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Foreign exchange

Structural changes in the FX market reduce liquidity

Moving target

Structural changes in the FX market have reduced the depth of available liquidity and buy-side firms must adapt their trading strategies to achieve best execution.

It is probably one of the most nebulous and yet fundamental concepts in financial markets. Liquidity is the lifeblood of foreign exchange as much as any other asset class, and yet practitioners and public sector officials often struggle to agree on a common definition or benchmark to measure its depth.

But what is clear is that a confluence of factors has led to widespread concerns that liquidity has diminished and buy-side firms can no longer always access firm and tight pricing in the way they once could. Such factors include the weight of prudential regulation constraining bank market making, the rise of the agency model of execution and nonbank liquidity provision.

Taken together, these forces have contributed to a major shift in the underlying ecology of the market and the role of banks as liquidity providers. That shift has been well-documented, but its full effects are only gradually being felt.

“Over the past year, the buy-side has become a lot more sensitive to the concept of depth-of-book liquidity rather than just top-of-book liquidity,” says Michael O’Brien, director of global trading at Eaton Vance. “Across asset classes there is only a finite amount of liquidity available at the top-of-book price, so investment firms need to constantly assess the impact of moving large orders and adapt their trading strategies accordingly.”

In addition to the broader regulations that may impact multiple asset classes, the increased scrutiny of conduct among FX market makers and changes to certain market practices may also have an indirect impact on liquidity.

“The higher standards to which banks must now hold themselves effectively make it more expensive to manufacture liquidity, which in turn reduces liquidity,” says Phil Weisberg, global head of FX at Thomson Reuters. “This is particularly true in the case of principal market making, which is being subjected to stricter limitations – that may eliminate some conflicts at the fringes, but it also makes liquidity provision more challenging.”

FX turnover data clearly gives the impression that the depth of the market has changed. While trading volume cannot be used as the sole barometer of liquidity – it is about the ability to access firm prices as much as the provision of those prices – turnover appears to have declined more sharply than usual over the past year.

The semi-annual turnover surveys published by the Bank of England and the New York Fed in January 2016 highlighted a 21% year-on-year fall in FX turnover in the UK last year and a 26% fall in the US. By October 2015, average daily volume had fallen from $2.7 trillion to $2.1 trillion in the UK and from $1.1 trillion to $809 billion in the US.

Meanwhile the results of the Bank for International Settlements’ latest triennial survey, which was conducted in April 2016, will indicate whether the overall FX market has contracted from the $5.3 trillion daily turnover recorded in 2013. But in the meantime, market participants are facing up to the implications of reduced market activity on a daily basis.

“There is a big structural change taking place in FX and we see it in the relative growth in the assets under management of the investment community in comparison to the declining amount of capital sell-side firms can allocate to market making,” says James Bindler, head of G-10 FX at Citi. “The imbalance between the growing buy-side and the shrinking sell-side means the liquidity that the investment community requires is not always there.”

It’s an imbalance that many policy makers have acknowledged and the public sector claims to be monitoring it closely, but the complexity of liquidity provision and the multiple factors that affect it make it a difficult problem to tackle.

FX liquidity imbalance, James Bindler

In a speech in London in October 2015, Bank of England Deputy Governor Minouche Shafik defined liquidity as the ability to trade in reasonable size without having a large impact on price, pointing to several recent examples of market fragility. They include the dramatic intraday appreciation of the Swiss franc in January 2015 that left several large market participants nursing heavy losses, and the sharp moves in USD/JPY during the volatile period sparked by China’s devaluation of its currency in August 2015.

“These episodes show us that banks and nonbanks’ ability and willingness to put capital at risk in the face of large-scale order flow imbalances has changed,” Shafik noted. “Although liquidity may on average be higher, the risk that liquidity may not be available when it is needed most has also risen.”

As policy makers continue to monitor the cumulative impact of regulation and the ways in which liquidity providers and market infrastructures may need to respond, buy-side firms recognise that they too need to adjust their operating models if they are to continue to access the market in the most efficient way possible.

This adjustment may take place in a number of ways. For some firms, it could mean expanding trading desks and resources so that they can tap liquidity through a more diverse set of channels, while others may consider peer-to-peer matching platforms that allow the buy-side to generate its own liquidity.

“There has been an explosion of solutions to source better liquidity and the FX market has certainly fragmented as a result,” says O’Brien. “We still rely heavily on the banks but we often test new platforms and will use them if there is liquidity. My goal is to give our traders the tools they need to get the best possible execution and that inevitably varies on a trade-by-trade basis.”

Against the backdrop of fragmenting liquidity and new execution channels, the need to monitor how trades have performed and use that analysis as the basis for future decision making has increased. Transaction Cost Analysis (TCA) has been an important tool for equity trading desks for many years and is gradually now permeating the FX market.

“TCA technology is evolving rapidly and we want to keep up with the latest tools to measure the quality of our execution because we believe our methods are achieving best execution but we need data to support this,” says O’Brien. “If something was not working as well as we had thought, this should be highlighted in the TCA reports.”

As with many industry issues, the level of buy-side engagement on liquidity varies from one firm to the next. But as prudential regulations are phased in over the coming year and changes to market conduct rules are finalised and implemented, there will be a growing need for trading desks to take greater control of their orders, relying less on the resources of their counter- parties. That will be a big cultural shift for many firms.

“As the cost of liquidity rises, there will be a trade-off for investment firms between accessing the market themselves or relying on someone else,” says Weisberg. “All of the work on conduct should serve as a reminder that when banks act as principals, there will be times when their interests don’t align with those of the buy-side, and firms may need to consider other execution options.”

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