The Last Look…
Posted by Colin Lambert. Last updated: October 18, 2021
Last week’s column about the bank-client relationship elicited some interesting responses, most of which – to my surprise if I am being honest – agreed with those that were telling me that relationships generally were struggling.
In part this is seen as a result of there being no personal contact with the clients (and, to be fair, a couple of customers themselves told me this), but generally it is seen as a trust issue – even if I happen to think it’s something less worthy. There seems to be a (to me) unhealthy mood amongst certain clients, as I observed last week, that service providers should only make fees out of them, not “profit”.
I use the word “unhealthy” deliberately, because if FX shifts to a fee-paying business for these clients, they end up with one thing they have been trying to avoid for the past four decades and more – execution and market risk.
There is no doubt in my mind that in the past some on the buy side have been cash cows for liquidity providers – but often this was in the form of a mark-up, hence applied by the sales desk. From a trading perspective, the traders, and then the machines, delivered the appropriate price for that currency pair in that amount at that time – pre-ordained adjustments were then made.
Mark-up is, in reality, a fee, and moves over the past few years to increase transparency around this aspect of the FX business have been a real step forward in making sure they are adequately disclosed, so where I diverge from many of my correspondents is in what happens next. There seems to be a belief amongst some – and I stress the word “some” – on the buy side that an LP shouldn’t make any more money out of them beyond the fee or mark-up.
This completely ignores the market risk element of the trade and is, I think, a reflection of the growing percentages claimed by LPs in internalisation rates. A customer who does not (or does not want to) understand how internalisation works can be of the belief that their order is matched in a matter of milliseconds (so instantaneously in their eyes) with another client order, therefore the LP is making a spread out of the business as well as the mark-up. That undoubtedly happens sometimes, but the vast majority of time the LP does hold the risk, often for minutes or more – I think that is often overlooked by too many on the buy side, who would find their jobs changed radically if they had to start worrying about where the FX market was heading.
There are, of course, those customers who are happy with the market risk, but my experience in recent years has been the complaints rarely come from this sector. More often it is from firms who are not in FX for Alpha, and who are, I would argue, demonstrating the innate human habit of swinging from pole to pole when they do change their opinion. These firms lived in blissful (some might say wilful) ignorance of how their FX trades were being executed and what happened in the market – they were woken up by the chat room scandal and lawsuits brought by corporates over the alleged mis-selling of derivatives, and have now swung to the other extreme and decided that the LPs should not make any extra money out of them. Why is an interesting question, I actually think this shift in attitude is a mix of guilt and shame over their negligence of the past two decades and more.
FX is a very competitive industry, if you don’t like what one LP is making out of you, go to another. Just be prepared to accept at some stage that the problem may actually be your trading!
Foreign exchange is a market, and in a market each trade has a “winner” and a “loser” in terms of the mark-out (as opposed to mark-up). It is nonsensical to suggest, as some have to me in the past, that everything needs to be “fairer” in that some firms should not make as much money as they do. This is the attitude of those primary schools where no child is a loser (or competitions are banned), and far away from the harsh reality of a global market where 90% of trades are done impersonally and, importantly, responsibility belongs with those making the decision to trade.
So I believe we need to stop the complaining – FX is also a very competitive industry and if you don’t like what one LP is making out of you, go to another. Just be prepared to accept at some stage, when the fourth LP is making “too much” that the problem may actually be your trading! It’s not as though there is a shortage of decent LPs out there (assuming you don’t need 10 in competition for every quote, in which case I think the complaining goes the other way).
One other factor I think needs to be taken into account here and that is market conditions. A lot of what I would term mediocre LPs are making good money because volatility is pretty low – they can take the trade and pretty much guarantee to bank a good chunk of the spread. Good LPs are doing this as well of course, but they also are there when things get busy.
Someone said to me last week they thought the first half of 2021 highlighted how the LPs (they used the word “banks”) were ripping clients off because they made so much money in that period. Luckily enough I have a strong relationship with the person in question so I could answer bluntly that the extra money was made through them assuming risk the clients didn’t want (and often panicked when trying to offload), it just so happens in riskier, more volatile markets that increased risk is reflected in larger P&L swings.
The banks’ collective culture breakdown in the early years of this century has not helped in any when it comes to the relationship, but I would argue there was always a healthy scepticism in the relationship anyway (I have noted before how the client always thinks they are being “read” and the LP thinks the client “is everywhere”). What we don’t want now is for the scepticism to be fuelled by an entitlement attitude that says firms should not make money out of the business. It costs a lot of money to build and maintain a large FX business, this has to be found from somewhere, and usually it is a blend of an intelligent business model and skill when handling and adopting risk.
This is, in effect, all about trading, and I suppose this highlights the damage done to traders’ collective reputation by the chat room saga – you talk to some people are there is still a stigma about being a trader and someone who takes risk. This is an unhealthy attitude in my view, risk takers are vital to a healthy ecosystem, and it is to be hoped that I have just been unlucky in the make up of this particular sample set.
I continue to believe that the vast majority of clients think their service providers do a good job, although that is not to say that they wouldn’t appreciate a little more! That sais, a little more appreciate for the trading role and the assumption of risk by certain desks, individuals and institutions would not be a bad thing. For while markets are quiet now, they are unlikely to stay that way – and then those clients who have pushed too hard or gone their own route, will find out the hard way just how much value a decent trader can bring.