Here are three statements.
“Fragmentation exacerbates the already inherent challenge – adequate liquidity – and increases market fragility as a result.”
“Fragmentation leads to smaller, disconnected liquidity pools and less efficient and more volatile pricing.”
“Divided markets are more brittle, with shallower liquidity, posing a risk of failure in times of economic stress or crisis.”
These are not my words, but those of CFTC chairman Christopher Giancarlo this week in his opening address to the Commission’s Global Markets Advisory Committee.
I should stress that Giancarlo was talking about swaps markets and the challenges of fragmented regulation, but his thoughts are nonetheless, food for thought for the FX markets. Is adequate liquidity always available in FX? No. Does fragmentation make markets fragile and brittle? Absolutely.
As always this is not a black and white issue, however, for competition is vital in the industry as it maintains reasonable price pressure whilst breeding innovation, but has fragmentation gone too far in FX? It depends on how you look at it. At the top level in terms of the public platforms we are seeing ownership consolidation – most of which will, somewhere down the line, lead to greater efficiencies for customers in their front-to-back FX trading. On the other hand we are seeing more interest from banks in building bespoke liquidity pools for their premium clients – and indeed the same from many public platforms – and this is fragmentation again.
To me the interesting question is ‘who is the market being fragmented for?’ I don’t see too many hedger-type clients struggling with fragmentation because all they really need is one bespoke pool of liquidity, with the LPs of their choice and the appropriate connectivity front and back to their systems. Quite honestly, if I am an asset manager I would wonder why I bother with public platforms where the vast majority of LPs are there to take advantage of my business and not help me with it? So few hold the risk, especially if it is traded publicly, so why expose myself to this risk?
The speculative community on the other hand – where fractions of a pip can make a big difference, and the high-tech players with a speed advantage – they love fragmentation. It enables them to “exploit inefficiencies in the market” (arbitrage) and bring price improvement (improve top of book by a fraction of a pip in a fraction of the amount).
Most LPs, bank and non-bank, will tell you which pools they prefer to price into and which pools get their ‘A’ stream.
Chairman Giancarlo is right to highlight the role that regulation plays in fragmentation because I think one of the bigger factors in FX has been the squeeze on credit and capital. This has seen the explosion of firms in the prime-of-prime space who are, effectively fragmenting the market further with their own quasi-ECNs. This has also, I would argue, allowed too many firms to claim “liquidity provider” status when they are really just recycling liquidity and are going to struggle to be in the market at the very time they are required because their own “tier 1” providers have turned them off.
Hopefully this will be an area where data and analytics will help sort the wheat from the chaff, but it also needs a degree of transparency about where the pricing comes from. Someone asked me this week how many “real” liquidity providers I thought there were and my answer surprised them, because firstly it was high (in terms of the global market) but then low (in terms of the major currency pairs). The question was framed in the context of ‘who would be in the market with a price if the screens went dead?’ hence my answer that we would still have a lot of local markets specialists pricing, but very few at the top end of the table.
I do wonder if the data will, eventually, show up the good from the less-than-good when it comes to liquidity in that it can help customers (and, importantly, their oversight) understand that a well-functioning FX market will bifurcate along two lines, “good” pools with a deeper liquidity ladder and the “shark tanks” (with a good top of book). It is then their choice as to where they want to execute, and if they choose the latter for a good top of book, good luck to them but don’t come crying to the rest of the world when you have market impact and slippage.
There is clearly too much spin in FX (it’s a reflection of wider society of course), but it is significant to me that the CFTC chair is sounding this warning about the swaps market which is still at a relatively early stage of its development into an automated structure.
It seems to me that Chairman Giancarlo does not want fragmentation of rules or liquidity, but it is hard to see how it can be avoided. FX is actually quite lucky in that it has, still, primary venues from which most prices are derived, but it may not stay like that. If we get further fragmentation, or more specifically a dilution of liquidity away from primary venues then FX will have to ask itself, as the swaps market inevitably will, how far does it want to push for efficiency at the risk of weakening market functioning?