The Last Look…
Posted by Colin Lambert. Last updated: July 12, 2021
A friend of mine in the analysis business (and of a similar vintage) recently bemoaned how people now get excited over a 10 point move in the FX market. We sympathised with each other and (obviously, being of a certain generation) asked the question, “how will people cope when we get a ‘real’ move?”
We are not alone in this – there is a whole generation of FX traders out there who simply don’t understand how FX businesses can make money when the market “never moves”.
To an extent this exhibits a lack of understanding as to how the modern-day FX business operates. I was talking with someone a couple of months ago who has been out of front line of the business for a few years, who didn’t realise just how much of a “broker” style business liquidity provision had become. As I observed, the fractions or whole pips that can be made from handling flow adds up – especially when you’re doing well north of 50,000 trades a day. That makes it a very different world from that of my generation when we sat in the chair.
Turnover generates revenue has been the mantra for more than a decade, although there have been periods, not least three or four years ago, when LPs started to leverage the data and analytics coming to hand, to trim the client tail.
In the past I have been critical of clients who spend most of their year squeezing the last drop of spread out of the LPs via aggregation and then run to complain when, during a liquidity event, the LPs aren’t there for them. I remain critical of this approach, it is after all, a relationship that works both ways – which is why I am now going to be critical of some LPs.
I was talking to a trader at a market participant whose flow could be termed “tricky”, and was told that LPs who had cut them off three years ago, were now knocking on the door again. This is not because the participant has changed how they execute in the market – they haven’t apparently – but more because market conditions have changed. The feeling of my conversant was that when markets are busy and moving around the LPs don’t want to know them, but when they go quiet? That’s a different matter.
This form of cherry picking may succeed – as I understand it the participant in question likes a larger panel of LPs – but, in the bigger picture, I wonder what happens to this business model going forward – when sustained volatility and more directional moves emerge? I had a conversation a few months ago with a very senior FX market person who was firmly of the opinion that the years 2018 and 19 were the outlier in volatility terms, not 2020 – and as interest rate divergence draws ever closer, it is hard to disagree with that view.
If this happens, does that change the nature of the FX market again? Some I talk to believe it will, and that risk-holding, big ticket quoting, LPs will come to the fore again, because the high turnover model will be unsustainable when we are seeing regular 50 point-plus moves. Equally, it has been pointed out to me recently by a different senior individual, that even in the moves we are seeing, the market often trades at every price point.
The latter may be the case when the market is shifting 15-20 pips, but would it be if the moves were sustained? Equally, can the LP world ever come back to quoting big tickets and holding serious risk for an extended period of time? The regulatory world has evolved and, perhaps more importantly, there has been societal change in the FX industry – prized now is the operation that can churn risk most efficiently rather than just hold it with a market view. It took a decade to really for the broker model to really dominate, which shows how difficult it is to change direction.
I tend to have faith in the modern FX market when it comes to this question, although there is a part of me that wonders whether the framework we have developed is adept at handling high volume turnover in a tight range and (more recently) blow out moves, but may not stand up to the rigours of daily hundred point ranges?
A market driven by uncertainty is a different beast, especially when the moves are outsized compared to the past few years, and that places a premium on the heads of those risk managers who can handle it. Those newer to the business should not think it’s just the same, only busier – the numbers, especially in P&L terms, get larger, and that raises stress levels in all areas of the business.
I find it no surprise at all that those FX businesses considered to be at the top of the tree have an experienced seam to mine when it comes to their staff roster. They have bright young talent, but they are talking to, and working with, older heads – this could become vital over the next two years as economies (hopefully) emerge from the pandemic hit.
For now, then, people can get excited by double digit moves in exchange rates, but the sense is these moves will get larger. Personally, I think that’s a good thing because not only does it present more opportunities for genuine traders, but it will probably weed out the weaker LPs and those who masquerade as such. A lot of the LPs mentioned earlier as trying to re-engage with some customers are likely to sit in the latter camp and as such, if the foreign exchange market, which has a mind of its own as we all know, can test them, then a more robust, tried and tested, set of LPs will emerge.