A recent study released by Greenwich Associates referred to non-bank liquidity providers (LPs) creating a more liquid, transparent and efficient FX market in the long term.
Of the more than 1,600 global investors interviewed for the study, 5% had access to non-bank LPs – up from 4% in 2014 – while 20% of volume was executed by these investors via non-bank LPs last year compared with 16% the year before.
These figures do not include trading done with non-bank liquidity on an anonymous basis.
Those non-bank market makers who are allocating capital to have a proprietary backbone to their pricing facilities and not just ‘price recycling’ are improving liquidity and access to it, suggests Paul Chappell, founder and chief investment officer of UK currency management firm C-View.
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Frank van Zegveld, |
Frank van Zegveld, Solid Trading’s head of strategy and investment, agrees it is important to distinguish between participants who are able to warehouse risk and add unique liquidity to the market and those who simply pre-hedge flow in the market.
According to David Ullrich, senior vice-president, execution strategies at FlexTrade, some non-banks are collecting differing players and locations, and are providing meaningful new pools of liquidity in specialized areas such as USD/MXN.
“Others are providing more risk-taking liquidity provisions, meaning that they have the ability to price and not necessarily clear straight away, like a bank,” says Ullrich. “This is important as the banks’ abilities to hold positions are being downgraded by regulation and the internal costs of capital, as well as a loss of experienced market makers.”
If non-banks cannot accumulate and hold large positions for long periods of time, they are acting as short-term intermediaries.
However, the current climate around use of capital and risk tolerance within banks makes it unclear to what extent most banks are behaving differently – and intermediaries provide a valuable service when they efficiently bring together and net off directional traders’ liquidity demands, observes David Mechner, CEO of Pragma Securities.
KCG is most active in equities and ETF markets, where it is one of few non-banks that are more frequently providing liquidity to counterparties while banks remain the primary intermediary, says head of execution services Rob Crane.
“There has been a shift to non-bank liquidity sources over the last two to three years, although the market remains fragmented in Europe with 40 members of the Principal Traders Association providing a range of liquidation solutions across asset classes and geographies,” he says.
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David Puth, CLS |
David Puth, chief executive of CLS, says the prevailing view is that the rise in non-bank participation in the FX market will complement the traditional dealer model, adding: “As this occurs and non-banks eye a greater role in the market, mitigating risk – and in particular settlement risk – has gained prominence.”
When asked how internalization of liquidity by banks is impacting the market, C-View’s Chappell suggests it is a moot point as to how much internalization is actually occurring within banks as opposed to what is effectively laid off in interbank and inter market-maker transactions, while FlexTrade’s Ullrich says internalization helps disguise the amount of true flow going into the market.
“If we take the banks’ word, internalization at 70% means that a $100 flow now looks like $30, which helps control information leakage,” adds Ullrich. “Internalization has a positive impact on the market as long as spreads remain good and no last look is occurring.
“At its best, it helps slow down the execution process, minimize market impact and heighten the best-execution outcome for both the buy side and the sell side.”
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Roger Rutherford, |
Roger Rutherford, COO of ParFX, suggests that in a truly efficient market, banks would have the choice to internalize or trade into a public market.
“At times, it will make good business sense to internalize flows; it enables banks to internally match (uncorrelated) flows originating from clients and leads to higher profits, lower brokerage costs and reduced reliance on external liquidity pools,” he says.
“A dramatic rise in disruptive trading patterns on some platforms has forced banks to internalize, leading to a vicious circle of further internalization that reduces liquidity, degrading the efficiency of the market further.”
Some banks have decided to outsource their market-making activities completely, but Ullrich does not necessarily expect this trend to accelerate.
“New solutions that simplify and reduce explicit costs on the LPs – such as forward compression and collateral management requirements – may allow them to have a rethink and come back into the market place, or potentially allow for non-banks to join this market segment by ‘renting a balance sheet’,” he concludes.
