Is It Time to Talk About the Liquidity Elephant in the FX Room?

The Voice of Experience is a new series from The Full FX which taps into the experience of senior, and independent, FX market veterans, and invites them to discuss an issue in the FX industry that maybe others prefer to avoid.

The first columnist is Ted Holloway, who asks…

Is It Time to Talk About the Liquidity Elephant in the FX Room?

The world of FX has always been a dynamic one, where the only constant is change. The last few years particularly so with regulation, technology and significant changes in risk appetites playing their parts. Yet margins, continue to be squeezed, which leads me to ask the following questions?

1. Is liquidity being priced too cheaply?
2. What implications, now or going forward, could this have on the market?
3. If liquidity is too cheap, who should pay and how?

In this writer’s opinion, liquidity is being priced too cheaply. Historically, FX has always been a volume game, the more you see, the greater your chance to capture the spread, which in turn leads to bigger profits. That is, at least, how the theory went. The constant evolution of platforms, however, that offer tighter and faster pricing, allied to the increase in dark pool liquidity, is serving to compress margins further. Another major factor has been changes in LPs’ risk appetite, the result of which have made this model obsolete.

Liquidity, which is the life blood of the FX market, is an interesting concept. It is almost taken for granted, right up until the point it is not there. Ultimately no matter how much faster or smarter a platform is, it cannot operate without liquidity providers. Yes, it would be great if every client could match one another via a platform but in reality we know this is very unlikely to happen – it is early days but P2P models are still struggling to gain the traction required. From an LP perspective it’s almost akin to asking turkeys to vote for Christmas, however, the buy side still appears to be uncomfortable with the concept.

Risk appetite therefore plays a vital role in supporting liquidity provision, but arguably, this is a commodity that has become rarer, particularly given the regulatory scrutiny FX markets now face.

Of course, risk appetite amongst LPs is not, nor has it ever been, linear; however increased regulation means that this appetite has decreased for many, meaning that the larger players in the market are seeing a greater share of the business. There is nothing revelatory here, I hear you say, and I agree, but what happens when the market becomes dislocated? It is less than 10 years since SNB day, and the Sterling and Aussie flash crashes that followed that. Also, for those of you with a few more miles on the clock, the events around 2008/2009 live long in the memory.

Making money in FX from client business has always been a sensitive subject. There has been a perception from the some on the buy side that LPs are in a position to capture the spread. In reality this is often not the case, especially when taking into account the costs of dealing on third-party platforms. hence those LPs with less risk appetite are choosing not to participate in certain areas of the market, which in turn contributes to liquidity becoming more concentrated.

It is the LPs that provide market liquidity, therefore is it reasonable to expect all those that do, at least have the opportunity to make money if they choose to participate?

LPs’ culture of sales credits is also a contributing factor when it comes to valuing liquidity. The overall value of a client can be distorted by this process, particularly those that trade high volumes. I would also argue that the notion of sales credits makes salespeople themselves less focused. If you are measured by the overall value your client brings to the business, this requires you to have dialogue with all areas and departments that the client touches within your institution. This, in turn, leads to salespeople having a better understanding of a client’s business, which subsequently gives them a much better opportunity of offering true value to their institution, and the client, rather than just earning a sales credit.

Ultimately it is the LPs that provide market liquidity, therefore is it reasonable to expect all those that do, at least have the opportunity to make money if they choose to participate? I believe it is. The key word there is opportunity, because it is not just about capturing the spread. Participation in the FX market costs, not least because LPs are required to set aside capital, and monitor individual risk limits, and overall VAR (value at risk). There are also regulatory, compliance, settlement and FX teams themselves to be supported, and all cost. Additionally, platform participation is also at the LP’s expense – all at a time when margins are being squeezed.

To me this feels like a race to the bottom, and I am sure the larger players in the market are already well aware of this. More business is concentrated among fewer players, as those with less risk appetite are slowly squeezed out. The buy side are happy as price compression eases pressure on their margins, but it is unsustainable.

As I have said earlier in the article, those accepting and managing market risk should, at least, have an opportunity to make money, if that ceases to be the case, then risks become concentrated, and we all know where that can lead.

Liquidity costs.

Ted Holloway has worked in the FX industry for more than 30 years in a variety of senior FX sales roles at institutions including Standard Chartered, Chase Manhattan, Citi, First Chicago, Sumitomo and Lloyds. In that time he has covered corporates, hedge funds, central banks and private equity funds.