Switching Tracks: A New Direction for Online Trading?
While the build up of bank-offered digital FX services began in earnest five years ago, today we appear to be entering a new phase. Over the past year, there have been several episodes – and not only during periods of market stress – when service providers learnt a harsh and expensive lesson in the downside of mass liquidity provision. This has led, in some circles to a re-evaluation of how liquidity is offered to clients – it has also meant that the innovative minds within the e-commerce groups have been refocused onto how to offer bespoke and prudent liquidity to clients in as seamless a fashion as possible.
Over the past 18 months, segmentation by client type has determined how banks focused and developed their FX products, and this differentiation led to numerous ways of providing execution services to clients – including multi-bank and single-dealer portals, ECNs, benchmarking, white labelling, prime brokerage, and any number of targeted offerings.
These services attempt to meet the execution needs of client segments ranging from regional banks and broker-dealers; CTAs and hedge funds; to asset and real money managers; and multinational corporations. While growth amongst the latter two sectors fuelled the initial flurry of digital services, these have been eclipsed by the phenomenal growth amongst the first two segments, which are now behind many internal discussions by banks about how to prepare for the future.
“The equity market has seen limited returns and fixed income is suffering from low interest rates globally, so it’s a question of alternatives. Investors are turning to CTAs and hedge funds with unique strategies, and they are in turn putting their money into emerging markets and currencies,” says Mark Warms, chief marketing officer at FXall in London.
“Meanwhile, business with regional banks and broker-dealers is also exploding. Just three years ago, currency trading for retail customers [high net-worth individuals and smaller companies] was only available through the futures markets, because they needed a margin-type product. But today, connectivity makes it possible to provide inter-bank liquidity to the retail sector via intermediaries – and this is done in real time, with technology managing customer margin requirements,” adds Warms.
The shift in the balance of power towards the CTAs, hedge funds, broker-dealers and regional banks has had some negative influence on some banks’ FX operations, however. In the main, traders at these clients are very professional – often with better information flow than the liquidity providers, who increasingly rely upon intuitive pricing engines that attempt to estimate the customer’s position or intention as part of the quoting process. This has led some to suggest that fundamental questions need to be addressed about pricing engines. “This is extreme to the point of racking up losses in minutes. There are some very technologically smart clients out there looking for opportunities,” a source says. “The second generation of pricing engines will be faster – this is now a millisecond marketplace and you have to make millisecond market making prices. We have clients that have models that can execute in 40 milliseconds across multiple legs.”
“The role of global liquidity service providers becomes very important in this world, because banks are providing liquidity to more market participants than ever before because of systems,” another source adds. “There is a need to control the pools of liquidity that are out there.
“The liquidity mirage is a genuine problem,” the source continues. “We believe there is little value in flow for flow’s sake. “By the end of this year, we will be able to make a value judgement on every piece of flow that we see, and will do so quantitatively. We will then decide what we would like to add to our portfolio, and what we do not. When we get to that point, it will be easier to increase the flow that we’re looking to see. We will always be there for traditional clients, the question is whether we continue to electronically give liquidity to somebody’s arbitrage models.”
Although there has been much attention focused upon the grab for market share, the theory that ‘share = profit’ has not been universally embraced. One top 10 bank has long had a policy of scrutinising the client relationship throughout the bank before continuing to offer FX liquidity to clients it deems to be cost-negative. In recent months more and more whispers have spread throughout the market regarding liquidity providers “switching off” white label clients after just one or two months.
It is not all negative news for the industry of course, because as innovation has continued it has sucked in more clients. Many that were initially reluctant to embrace the e-channel have now adopted it, because the banks have provided the necessary flexibility and efficiency to make automated trading indispensable. “Electronic FX is spreading to the middle tier customer base where take-up is huge – and this is not just in FX – clients want money markets and commodities, which is why we are offering multi-asset classes on the same platform,” says James Van den Heule, director at Barclays Capital (BarCap) in London. “[Barclays’ proprietary platform] BarCap Trader is customisable so that it appeals to a cross-section of our clients, and we’re seeing strong take-up from middle tier corporates that use it for payments and execution.”
