The Last Look…
Posted by Colin Lambert. Last updated: March 1, 2021
I ran a poll last week about peer-to-peer trading to gauge the temperature of the FX industry over this still nascent idea. All I can say about it is those looking to make a living out of the model should hope that they can offset half as much flow as we could votes.
There were 150+ votes cast – bizarrely some thought it better to email or message me their vote – and at the end it was 52.5% to 47.5% tilted towards the ‘no – it will not work’ camp. This was actually a lot closer than I thought, especially given the extra votes were from FX people of a (ahem) ‘certain generation’ who can be, I am sure they will forgive me for saying, a little reactionary!
There is an innate caution in markets over ideas that can change the market structure, this is natural given the potential consequences of something not working when it is rolled out, but is more a factor of vested interests. We may like to mouth the platitudes of welcoming competition, but if it’s a new and radical idea that may mean a serious overhaul of existing practices (and our position in the hierarchy), then it’s a bad idea.
Notwithstanding that, while there are genuine challenges facing any peer-to-peer mechanism in spot markets, in some shape or form it is likely to work. The question is, in spot terms, will it be big enough to make a difference?
Only time will answer that question – that and a good old-fashioned bout of illiquidity prompted by a vol shock – but the very fact that almost half of those responding thought it could work tells me something has happened to the FX market structure. It is, in fact, a question I have never really asked before, but how is it, at a time when spreads are widely considered to be the tightest they have ever been for end-users, that several of those same firms feel the need to shift to another mechanism?
People talk about a “lack of trust” in the banks following the chat room scandals of the middle of the last decade, but do they really believe that a problem still exists? I accept that further down the ladder there may be a small number of firms operating in a grey area, but when it comes to the top 50 firms – and many beyond – the FX Global Code has made sure that behavioural boundaries are recognised, and adhered to, when it comes to customer information and orders.
It could also be a factor of the borderline paranoia that some buy side firms have over banks, or LPs generally, making money out of their flow. I accept this is not helped when institutions report billions of dollars of FX revenues, but then the impossible question is, “how much is the ‘right’ amount of money to make?” Some buy side firms need to accept that the LPs are, depending upon their skill, going to make money. The former may also, while they are at it, accept that sometimes their timing is not perfect and that they can actually get it wrong.
For me though, the biggest factor that is driving support for a peer-to-peer solution is the impact of regulation, technology and high-speed trading firms upon several bank FX businesses. Put simply, the number of institutions willing to take on the type of risk some big buy side firms are trying to shift, has shrunk dramatically.
We will still hear the cliches from certain players about having a large principal business and being “client-centric”, but the reality is their level of risk warehousing is nothing like it was several years ago. Today the response of many to a large trade request is “why don’t you try my algo?” That way the “LP” doesn’t have the nuisance of market risk and all that comes with it.
There are, of course, big players still willing to step up, often for the ‘right’ client it should be noted, but they are smaller in number and that concentration risk brings its own challenges to the buy side. Amongst this number of big players, however, are some who see risk warehousing measured in (single digit) seconds or less.
Internalisation has played a role, it is natural if an institution can automatically match risk between two clients that they do so, but I have to stress, skewing a price is neither genuine internalisation, nor is it risk warehousing.
A big factor in this shift has been regulation, but so too has the advent of technology and fast traders. Aside from the fact that many banks in particular, when faced with the challenge of HFTs decided to follow the adage “if you can’t beat them…” these firms, with their ability to sniff out larger tickets, also meant a change of tactics on the part of the major warehousers. It become a lot more difficult to hold onto risk for a period of time, knowing there were so many “sniffers” out there when or if you did need to shift it.
So the chances of a successful peer-to-peer model have been helped by market structure change – and it needs to be stressed that there is no putting the genie back in this bottle, the change is only likely to accelerate – but it still faces one significant challenge, guaranteed liquidity.
Effectively, a peer-to-peer mechanism is seeking to provide the same solution, on an ongoing, real-time, basis, or in a longer window, as a Fix – and that means it all comes down to netting efficiency. Internalisation is a netting mechanism to all intents and purposes, with one major difference – the customer’s deal is already done – the risk has been transferred.
How is it, at a time when spreads are widely considered to be the tightest they have ever been for end-users, that several of those same firms feel the need to shift to another mechanism?
This is not to say that matches will not be found amongst buy side firms, they undoubtedly will, but more to ask, will it be enough to compensate for the removal of that liquidity guarantee? After all, a lot of these matches will be from so-called ‘soft’ flow, the type that allows an LP to see a net profit from a customer’s business. If that disappears, how do the client analytics look then? With LPs being more assertive in how they talk to clients about their flow, is removing the soft flow actually going be net (no pun intended) beneficial?
Overall then, I find myself as divided as my poll, you can see a peer-to-peer model working, but if FX really is a relationship game as people claim it is, then how does that play out? I tend to believe that FX is largely a transactional relationship until you get to the bigger tickets – that’s when the relationship is everything. The problem is, in a world with ever-improving analytics, how willing are LPs going to be to accept a risk when the rewards are little more than can be achieved through a fee?
So, for the two sides to this story there are different challenges. I believe at some stage, if a peer-to-peer model is going to work, then the buy side has to take on more FX risk – which will be interesting given how so many of them barely acknowledged FX just seven years ago.
For the LPs however, there is a different risk that has emerged out of this market structure change, competition. An institution can compete successfully by exposing more of its balance sheet to clients, but too many seem intent on competing on cost – they are undercutting each other while avoiding market risk. This is, to all intents a broking service, to which all I can say is, look at what happens in just about every broking environment. Fees race to zero, “innovative” payment models like PFOF proliferate (and bring countless problems with them), and firms shut their doors to the business because they have no ‘Plan B’ and the technology spend required to keep up is no longer justified.
Whether it succeeds or not, and I do think there are major obstacles to overcome to get widespread buy in, the interest in peer-to-peer is as much a symptom of changing market structure as anything else. If this change continues, then some buy side firms may have to consider stepping up as risk warehousers, or at least buy or build an internal trading function to service these models.
If that happens then we would probably have witnessed the biggest demographic change in the history of the FX markets – and I wonder how many of us are ready for that?