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And Another Thing…

And so the real crisis approaches.

Industry financial markets have felt the squeeze for the past six years, initially in the form of a battle for financial survival, and latterly more from the growing pressure of regulation. I have discussed several times in this column the growing problem of margins being squeezed while compliance costs soar; now we are starting to see the response of some players.

The withdrawal of Rabobank from FX prime brokerage is something of a surprise given how several platforms were content to use them and it seems, at a distance, to be a decent, functioning model. Whether or not the withdrawal was the result of a blow up at a customer, as is rumoured in certain quarters, is neither here nor there. If the model was working then a bank of that credit strength could withstand it.

The issue is it chose not to.

Likewise, we should not be overly surprised by RBS pulling its horns in when it comes to OTC derivatives business – the bank has had some widely publicised problems and inevitably the recovery from those issues means some businesses, that need investment badly, are not going to get it.

My concern is that these banks are only the tip of the iceberg. I continue to hear of this player or that player pulling back from what were not especially ambitious growth plans – and always it is on the grounds of cost. I need to stress that I am not advocating a return to the days where banks could charge what spreads they liked and made money pretty much from every trade they did; more I am arguing that we need a fair system that allows those taking risk to be rewarded for it.

This is not only about banks – several non-bank market makers having already been forced down this route by curbs on high frequency trading, have drifted away from the role of making markets. Why? They can’t make money at it. And whereas a bank has other business lines to fall back upon – a revolving line of credit, for example, or a custodian relationship – non-bank market makers have nothing.

This group survives by having better technology and using it smartly – if that value disappears where do they go? The only sensible solution is the door marked “exit”.

If I am right and more institutions are going to exit parts of the business, this does ultimately create the real crisis. We understand the “flow monster” approach can work, but typically only for three or four institutions. But a great deal of that flow, especially in foreign exchange, is generated through business with other banks. If these banks pull back, then that has an impact at the top end of the market.

The real liquidity crunch could be approaching – and it’s a crunch for some of the end users, the very people regulation is meant to protect. Increasingly people are asking, “Why am I in this business?” It’s a valid question and the answers all too often are unpalatable but inevitable.

Unless we get a serious debate going over how the market continues to maintain a healthy ecosystem, with players of all shapes, sizes and background, the danger is we drift into an inefficient, worthless industry that costs the real economy money. And that is the antithesis of foreign exchange – it is a market that oils the wheels of commerce, not one that throws a spanner in the works.      Twitter @lamboPnL

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