappell, C-View |
When asked about the impact of market making hedge funds, C-View’s Chappell suggests the inevitable response to the rise of non-bank market makers has been to conclude that they are HFT traders who will rapidly retreat when liquidity or a trading environment deteriorates.
“There are some signs that this is not always the case and that hedge fund markets makers properly resourced with investor capital may represent a more direct challenge to the traditional role of banks in the FX market,” he adds. “But for this to occur, the issue of credit has to be addressed.”
When market making hedge funds first appeared, it was a wake-up call for many banks that had perhaps become complacent, concludes Integral’s Sandhu.
“I credit market making hedge funds with raising the bar and improving technology all around,” he says. “They also added a new source of liquidity and pushed everyone to become more efficient, make smart use of technology, and compete on quality of service and execution.”
