A Perfect Storm: The Buy Side’s Liquidity Conundrum

David Newns, senior managing director at State Street and global head of Currenex, speaks with Nicola Tavendale
about the confluence of factors that are creating a unique set of challenges for the buy side.

ncreasing regulatory requirements, coupled with the
changing characteristics of liquidity in the FX market place in
recent years, has resulted in a heightened focus from the buy
side on how it can effectively manage its FX exposures. The
phase two release of the Global Code will also address
specifics relating to the principle of execution.

“The characteristics of liquidity in the FX marketplace have
changed significantly since the financial crisis,” says David
Newns, senior managing director at State Street and global
head of Currenex. “The rise of the non-banks as liquidity
providers to the FX market is evident from the Bank for
International Settlements (BIS) survey and this rise has been
coupled with a change of appetite among many of the sell side
banks to provide liquidity to the FX market.”

Indeed, a recent quarterly paper released by the BIS entitled:
Downsized FX Markets: Causes and Implications, observes this
trend in its survey data and finds that the “number of dealer
banks willing to warehouse risks has declined, while non-bank
market makers have gained a stronger footing as liquidity
providers, even trading directly with end users”. In addition, it
warns that while some of these technologically driven players
have also emerged as flow internalisers, the majority of nonbank
market makers often do not bring much risk absorption
capacity to the market.

Furthermore, recent changes in FX regulation is making it
increasingly challenging for banks to continue participating in
their traditional capacity as market makers. Newns agrees,
adding that buy side participants also indicate that their
increased focus around transaction cost analysis (TCA) has
provided greater visibility of the scale of this situation. “As a
result, the buy side is now looking at how to transact their FX in
ways that minimises market impact, stimulating interest in new
styles of execution and new sources of liquidity,” he says.

One of the outcomes of these converging factors is the
increased interest and utilisation of bank algo execution in FX.
However, this is not in itself a universal panacea for the buy side
as algo execution comes with its own challenges, warns Newns.

Tailor Made TCA

There are, for example, key issues around being able to
perform comprehensive analytics for the entire trade lifecycle
when using bank algos. The banks provide TCA as part of their
algo offering, yet the problem with many of these TCA solutions
is that they only start their analysis at the point where the bank
received the execution request, starts processing that algo and
then completes the order. “But the buy side’s requirements
actually commence at the point when the cash exposure is
generated,” explains Newns.

In his experience, this has led to the rise in use of third-party
TCA tools and even the development of ‘in-house’ TCA solutions
by some of the larger algo users to address their need for TCA,
which encompasses the entire FX exposure lifecycle.

Further to this, buy side firms face the challenge of just how
to determine what constitutes effective TCA. Algo execution is
also typically only available for spot trades, yet the buy side
does not tend to trade spot, according to Newns. “Instead, they
typically trade outrights and swaps and there are issues
around the ability to analyse those forward outrights,” he adds.
“Finding market standards for reference data in the forward
outright area is also a challenge and again, many buy side
institutions have had to develop their own in-house solutions
around that.”

Access through algos

The other side of this discussion is the buy side appetite to
access non-bank market making liquidity. Direct credit lines are
often not available between the buy side and non-bank market
makers, Newns says. There has, however, been a small amount of prime brokerage take-up amongst the asset management
community, which provides the traditional credit intermediary
to bridge that gap. “It could also be argued that bank algo
providers are in effect providing the buy side with access to
non-bank market making liquidity, given that a bank algo can
run against the sources of non-bank liquidity that the buy side
can’t access directly,” Newns adds.

This is because the bank algo provider is, in effect, allowing
the buy side to leverage the credit lines that the bank uses to
access ECN liquidity pools, such as Currenex, where non-bank
market makers comprise a significant proportion of the
available liquidity.

“This is an interesting end-to-end value chain,” he explains
further. “The buy side has a credit relationship with their sell
side banks, the sell side banks in effect provide their IP [their
algos] and their credit lines to access ECNs as liquidity sources
for those algos and those liquidity sources that are supported
by non-bank market makers, as well as the traditional bank
market maker community.”

State Street’s Global Link franchise, which includes the
Currenex and FX Connect platforms, can essentially provide the
buy side with the end-to-end solution they are looking for,
according to Newns. FXConnect, through its significant footprint
in the real money space, provides the buy side with a portal
through which they can access bank algos. Within FXConnect,
algos are represented in terms of a parameter definition
screen that the sell side can define on a per algo basis. These
parameters can even allow the buy side to determine the
specific ECNs (such as Currenex) that they want to have the
bank algo execute against.

Guiding the way

In terms of the Global Code, execution also features as one
of the six leading principles. While phase one has already
outlined general guidance in this area, it also states that
principles related to electronic trading – including algorithmic
operators and users – trading venues, brokers, prime
brokerage and unique features of FX swap, forward and
options transactions, are due to be published as part of phase
two. But the Code already advises that “market participants
are expected to exercise care when negotiating and executing
transactions in order to promote a robust, fair, open, liquid and
appropriately transparent FX market”.

Yet, if solutions are already available in the market, what is
holding the buy side back from more widespread adoption?
“Firstly, there is simply the issue of focus/priorities: there has
been a lot of work required of the buy side of late to get ready
for the implementation of new regulations in FX,” Newns says.

For example, preparation for the Variation Margin Rules
(which came into effect on 1 March) involved a significant
amount of work. According to Newns, this preparatory work had
already consumed much of buy side’s attention and even now
their focus is turned to getting ready for the implementation of
MiFID II. “Secondly, considering the universe of sell side banks
that the buy side have access to, it’s a very small percentage
that provide access to a comprehensive suite of algos today,”
Newns also argues. “And thirdly, the fact is that executing via
algos in FX is a new phenomenon – and may require the buy
side participant to modify an existing FX execution and
allocation workflow, which is familiar to them and has been in
place for some time.”

Change on the Horizon

In addition, according to a recent FX e-trading study
conducted by JP Morgan, institutional FX traders currently only
spend around 12% of their time trading with algos. However,
the same study also revealed that some 38% were also
planning on increasing their algo usage in 2017. “The good
news in this case is that you don’t have to be a “tier one” FX
bank to be able to provide algo execution services,” says
Newns, adding that there are already vendors that can offer
the ability to “white label” their solution, such as Currenex’s
White Label Algo Engine.

Newns believes that in the near future, we are likely to see
more mid-tier banks adopting third-party algo engine solutions,
which will enable them to also provide comprehensive algo
execution services to the buy side.

Ultimately, there are also sensitivities around compliance,
etc, when it comes to providing execution services to the sell
side, he warns. “So coming from a trusted, third-party vendor
like ourselves checks a lot of boxes,” Newns says. “When
looked at together, Currenex and FX Connect represent
robust and comprehensive solutions that address many
aspects of the liquidity and execution challenges faced by
the buy side today.”

Furthermore, State Street is also a global, systemically
important bank. “This means that if you are a bank looking
for a provider of white labelled algorithmic execution
services and infrastructure that addresses the needs of your
customers, we as a vendor are subject to at least the same
scrutiny around compliance, information security, IT
development standards and so on as you are,” Newns
concludes. “This is a critical factor when it comes to
outsourcing key functionality such as the FX algorithmic
execution, which is increasingly being demanded by buy side
customers today.”

Galen Stops

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