The Last Look…

Bad news for the crypto industry – I suspect that one of my least popular FX market mechanisms is coming fast to digital assets.

The mechanism in question is the muddying of the liquidity channels, meaning, from a personal and less important point of view, lots of emails from technology firms claiming to be “liquidity providers” when in fact they are merely providing connectivity. The second, and to me more important aspect of this, is how it is difficult for the end consumer to know where their liquidity actually comes from and, from the LP point of view, where the liquidity is actually going.

I received a release last week about a regulated brokerage partnering with a trading platform provider to position itself as a “leading liquidity provider for institutional clients”.

First of all, the firm may be regulated, but does it have balance sheet? Probably not, which means true “institutional” clients probably can’t trade with them unless they are merely matching trades with LPs through a central counterparty. That may be the case, but that doesn’t make the broker, a “liquidity provider”.

Secondly, the partner firm provides technology to brokers and traders – I must confess I haven’t heard of them, but a cursory look at the website tells me all I need to know. The form highlights its “forex” capabilities – always a signal to me that the main focus is retail – and then a look at its own LPs brings up a list of retail/institutional brokers who largely access liquidity from elsewhere.

I dug fairly deeply, five links on my laptop, before I got to a mention of a firm I would view as a genuine LP in FX – as far as the crypto “liquidity providers” are concerned, I’m still looking – thus far it is only connections to crypto exchanges.

There is room for brokers and technology providers at all levels of the market, so I am not suggesting anything suspicious is going on here, rather I don’t like the number of connections the liquidity goes through. We have found out previously in market events how liquidity dries up the further down the chain you go – and even though things are quieter than they have been for some while, crypto is an asset class prone to event-like moves.

This is not a new problem, I remember writing about Wooden Nickel about 15-20 years ago where retail boiler rooms were washing points through the wholesale FX market. In that case it was inter-dealer brokerage firms that got caught up but banks were on the fringe as well – albeit innocently.

What crypto doesn’t need, is the type of scandal that results when the liquidity waters are muddied too much and genuine institutional LPs are dragged into a legal mess thanks to the actions of a firm they didn’t even know was accessing their liquidity

In the current environment, technology makes it easier to pass through liquidity – how far do the original LPs check this stuff? There is a reliance on each link in the chain, which is fair enough, but it also means that the whole is at the mercy of the weakest link. The firms involved in the venture I refer to earlier are probably doing their best for their clients, but sadly, history shows the number of retail brokerages acting nefariously is not inconsiderable.

There is also the question of what happens if, or when, those in the chain alter how they do business. There was a judgement in the UK High Court a week or two ago where one brokerage firm had a “liquidity agreement” with another to trade “all available products” on an exclusive basis, for a three-year period.

The problem was, the service provider unilaterally changed the legal entity offering one of the products – index swaps – from the UK to Hong Kong, due to, according to the judgement, “growing regulatory complexity and uncertainty in Europe as a result of MiFID II.”

The consumer saw this as a change in the conditions, meaning it did not have to trade exclusively with the firm, triggering a sequence of events that led to the type of court case that only lawyers can love, where it is all about the nuance of what is “available product” (if you really feel the need, you can read it here).

The judge found in favour of the consumer, stating that the conditions had changed because the provider had changed the regulatory location for one of its asset classes, but notwithstanding that, my point is – and given how trivial (in my view) this whole business was – what happens if someone third, fourth or fifth link down a chain, suddenly changes how they operate especially if the change pushes them into grey territory?

The fact that firms are willing to jump through so many hoops to get to the end client, which they claim is institutional but most of us would class as retail, only tells me how much money these firms make out of the end client – which is potentially a concern, especially in those jurisdictions where taking risk is a no-no for these businesses.

Crypto is battling hard to build a reputation as a maturing, responsible market after the early days of hacks and Silk Road etc, and there are signs that as more providers to the institutional space in, for example, the FICC asset classes, get more involved, it is having come success.

What crypto doesn’t need, is the type of scandal that results when the liquidity waters are muddied too much and genuine institutional LPs are dragged into a legal mess thanks to the actions of a firm they didn’t even know was accessing their liquidity (and I am in no way suggesting my above example is a case of this).

Legally they will be fine, but reputationally? Both the crypto industry and LPs could do without a hit to that at such a critical time in the market’s growth.

colin@thefullfx.com

@colinlambertFX