The Last Look…
Posted by Colin Lambert. Last updated: February 22, 2022
There seems to be a mood of optimism around the FX industry at the moment, I am struggling to find people in the trading business who are unhappy. Inevitably there are some who want more, but in general it seems the start to 2022 has been upbeat thanks to one thing – busier markets. As always, however, these conditions do not suit all it seems.
Most LPs seem content with how things are going – although one or two have mentioned challenges and the need to recalibrate pricing and risk engines. I can only put this down to a comment one acquaintance made late last month, specifically that models designed for the market regime that has existed for the past few years, are struggling.
I should stress that the struggles are occasional, but it seems there are players getting caught out by fewer mean reversions. In a way this is highlighted by early results from trend-following CTAs – to the middle of February, the SG Trend Index was up some 7%, indicating that the choppy conditions and many false dawns for trend followers witnessed over the past years are possibly behind them.
It is strange also to think, that there are traders out there, responsible for major books, who until recently had yet to witness any real monetary policy movement or, it could be argued, serious geopolitical risk – both of which are the trend’s friend.
Given my record for predicting market movements, I won’t tempt fate by expressing the opinion that things will continue – I couldn’t do that to the industry – but it is interesting to hear different takes from different players, and people of different experience. Some buy side contacts are talking more skewing by LPs when they ask in larger amounts (interestingly they don’t seem interested in algos at the moment), but they are happy with this because, anecdotally, reject rates for these tickets are lower. One asset manager source tells me that they are finding it easier and more efficient to go back to bigger tickets in these conditions, effectively it’s ‘old school’, they just want the risk hedged so they can move on.
I am not sure what this means for the algos. Clearly, they won a lot of people over during the peak pandemic, but it seems that in some cases – and this no doubt depends very much upon the quality of the algo build – signalling risk, and therefore slippage, is heightened thus far in 2022.
Rejects are becoming a little more expensive at the moment
I think what intrigues me is the level of surprise amongst some participants at the impact of what is, after all, a subtle shift in conditions. I am not sure why they are surprised, for there is a truism around all markets that in periods of uncertainty, scale and quality become important. For the past three years it might have been fine (probably preferred) to use, for example, a prime-of-prime or multi-dealer platform to execute because everything was so calm and there was always another bid or offer if you missed the first. These channels remain valuable of course, but if you need to clear out risk quickly there is no substitute for the modern-day equivalent of asking the LP for a price in the full amount, according to some. Equally, rejects are becoming a little more expensive at the moment.
What is likely to result from this period of prolonged activity in FX markets is yet another subtle shift as players react to the changing regime. This is something that has happened countless times before of course, the FX industry is very good at adapting, but for some firms there is the added challenge of being able to hold risk for a period of time.
As someone said to me the other day (and I have to confess that this view was opposed by a peer just a day later), holding larger risk for a longer period of time is not in the DNA of their firm, but as they try to clear it, they are having market impact and performance is suffering.
The answer, in this case, was apparently to trim the amounts being streamed, something that will, no doubt, be noticed by some customers. The big question for this firm (and perhaps others) is, will the reputational damage from failing to respond to changing client demand be sustained?
History suggests it probably will not, but I do sometimes wonder why more clients don’t build a sustainable, medium- or long-term scoring model to assess their LPs. In March 2020 some customers had cause to regret dropping relationships with some LPs when extreme volatility hit. In 2022 some may be regretting it because they want to do larger tickets but only really have access to algos that may or may not be working sufficiently well. A regular and sustained monitoring of who keeps up in a changing world would help these customers build and sustain stronger relationships and, into the bargain, reward those LPs who continue to deliver excellence (which in every other walk of life attracts a premium).
Of course, if the LPs continue to let the customers cherry pick and walk all over them, then they need do nothing, but you sense that the smart move is to pick and maintain a small group of strong relationships. After all, things could get worse…for longer.