The Last Look…
Posted by Colin Lambert. Last updated: May 3, 2021
I am told the numbers are changing for FX market makers – and not in a positive way – and that the shift is prompting no little head-scratching at the major LPs.
So, is a major player, somewhere, doing things differently? I ask the question because the chatter in the industry is that revenues have been pressured, there has been a change in the distribution of flow, and the time horizon for mark-outs has been squeezed.
This all points to a change in behaviour or operating methods by a major LP – it also offers an interesting insight into the inter-connectedness of the modern foreign exchange market. This is not the first time I have had conversations with people investigating changing business dynamics in the LP space, it is, however, the first time I can recall that the discussion has been with multiple LPs.
So what could be causing it? At a simple level, a firm that was previously an internaliser could be externalising more flow, or holding onto it for shorter periods. This has happened before and there has been some interesting academic research done on this, but for what it is worth I don’t think this is what is happening. Talking to liquidity consumers, while one or two are suggesting they are making less on that flow they hold for short periods of time, the majority of my straw poll respondents tell me they are seeing no discernible change in market impact.
If a major LP was externalising or leaking information, there are techniques that make it possible to find out when, and, probably, who – as long as it occurs in a limited liquidity pool. Given upgrades in recent years to the pricing and risk capabilities at several of the major banks (the non-bank firms typically have this stuff well in hand because it’s their bread and butter), it is hard to believe that signalling is behind the change that is prompting a deal of investigation at the LPs.
That said, a few people have mentioned to me that a major LP has been on the street this year touting improved capabilities and access to futures market liquidity. This LP has also been winning more flow from consumers that I spoke to, and if the firm is hedging more flow through futures markets that could have an impact. Firstly, by accessing futures markets it is externalising, and secondly, the characteristics of futures markets being very open and transparent, there are a lot of typically smaller, non-bank trading firms in those venues that are eager to jump on any signal they see from information leakage brought about by the market model.
The issues seem much broader, and the change is being felt in too wide a circle, to be just down to a new LP entering the fray
The problem with this notion is, as noted earlier, it should be registering with consumers as increased market impact and it isn’t. Perhaps a slightly different way of measuring and monitoring impact may throw up something different, but it’s doubtful, however I am unsure if those consumers are including futures markets in their analysis – there is a chance the transmission from futures to OTC is happening outside their analysis windows.
For those firms right at the very top of the market making pyramid there may also be concerns about signal leakage – after all, if a firm at the top is showing axes to clients and that axe is being used and forwarded to the market, then profitability would inevitably decline as a proprietary asset is undermined.
Again though, the firms at the top of the ladder are very skilful and monitoring their alpha signals and would likely work out fairly quickly if and where it was being leaked. This change in the markets has been apparent to the major LPs for almost two months, so unless those using the signals are masking it very cleverly, it’s unlikely to be this, unless it happens to be a very valuable customer is taking and passing through the skew and the LP is turning a blind eye. Such is the fragile nature of the modern FX market structure for LPs.
Another factor could be a new entrant to the top group of LPs. Over the past two decades the top five market makers have varied more than is probably obvious, with some institutions dropping out and others stepping up, especially as their technology has drifted behind, and then caught up with, the pack. More prosaically, unless it is planning to make cuts to the business or if it had had a horror year, most banks approach a new year with a promise to their customers to “step up”. Is it simply the case that a new, or returning LP has muddied the waters?
This would explain a squeeze on revenues, and, equally, a new competitor could have a slightly different way of hedging out flow, but the nature of liquidity in FX markets in more recent years, thanks mainly to low volatility, is that customers’ liquidity pools have largely congregated around a smallish group of LPs who each have similar hedging techniques.
To my earlier point, the introduction of one externaliser messes things up for the rest of the liquidity pool and that generally ends up being detrimental to the discerning client. If LPs are added by those clients who care about such things, the latter will run checks on their hedging impact both before (if possible) and especially during the time the LP is operational in the pool. My understanding of the current circumstance is that the issues are much broader, and changes are being felt in too wide a circle, to be just down to a new LP entering the fray.
The really interesting facet of this is how one firm making changes can ripple down through the market.
In reality what we are probably seeing is a mixture of all of the above, although if someone pressed me I would investigate as much as possible the futures angle. Just as customers want good, robust LPs who are willing to hold risk, so too do the LPs need the same when they hedge out their exhaust flows. I am not sure a totally transparent market place is the best place to do that – look at the volume data from the primary ECNs over the past few years, that suggests it is not.
Either way, there is a lot of head-scratching taking place and it will be interesting to see who, if anyone, has thrown a spanner in the works, or whether this is just another evolution of the market.
Of course, this may not actually be an evolution or anything new at all. There is a long and honoured tradition in the FX markets of making efforts at a certain time of the year to grab as much market share as they can. Could this be a firm making a dash for volume to snare an award? We’ve seen stranger things, however, I am told spreads are stable and not indicating a big push by one LP.
Personally, I don’t think this is a grab for share per se – to me this smacks of someone changing how they operate, albeit slightly. The really interesting facet of this is how one firm making changes can ripple down through the market – that and whether the firm in question’s profitability has actually gone up over the past couple of months or if they are merely stuffing it up for everyone else!