FX Liquidity and Technology — An Ecosystem in Flux
By Ivy Schmerken, Editorial Director
Change is accelerating in the electronic foreign exchange markets. With the fixing scandal and the currency rigging cases resulting in multi-billion dollar bank fines, investors are choosing a mix of liquidity providers or venues in an FX ecosystem that has become more complex.
As transparency and compliance become top of mind, buy-side participants are also seeing a second wave of consolidation ripple through the markets, while new venues keep emerging.
After decades of incremental change, the FX landscape has “rapidly shifted in the last two years,” according to “FX Trading 2.0: Technology and Platform,” a new Celent report citing the rise of global FX mega-platforms.
Mega-Platforms: Merging the Pools?
“We are witnessing the birth of mega-platforms that are buying trading technology and access to a variety of execution methods and analysis tools,” according to Celent.
The rise of global mega-platforms, such as Thomson Reuters with its acquisition of FXall in 2012 and EBS BrokerTec’s October 2015 acquisition of FX technology provider Molten Markets are signs of consolidation and expansion. Acquiring FXall was a strategic move to gain client-side liquidity for Thomson Reuters, which already had had the dealer-to-dealer side, but the vendor also put buy-side middle and back-office functionality under the same roof. “The theme of merging dealer-side and client-side functionality has been a key feature of recent acquisitions,” wrote Brad Bailey, research director at Celent.
With the shock of the WMR fixing scandal in 2014 and the potential for more regulatory oversight in the FX spot market, buy-side firms are paying closer attention to measurement and analysis tools such as transaction cost analysis (TCA).
Global exchanges are also strategically positioning their business models to diversify into spot FX. BATS Global Markets’ purchase of Hotspot for $385 million in January, followed by Deutsche Boerse’s $796 million deal to acquire 360T, a multi-bank, multi-use platform, in July are further evidence of this consolidation wave. Exchanges with product coverage in equities, futures and options are looking to create opportunities for cross-FX product leverage as well as merging of liquidity, states the report.
“The latest wave of acquisitions has continued to blur the lines between different types of venues, consolidating protocols and liquidity within larger firms,” writes Bailey However, the landscape has become more challenging in terms of identifying which liquidity providers (LPs) and venues to interact with, notes the report. In an OTC market like foreign exchange, participants must construct a view of the state of the market, since there is no consolidated tape or centralized market.
“We really moved away from a situation where people are happy with one price. They want to demonstrate best execution. They want tools for doing TCA. They want to understand the state of the market,” said Bailey in an interview.
New venues have brought new functionality and transparency to the FX e-trading ecosystem. FastMatch, a startup ECN whose customers include high frequency trading firms as well as corporates, proprietary trading shops and buy- side firms, provides round trip executions in 17 microseconds. “Before FastMatch nobody had a tape,” said CEO Dmitri Galinov, speaking at Markets Media’s global conference in December. On any exchange in futures or equities markets you know the fees you are going to pay. In the foreign exchange market, it was non-existent,” said Galinov.
Prime Brokerage Economics
Changes in the prime brokerage space are also impacting the nature of accessing liquidity. In the wake of regulations like Basel III and Dodd Frank, big banks have been assessing the profitability of their prime brokerage businesses. Hedge funds often gain access to liquidity providers and venues through their prime brokers.
As the capital requirements and economics of prime brokerage have changed, some of the prime brokers have been dropping clients and raising fees. This, in turn, is impacting hedge funds. “If you don’t have a prime brokerage relationship in the right way, it’s hard to access certain types of liquidity directly through a venue,” said Bailey. If this model is too expensive for clients, hedge funds will seek alternative sources of funding, including private equity and synthetic prime, potentially causing volume to shift away from venues like Hotspot and EBS,” suggested Bailey.
As the prime brokerage model evolves, dealers grapple to have direct contact with their clients, notes the Celent report. At the same time, the FX landscape is challenging because there are so many types of venues to choose from – ranging from single dealer to multi-dealer to ECNs and exchanges. The bigger theme in the report is the merging of liquidity in the venue space across platforms and the blurring of once clear lines in the sand.
As a case in point, IDB platforms are either acquiring or building client-facing platforms, while exchanges have acquired multi-dealer FX ECNs.
Interdealer broker Tradition is behind the design of ParFX, a wholesale global FX spot platform launched in early 2014 but open to institutions that settle through CLS and go through a prime broker. Founded by 14 banks, ParFX is open to all professional institutions that want a low-cost, convenient and reliable venue for sourcing FX liquidity in CLS-eligible currency pairs.
Buy-side firms completed their first trade on ParFX in September of 2014 through its prime service. “ParFX Prime was launched to enable buy-side customers to trade through their prime broker on a post-trade disclosed basis, alongside the growing community of banks already trading on the platform,” notes a press release on the site.
ParFX offers a matching mechanism that applies a randomized pause to all submissions, amendments and cancellations, to ensure a level playing field for all participants regardless of technological sophistication or financial strength, states the venue operator.
Meanwhile technology providers, such as FlexTrade, are making it easier for clients to construct their own views of the FX spot market, where they can be anonymous or disclosed to liquidity providers.
Rather than go through a venue, pure technology solutions provide FX aggregation tools and smart order routers. Buy-side firms can pick their own counterparties, requesting quotes from 15 to 25 dealers, based on their credit relationship through an aggregation tool.
“The buy-side sets up an infrastructure that boils down to request for quote or request for stream,” said Bailey in an interview. “Then with technology, you are ranking bids and offers to quickly execute,” said Bailey.
Judging from the report’s subtitle, “The Pools Merge,” Celent is predicting what will happen. For the moment, the dealer vs client pools are “separated or partially separated pools of liquidity within the same firm.” Because FX is still a principal-based market, there are still distinctions as to who is let into certain areas and how they are defined, adds Bailey. But as non-traditional liquidity providers compete with the sell-side as price makers, “It becomes more and more grey who a dealer is,” said Bailey.