The Last Look…
Posted by Colin Lambert. Last updated: November 29, 2021
The publication a couple of weeks ago by the FMSB of a Spotlight Review of the precious metals market structure, contained a lot that would be familiar to FX people, which got me thinking about how successful some of the suggestions that are clearly taken from FX, have actually worked in that market.
Back to market structure, however and how successful have the core recommendations of the FMSB report, a CLOB and clearing, been in FX?
We should not be distracted by the current volume data from the CLOBs, they are only relative to what was an absolute heyday from 2006-2011, the fact is the firm CLOB, with no last look, remains an invaluable aspect of today’s FX market. You can internalise all you like, but when markets start moving you need access to a wider pool of interest – it is to the CLOBs’ detriment that volatility has been so low for so long.
Of course one lesson for the precious metals market if it goes the way FMSB suggests it should, might be to back one, maybe two, horses in what will probably become a crowded field. The paper talks about the benefit of data and how this lowers the cost of trading, I would humbly suggest that if the data is spread around three or four venues, and a participant needs at least three of them, then the cost of data will be a drag on the bottom line, not a benefit.
The fragmentation of liquidity is acknowledged in the paper, and it is hard to know if the precious metals market will follow FX in being so fragmented. It’s a smaller market so the chances of fragmentation should be limited, that won’t stop it happening, however.
If a CLOB(s) develops in precious metals it will be interesting if it brings more banks back to the market. In terms of the single dealer platforms, most offer some sort of gold and silver trading, along with palladium and platinum, but few are really committed to the commodities business. I would argue, admittedly through the prism of 2020 when I last looked closely at all the bank platforms, that only three players – JP Morgan, Goldman Sachs and BNP Paribas – really back their commodities businesses. The rest are merely streaming a price.
If a CLOB(s) does start producing more market data, will it bring a few banks back? I doubt it, thanks to a lesson from FX. What will happen is the non-bank market makers will action the data in a much quicker, leaner fashion, spreads will be compressed, and those banks without a large franchise to fall back on, will see little point in getting involved.
If there is an influx of non-bank market makers, it will be interesting to see how this affects market quality. A small number of them are very good at supporting market quality, but there is a larger group that is not – witness the challenges the US Treasuries market is struggling with as banks have stepped back and non-banks stepped in. Just as the precious metals market doesn’t want to see too many CLOBs, it probably also wants to see the “right” kind of market maker – can you control that? I don’t think so.
The case for clearing (and indeed a CLOB) in the FMSB paper I found interesting in that it appeared to lead with the enhanced ability for market overseers. That is undoubtedly a benefit of the CCP, with all transactions in one place to be scrutinised, but I would have thought the paper would have “hero-ed” the reduced systemic risks, rather than relegating it to one of the last points made.
Clearing will make trading more expensive for participants, but as the paper notes, this can more than be made up for through easier access to compression and optimisation services. The story in FX for clearing has been a difficult one, and that may be a warning for the precious metals markets. Clearing volumes in NDFs are OK, in options they struggle and in swaps they barely exist. That’s because too few players in FX swaps are actually in it to generate alpha – they are either providing a risk warehousing service or want to hedge an explicit exposure(s). It is hard to see why that would be different in metals.
One thing in favour of clearing, however, is that the impending capital rules are going to seriously impact FX swaps markets, and that could drive more volume to clearing solutions, although again, with compression and capital optimisation services for bilateral trades doing such a good job, is there really an incentive to change?
So it will be interesting to see how things develop in precious metals if the market structure does undergo the suggested change. My instinct is regulation will drive some of the change, but quite a few players will be dragged along reluctantly. The adoption rate among those doubters will be the key to the success or otherwise of what would be quite a significant shift in the market structure.
Perhaps the biggest query over there proposed changes, however, is whether anybody will be bothered enough to lead the way? There are a lot of calls on technology investment budgets and teams – I am not sure there has ever been such a shortage as there is currently with developers – in those circumstances are firms really likely to want to embark on an expensive change to what remains, in markets terms, a relatively small business (and one potentially that is under threat from crypto)?