The Last Look…
Posted by Colin Lambert. Last updated: March 15, 2021
Nothing is highlighting market structure change like the current furore over retail traders – yes, the crux of that debate is over what I consider to be the flawed equity market structure in the US, but there are lessons there for the FX industry as well.
On the equities side, it is interesting how punters have finally worked out that the scalping for a pip or two simply doesn’t work. This, in turn, has diluted the influence of speed in trading strategies and, ironically, some of the loudest voices opposing the retail traders’ tactics are firms that were, or still are, high frequency traders, and whose tactics of jumping in front of just about every order forced the change of approach.
Put simply, the retail army has now part-reverted to where it started – it is looking for a larger profit over a longer period of time. The difference it it’s just that the tactics to deliver these larger, or longer term returns have nothing to do with market research, more they look for weak and vulnerable points, helped in no small way, by the availability of positioning reports from major traders.
What cannot be disputed is the impact these traders are having on market price, which is why the FX industry may want to sit up and consider its evolutionary path.
I was talking to someone about this a couple of weeks ago and my conversant, who is well-versed in the institutional FX space, observed how the amounts involved in retail FX trading had grown enormously in recent times, thanks to the multiplication effect that we saw with GameStop and other shares.
This observation backed up something remarked upon during a recent call hosted by MahiFX, the number of brokers that were increasingly struggling with the level of flow they are seeing from this sector. As an example, I was talking to somebody else who observed that a group of 30 punters with reasonable leverage on $100,000 each would be able to generate a trade that would overwhelm the top of book in most FX pairs.
True, the impact would be short-lived, but add in the fact that mirror trading accounts and the social media groups are populated by significantly more than 30 people and you have an idea of the potential scale of the trading. As was pointed out to me by someone with access to the data, these sources are often generating flow in the hundreds of millions of dollars – it may often not be one ticket, but the trades come through so quickly, they are close to being just that.
The mainstream FX market should consider itself lucky that it has a significant shield from the impact of this flow not only in the form of the brokers, but also the existence of risk absorbers
What has happened, effectively, is that the challenge some LPs had pricing and risk managing retail aggregator flow, has shifted downstream – or is it upstream? – to the retail brokers themselves.
The mainstream FX market should consider itself lucky that it has a significant shield from the impact of this flow not only in the form of the brokers, but also the existence of risk absorbers – and this is where FX needs to pay attention to how it evolves.
For all the good intentions and huge investment, the fact is, in the modern financial markets the only real differentiator a bank can have is its capacity to hold risk on its books. Technology stacks are always likely to be more up-to-date and nimbler in smaller firms and business models more adaptive, but those firms cannot hold market risk at the same level as banks. In the past they could hold risk from the retail sector because the amounts were fairly insignificant, but if we are getting to the stage where they have to hold hundreds of millions? Prudence dictates that will no longer be the case.
This throws the spotlight on the banking industry and its ability and willingness to absorb that risk through internalisation or risk warehousing, which are, depending upon your time horizon, the same thing. By having this risk absorption in place, FX markets can avoid the kind of equity market blow outs we have recently seen.
What concerns me, however, is the number of banks that still seem to believe that the agency way is best in FX. It’s not. As noted, banks cannot compete in an agency world, their costs are too high and their differentiator – the internal flows they can access – diminished as an asset. There are some who argue that their agency business accesses the liquidity from the principal side of the business, but what is really happening here is the latter is aggregating liquidity from multiple sources and then trying to match off where possible with the agency flow. It’s an ECN model (and incidentally if you want to know why ECN volumes are, with the odd exception, either declining or stagnant, it’s because the banks are the real ECNs in today’s market) and that means a highly competitive landscape with ever-increasing pressure on fees. It’s a race to the bottom and you would have thought ostensibly intelligent people in parts of the banking industry would realise that.
There is a narrowing of the gap between institutional and retail with the former’s collective risk appetite heading south and the latter’s trade sizes heading north
On a broader note, without genuine risk absorbers in FX markets they offer yet another equity-style environment in which price moves are erratic, market impact is high and volatility highly…well, volatile! This is great for the retail punter (perhaps) but not great for the hedgers of the world – which, to repeat (ad nauseum I know), is the prime reason for the foreign exchange market’s existence.
At the risk of accusations of being of (polite version) “a member of a certain generation” I feel impelled to point out that the FX market could, and still does, handle risk extremely well. In the past, retail-type flow was, perhaps unfairly, looked down upon. I accept that flow is much larger now, but is it more informed?
What is happening is a narrowing of the gap between institutional and retail with the former’s collective risk appetite heading south and the latter’s trade sizes, thanks to their ability to bring critical mass to market in a short time horizon, heading north. At the moment I don’t think it is a critical issue, but if the trend continues it will be some day – who, after all, predicted what happened with GameStop et al?
What is needed on the part of everyone concerned with the FX market functioning, is a realisation that the current structure does provide protection against silly moves for no real reason, but that if risk appetite continues to dwindle or be suppressed by regulation, the shield becomes weaker – and end users, in the real economy, will be the ones to lose out.
The FX market structure and functioning demonstrates why risk should underpin services in financial markets, not access to market as seems to be the model with equities. Frankly anyone with the money to buy and/or build the tech can provide market access, but very few can handle the resulting flow. That is what really differentiates the FX market and it would be a shame to see it threatened.