There have also been positives emanating from the sharp increase of active CTA and hedge funds in the FX market. This trend has driven the growth of FX prime brokerage, and helped marketplaces such as HotspotFXi gain traction as well as helped boost banks’ prime brokerage businesses, which have in turn extended the service benefits to other segments of the buy side.
“I think we will see continued growth in the prime brokerage space for some time, based on the growth of hedge funds and second tier banks trading volumes through electronic systems, which allows relationships to grow with these counterparties,” says Van den Heule.
Vince O’Sullivan, director at BarCap, adds that there are still a lot of manual processes behind many other prime brokerage systems. “Ours is truly cross product, run by our cross product prime brokerage group with portfolio margining across multiple asset classes,” he says.
The FIX protocol is one of a number of standards that will eventually play an important role in the future development of the market; however, the market has yet to reach common ground on the best approach. Besides initiatives such as FIX FX and Twist, many vendors and indeed banks, use proprietary languages. While FIX is gaining acceptance, often times a program can be FIX compliant, but since there is no FIX protocol for FX, the application of FIX can have minor differences. As we report on page 34, there are moves afoot to unify standards, but a common interface remains a long way off.
“The thing that has surprised me this year has been the very rapid use of FIX for FX by a number of banks who have shown leadership in this market,” says Simon Wilson-Taylor, worldwide head of Global Link in Boston. “But there is an issue of everyone using FIX in different ways, with no standard as to how FIX is applied for FX.”
BarCap is taking a leading role in its adoption of FIX for FX. “The API is a strategic heading,” says O’Sullivan. “A FIX API comes down to cross product access. Using an API, you can access equities, futures, FX, etc, down a single pipe – which is key for a lot of people.”
“As we see other banks join BarCap in adopting FIX, companies like ourselves will provide a standardised interface to customers to capitalise on multiple streams from multiple sources – and we are some way down the path towards doing this,” adds Wilson-Taylor.
Global Link is introducing an order management system, dubbed Trade Manager, that receives FIX-based streams from a variety of sources to enable users to view multiple prices, see depth of market, best bids/offers and the ability to hit best or multiple prices. “This will put more tools in the hands of those alternative investors trading FX as an asset class,” Wilson-Taylor explains.
As far as innovation is concerned, while it may appear to be something of a paradox, greater standardisation could be the key to the next wave. Banks are known to be offering or developing veritable mini-ECNs that pull in prices from multiple feeds, and the closer the market gets to a single connectivity standard, the easier it will be to showcase service innovations to clients.
New execution models are not the preserve of the banks of course. Lava Trading is one of the largest equity aggregation platforms in the US, accumulating liquidity from most, if not all, the equity market ECNs. Recently acquired by Citigroup, Lava has moved into the FX space with the introduction of LavaFX.
Lava is launching with two versions of its FX product – both designed upon the liquidity aggregation concept. The first version will take executable streaming prices direct from banks; the second will aggregate liquidity from several of the existing multibank portals, onto a single screen. “We are very much a facilitator aimed at providing best execution for the buy side,” says David Ogg, head of LavaFX.
Lava is not the first company to stray into this area of development. More than a year ago, Currenex introduced the first such iteration with its Executable Streaming Price (ESP) product, and in May, Integral Development Corporation released the Integral Integration Network, a real time connectivity system linking liquidity providers and takers in the FX markets. The system works alongside FX Inside, which enables dealers to access the network via a single, executable platform to tap all available electronic FX sources.
According to Harpal Sandhu, Integral’s president and CEO, FX Inside distils numerous liquidity sources into a single trading application that enables dealers to see not only the best tradable price, but also real time depth of market information.
“We have built adaptors into the liquidity providers’ APIs and created a virtual private network which brings everyone together,” says Sandhu, “So all a buy side organisation needs to do is connect to the network at a single point and that allows it to have automatic connectivity with all the other market players. It can then create a virtual portal, which is completely controlled at their desktop.
“Basically what this does is feed APIs into a single place and show all the bid and offers in the market,” he continues. “This provides consolidated pricing from both banks and ECNs.”
