NY Fed’s Neal Sees Shifting FX Dynamics

Declining volumes on primary platforms and the rise of non-bank market makers are key trends shaping currency markets that resemble a “land of a thousand lakes” as a result of continued fragmentation in liquidity, according to Michelle Neal, the Head of the Federal Reserve Bank of New York’s Markets Group.

Neal said that in the past decade, with the advent of electronic trading, trading has become “increasingly decentralised” and as the market share of central limit order books declines the dynamics are shifting and questions about the broader implications of these changes are beginning to crystalise. “The primary platforms are also important in generating the rates that serve as reference to price many derivative contracts. One interesting watchpoint will be whether this trend persists – and what potential impact it could have on the market,” she said in a speech on November 19, at the FX Market Structure Conference of the Federal Reserve Bank of New York.

Neal also questioned what the impact of continued growth in the non-bank market making segment means for market dynamics and liquidity provision and emphasised the role of technology in shaping the future of trading. She said that while NBMMs are not expected to replace bank dealers anytime soon, an open question is whether they complement traditional dealers or compete with them. This is especially important due to the growing presence of these players in smaller economies, not just major currencies. “Key watch points related to the growing role of NBFIs include their potential impact on liquidity conditions, price discovery, and market fragmentation,” she said.

Neal also stressed the impact of technology on market structure developments, pointing to the move away from phone-trading to algos and the subsequent reductions in trade sizes. Market participants are also relying on technology to minimise their footprint in markets, making it easier for some dealers to internalise flows and for buyside firms to use execution algorithms.

 “Algorithms and liquidity aggregator platforms also help connect the different lakes via “rivers” that support price discovery,” she said, adding that these changes came with some downside. “There is also a perception of increased bouts of sudden pullbacks in liquidity, exacerbating price movements that can lead to flash events—a phenomenon that has occurred in major currency pairs in recent years.”

She also noted the leading role of FX in financial markets innovation, calling the industry a “testing ground for modernisation,” adding that “considerable research currently focuses on accelerating [settlement] timelines and decentralising systems, often leveraging single unified ledgers or distributed ledger technology.”

Neal also noted the important role FX swaps play in the ecosystem, with half of daily FX turnover coming from this crucial segment where Fed’s market outreach has found that participation is coming from an increasingly diversified group due to technological change. “Reserve managers, sovereign wealth funds, and hedge funds have become increasingly engaged in the FX swap market, further diversifying the set of participants,” she said.