The Last Look…

Time for a full-on, generation gap, rant. Don’t give me this “liquidity mirage: stuff again, FX markets are as robust as they have ever been, if you can be bothered to look back…

In other words, there are some in the FX industry who would be well served by remembering the adage “those who ignore history are doomed to repeat it”, because we appear to be going through another fretting cycle over liquidity in the markets.

Over the past few months, I have heard the phrase “liquidity mirage” dusted off, I have also heard people expressing concern over the “thin crust” at top of book in FX markets, as if it were a new phenomenon. Let me tell you – it isn’t, conditions are ever-changing in FX, but as far as I can tell, we aren’t seeing anything particularly new in the current environment. We have had blow-ups in geo-political (and macroeconomic) areas before, volatility has spiked before, and, hedgers are getting their business done better than before.

We have had plenty of discussions about the liquidity mirage as well – 20-odd years ago when the phrase was first coined (to my knowledge at least), there was something in it because we were worried about last look and reject rates, which were a relatively new issue in FX, but the reality is, those concerns have never gone away – and actually weren’t that new in the first place.

Liquidity has always been a concern to any trader – the greatest fear is that you have a position that you can’t get out of quickly enough to survive to fight another day. This was the case in the 1970s, 80s and 90s as well, the only difference was in the first two decades the source of pricing was the voice market. There was even multiplication of pricing back then – if the number one broking desk in a particular pair had a price, you would often find that the other firms’ desks would also have one – albeit slightly wider. The number one desk was a reference point for pricing on other desks and to customers direct – sound familiar? If the number one desk was hit or lost the price, you would hear “off” pretty quickly down the other lines – it wasn’t last look but if the dealer said “off” before the broker said “mine” or “yours”, the deal was unlikely to be done. It wasn’t exactly last look, but notwithstanding that, the price discovery mechanism looks very similar.

What is different about today’s market is, naturally, technology, and as something that continually improves, that is a dynamic symptom of any liquidity problems – put simply, in the voice days everyone had pretty much the same tech – a phone line, a Reuters Dealer and a few speaker boxes. Now market makers have different standards of technology – and the issue is muddied by the dominance on ECNs of non-bank firms. These have invested heavily in technology to make sure they can price (and cancel) as fast as possible, something that has led in some cases to higher reject rates on some of these venues.

One difference today is we have two distinct channels, with two distinct business models dominating them

Equally, the banks have had to keep up to some degree, and have also improved their pricing technology to the point that, allied with last look, all market makers are protecting themselves better. What sometimes gets lost in the debate over liquidity dynamics is that the makers do need to protect themselves, especially in an environment such as we have now. The sense of entitlement that too many consumers have is another driving force – the problem is that complaints over liquidity often come in the form of the price being “wrong”, where “wrong” merely means at a level at which they don’t want to trade.

How many times do we have to explain to these people that that is the nature of markets, especially when they get busy. To cite my good friend Stephen Flanagan, there is always a price in the market. It may not be where you want it, but it is there.

That has always been the case in FX markets, I can recall trading Cable in markets that were routinely a big figure wide in 1 million, certainly much more often than has been the case over the past 25 years. Something else that hasn’t changed is that when the smelly stuff hits the fan, it is still easier to get a price from a market maker direct than it is an ECN. The latter still do well in busy markets, but I suspect we will see in the months to come that the direct channels did better in April. In the modern market a factor in this is the domination of non-bank firms and talking to someone last week about this, they suggested that part of the concerns being expressed currently is the fragility of the non-banks’ position in the market.

You will have seen in this week’s Entries & Exits section of the newsletter (exclusive to the newsletter sign up now!) that Kevin Kimmel, head of e-FX at Citadel Securities, has left the firm. Last week, we reported that one of their senior FX business development execs, Brian Seegers, also left. This inevitably raises questions as to whether the firm will remain fully-committed to the FX business, because, let’s face it, for these firms it is easier to make money in equities, crypto and, probably, certain fixed income products. In FX, too many non-bank firms have discovered, or at least think they have discovered given the PB anonymity provided, that they are dealing quite a lot with their peers, which is not what they signed up for and means lower returns then when dealing, often direct, with retail punters.

In the case of Citadel Securities, I would merely point out that this would not be the first time a couple of senior departures have prompted rumours of a firm pulling back from the market, but more often than not, the behemoths that these firms are, means the business just grinds on.

I should stress that my conversant was not suggesting they were pulling back, merely speculating over the coincidence of two senior departures. The very fact, however, that they felt the need to, highlights one big difference between markets today and those of 20+ years ago.

There have always been two main channels – a broking desk/CLOB/ECN and the direct voice/platform/API route. The difference is back in the day both were dominated by the big banks, whereas now, the former, especially the CLOBs and ECNs, are largely dominated by non-banks, while the banks hang onto the direct business. This leaves us with two distinct channels, with two distinct business models dominating them (and before anyone fires up their keyboard, yes, I know there are nuances and some other channels that the banks still compete well in, and I know that “your” platform is different but I am in the middle of a sweeping generalisation rant so let me get on with it).

The ‘liquidity mirage” in FX does not exist any more or less than it did previously, what does exist more is peoples’ willingness to complain about it

The bifurcated nature of LPs in the market, however, leads to the heart of the “problem” such as it is. Throughout the history of FX markets, makers have been happy to quote fair customers, and often go out of their way to price them well to keep the relationship sticky. As returns have become trickier to achieve and best execution has become a bigger part of the conversation, several buy side firms turned more towards the attractive top-of-book available on some venues. Alongside this, the same data capabilities that supported their best execution efforts were starting to be deployed by the banks especially to accurately judge exactly how good (in revenue terms) a customer was. I have been witness to some pretty astounded people when they saw the true value of some of their clients!

This in turn, raised questions about the “sales-first” business model, and certain banks started cutting some clients off, preferring to meet them on venues where they had less obligation to actually quote them a two-way price. This was also, in some cases, part of a broader withdrawal from the public market in favour of a heavy focus on their core book of customers.

All of this is the root of the liquidity “issue” today in my view. Some customers were happy to chase the extra tenth or two of a tick, and some were content to pick their LPs off direct, both of which led, eventually, to them being forced into the public environment, where relationships are less robust.

All was good while markets weren’t particularly busy, but it became a big issue when things kicked off, as they have done over the past six months (and are likely to continue to do so over the next 36 at least). Those customers who minimised the direct relationship with their LPs have been left to their own devices, without a guaranteed price in their amount whenever they want it, and this is their real problem. Their actions prompted the shift, and they are now complaining the loudest.

Yes, markets are busy, but in reality things are not that different to the way they have always been, there are just a couple of subtle differences. The ‘liquidity mirage” in FX does not exist any more or less than it did previously, what does exist more is peoples’ willingness to complain about it.

The market is what it is, and it doesn’t owe anyone a thing. You don’t like the price? Fine, don’t hit, but please, for once, take some responsibility and accept the consequences. The price is going to be there, but it may not be pretty; welcome to the real world – a world that hasn’t changed that much…

colin@thefullfx.com