According to Sandhu, 75 institutions are currently connected to the network, of which 16 represent liquidity supplying banks. He adds that by December, this number will exceed 200.
Provided that a buy sider can deal with the credit issues, they can simultaneously operate as both price makers and takers. Connection to the network is through a single interface (API) from which dealers can interact with counterparties to negotiate, execute and settle trades. And clients can predetermine which price they deal on based on parameters such as speed of pricing, quality of price, bank preference, etc. The network provides a deal blotter, and allows users to indicate stops and limit orders. Integral is also developing a new order management module to be released later this year.
“We developed the network and FX Inside in partnership with FX banks over the past year – with a goal of reducing the number of screens needed to monitor the markets, thus affording dealers greater market visibility, transparency and execution capability,” says Sandhu. “For example, with FX Inside, dealers will see a consolidated list of providers with the associated best bid/offer prices, corresponding deal sizes and the combined best bid/offer prices aggregated by size.”
This provision of ‘bespoke liquidity’ appears to be the immediate future. While portals such as FXall do provide pricing from multiple banks, this latest concept takes the market to a new level. The ability to offer the buy side the potential to trade across multiple channels is the beginning of a new market paradigm. Indeed, there is a growing body of opinion that two models will dominate the FX market – bespoke liquidity, based upon a request-for-stream and executable streaming prices, and an exchange.
When the idea of FX moving to an exchange was first floated, there were many doubters. However, today, given the advances in credit and settlement – the idea can no longer be shrugged off completely.
While a true exchange does exist in the Chicago Mercantile Exchange (CME), market participants note that the set contract dates limit its appeal for the wider market. “The shape of the regulated market does not yet serve the needs of the constituency,” says Wilson-Taylor. “However, virtual exchanges do exist in the sense that several banks are providing liquidity to the wider market through prime brokerage and white labelling services – which are similar in that they each separate the provision of credit from the provision of liquidity.
“So the exchange model exists in a sense with the super liquidity providers – the thing that is missing is a central or super clearing house with all prime brokers clearing through a central point,” he adds. “But I don’t see a need for a formalised exchange. FX by nature is a global market and there is no global regulator. The market operates very well given the amount of regulation that exists.”
Interestingly, he adds that there is growing awareness of the CME as a source of spot liquidity. “There seems to be growing traction behind the idea that the CME can compete at some level with EBS,” adds Wilson-Taylor. “Spot liquidity may well have an additional home on the CME. Some banks are consciously supporting the CME initiative to create additional competition should EBS take the decision to open the Pandora’s box and allow some buy side traders to trade directly. Naturally, having Bloomberg in the EBS corner, and Reuters in the CME corner is adding significant spice to the mix!”
An increasing number of sources within the industry suggest that such a move by EBS is inevitable, although a spokesperson could neither confirm nor deny this possibility.
Depending on how you define “exchange” there are already alternatives to the futures exchange, such as Hotspot FX – which was the first spot platform to provide anonymous matching for both buy and sell sides and is proving popular amongst prime brokers through Hotspot FXi, its institutional dealing platform. A more recent entrant is eSpeed, which proffers up its Cantor Fitzgerald parent as counterparty, and uses CLS for settlement. eSpeed offers trading in the 11 CLS currencies in spot, spot/next, tom/next and spot/week and hopes to add execution in CME’s FX futures shortly, as Cantor is a clearing member of the Merc. The FX module follows the company’s government bond execution platform, launched in the late 1990s, and includes futures, fixed income, FX and equities (although this is currently an order routing product).
Nigel Renton, managing director, FX, at eSpeed, says the platform is aimed at frequent traders, whether they be hedge funds, asset managers, regional and private banks, or mid-tier to large money centre banks.
“CLS changes the landscape of FX,” says Renton. “Our objective is to build a pool of liquidity and a credible alternative to existing pools, but that is available to all participants. Our open API means bids/offers can easily be transferred to other market places. We have seen evidence that we are going to do more business with existing counterparts with CLS and do more business with new clients because of CLS.”
