Non-bank providers are failing to make a dent in the $117 billion per day global business FX market, according to a study of the global business spot FX market from market analysts East & Partners (E&P).
Although the daily spot FX market grows, the contribution from big and small businesses has continued to decline. Total spot FX volumes traded by businesses across Australia, Canada, Singapore, the UK and US have fallen by around 42% since 2012, says E&P.
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Russell Dinnage, |
Russell Dinnage, lead consultant at GreySpark, says the spot FX marketplace reached a tipping point when algorithmic and high-frequency hedge funds began providing liquidity on EBS, at which point the market began leaning heavily toward an all-to-all model.
“That was a catalyst for more non-banks to enter the FX business, leading to the proliferation of different liquidity pools within the trading models of the leading dealer-to-client trading venues that included new dealer-to-dealer, client-to-client and all-to-all liquidity pools,” says Dinnage.
“This diversification of the range of liquidity pool types within both the dealer-to-client and dealer-to-dealer FX marketplaces drove the evolution of the market, but it has probably been a slower process than many expected.”
Non-banks made most headway in the retail FX and market making, typically by offering prices that the banks cannot match. Non-banks have grown to be a formidable presence on ECNs, where they are often among the top players.
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Stephen Baseby, |
However, Stephen Baseby, associate policy and technical director at the Association of Corporate Treasurers, feels non-banks might not have been able to meaningfully undercut the banks on price.
“I’m not convinced non-banks offer FX services cheaper than banks,” he says. “It may appear cheaper at first, but once you factor in the additional costs the difference can disappear.”
Banks have an advantage serving corporate clients because they offer a broad package of FX services, including treasury, volatility risk management and hedging, as well as all their services outside of FX. Non-bank providers cannot offer the same spectrum of services.
Baseby says: “Many corporate FX needs involve forwards and that requires credit. Banks can take that forward risk and build a credit margin into the price, but that arrangement is not typically available from within the shadow-banking system.”
If non-banks do make more inroads into corporate FX, by extending lines of credit, regulators are likely to subject them to the same capital adequacy rules as banks, says Baseby, at which point their ability to compete on price would be severely undermined.
“Corporate treasurers themselves are very aware of counterparty risk and will have concerns about dealing with institutions that are not fully regulated,” he adds.
This might account for the growth of white-labelling arrangements, where banks retain the relationship with the client, while offering a price derived from another institution. It is therefore possible that corporates experience their relationship with their bank, but are actually enjoying liquidity provided by a non-bank.
Kevin Kimmel, COO of FX at Citadel Securities, says: “There are many opportunities for banks and other market makers to partner in FX; traditionally to facilitate hedging risk, but relationships are evolving further as some banks move to more of an agency model.
“At Citadel Securities we specialize in market making and warehousing and managing risk, and can provide additional value to those banks reducing capacity whilst continuing to service broad client franchises.”
Across all business segments globally, non-bank providers account for around 11% of business spot FX, according to E&P, but there are some regional variations. In Australia, 25% of businesses primarily use a non-bank provider to execute their spot FX transactions, the study found – a figure that is inflated by the prevalence of a single provider, Western Union Business Solutions, which has a market share of 21.7% among SMEs.
Elsewhere the figures are much lower: in the UK, 15% of businesses use non-bank providers, while it is as low as 5% in the US, Hong Kong and China.
Simon Kleine, head of client services at E&P Europe, says: “Although UK businesses have reduced their spot FX volumes by more than a third over the last four years, they remain highly exposed to currency fluctuations and increasingly in the volatile post-Brexit vote markets.”
Around 75% of small UK businesses exclusively use spot FX solutions for their foreign payments, but their use of hedging FX products has been increasing gradually, says Kleine.
“Considering recent record drops in the pound, the question is now how quickly will the majority of small business in the UK move away from spot FX to hedging FX products to reduce their FX risk,” he says.
Battleground Asia
However, GreySpark’s Dinnage argues Asia is the real battleground for banks competing for FX client market share, adding: “There is a large base of largely untapped non-financial corporate clients in the region, especially within the small-to-medium-sized bracket, that all need access to FX services.”
It is much harder in Europe and North America for tier two banks to win new FX client market share, argues Dinnage, “because even the smaller companies tend to have much more established relationships with the bulge-bracket dealers”.
Amit Alok, head of E&P Asia, says Asian businesses, particularly in China and Singapore, use branch networks in addition to online platforms and phone to execute their spot FX transactions at a much higher rate than other regions.
“This gap in service availability may provide a clear explanation as to why niche providers have not been able to increase their market share,” he says.
By far the biggest non-bank players in the FX market are hedge funds, which have become significant players in market making in particular.
“[However,] hedge funds using algorithmic or high-frequency trading strategies to provide market-making services on an agency basis are still a relatively new phenomenon in the flow FX marketplace,” says Dinnage. “The business model has only been around for two or three years. Clients are still adjusting to it.”
Even among the hedge funds there are different approaches.
Citadel’s Kimmel says: “Not all market makers are the same and it is important for market participants to distinguish between trading models. We warehouse risk, with a focus on high internalization rate while others may quickly recycle liquidity with much shorter holding periods. Customer preference is strongly biased toward those willing to hold risk.”
It is hard to know how actively hedge funds are pushing to win corporate market-making business from banks, but it does not appear to be a priority for the segment as a whole.
Dinnage says: “Hedge funds have tended to not focus on competing for non-financial corporate market-making business in spot FX, and they are increasingly less interested in proprietary positioning or arbitrage.”
However, if they do want to win non-financial corporate client market share away from banks, “they need to look at cross asset servicing, which starts with FX”, says Dinnage.
Where hedge funds make markets for FX, they should be looking to offer the same market-making service for G7 government bonds, rates, investment-grade and high-yield corporate credit, says Dinnage.
“They need to offer non-financial corporates a package of these types of basic capital markets-centric treasury management and hedging services, and at a lower price than can be offered by a bank competitor,” he says.