Others suggest the exchange model has not proved its worth in other marketplaces, so why consider it for FX? “If you look at equities, there is fragmentation because there is not a single exchange – and that means inconsistencies,” notes Martin Spurr, head of eVentures at RBS in London. “The exchanges that exist are efficient in their particular market places, but the fragmentation means there is a lack of the kind of liquidity you get in FX.”
“The FX industry is a very liquid, efficient and very fungible market – so what would be the benefit of moving to an exchange? Electronic trading continues to push out the boundaries and it will be interesting to observe how the relationship pricing model for streaming dealable prices – where banks create liquidity for clients – will stand up in a market environment where clients are increasingly acting as trading counterparties and using technology to exploit the market inefficiencies,” he adds.
Some argue that the greatest demand for the exchange model (besides CTAs and hedge funds) comes from those banks that have benefited least by the drive to online trading. “These banks tried to play in the premier league, but found the costs to be too high and are being forced out – so now they are looking for ways to disrupt the current model,” says one source.
While most of those interviewed do not foresee a single place where all business will be transacted, most do believe the future will be about networks talking to each other, including interconnectivity between asset classes.
“Discussions about the exchange model may be premature,” says Renton. “With technology and communication costs declining, and credit becoming more accessible, there are a number of models that can be very successful – and in a world where these are connected, the market will thrive. There are still opportunities to mix technology and business models to meet niche requirements.”
For all the concerns and opinions expressed about the current methods of liquidity provision to clients – not forgetting that innovation will continue to play a key role in pre- and post-trade services – at the end of the day the issue has a very simple focus: how good is your relationship with your client?
FX is a relationship service, notes RBS’s Spurr. “FX is still perceived as such by banks and customers – so we are creating liquidity specifically for clients (versus prices provided to a matching engine),” he says. “Some clients are not looking for relationships, they are looking for inefficiencies – which does drive efficiencies in the market. We are focussed on continuing to provide a relationship service and client solutions through things like our benchmark service. Clients want market transparency and we are gaining them this by creating a reliable market benchmark through the use of the EBS benchmarks that we collaborated to create. We are building on this benchmark to offer a range of innovative solutions including VWAP trading and fully integrated processing.”
Which brings us back to pricing engines and how smart they are. “A lot of banks are stepping out of market making, which is fuelling consolidation,” notes Spurr. “Around the fringes, brokerages are stepping in with alternatives. The challenge for our industry is streaming dealable prices – the early adopters learned the hard way, but against a benign background. It does challenge the relationship pricing model.”
“This requires a number of things to come together,” adds Tom Roche, global head of eCommerce and Agency Treasury Services at RBS in London. “You need a very good pricing engine, which is supplemented with strong quantitative capabilities. Your pricing engine needs to reflect your gross exposure, the market price and depth of liquidity to then create a price which is competitive.”
This sentiment finds support elsewhere in the market, as a source at a top 10 bank notes, “The early pricing engines take Reuters and EBS prices, chops them up and pushes them out. That is what is being severely tested now because that is where banks are offering prices that are not really there.”
To this end, eSpeed’s Renton adds, “We are aiming to build our pool of liquidity, because we see increased connectivity between different pools. The challenge is to build the order book behind this liquidity and give something back to the banking community whereby the big banks can trade liquidity pools against each other.”
“The bank of the future will be interacting with these platforms rather than just pushing out prices – those that view it as such are doing themselves a disservice. I think there will be a mix of platforms – liquidity aggregators, niche participants and models such as ours reaching a wider audience, all connected such that the best price is the best liquidity,” adds Renton.
It has been noted in these pages previously that the balance of power has shifted from the sell side to the buy side in terms of available liquidity and information advantage. One side effect of the drive to offer bespoke liquidity could be the re-establishment of equilibrium however, for it seems clear that more than a few banks are studying their client base with the intention of penalising (by way of wider spread) or even shutting down overly aggressive or predatory traders.
Price remains everything to the active buy sider and as such, a threat to the steady supply of prices has to be taken seriously – even to the extent of ‘softening up’ one’s trading style. Having said that, a recent innovation to emerge may even undermine this, as the more predatory buy side firms look to those smaller banks with white label relationships to diffuse the impact of their order flows. Innovation has been, and will probably always be, a double-edged sword.