I noticed that an old favourite turned up in the news cycle last week – indeed I suspect it is moving into the market’s general psyche given more people are talking to me about it – and that is peer-to-peer matching, more specifically asset managers seeking to by-pass the banks because the latter are able to “read” their intentions.
It won’t work.
There seems to be this Narnia world out there in which people actually believe asset managers and corporates will match off with each other. It does exist (nearly), it’s called the Fix, but asset managers seem to understand, if one story I read is right, that is a costlier way of doing business. Aside from asking the question ‘why are you continuing to use it then?’ I would be very interested in seeing the matching opportunities between these client segments, I suspect it would be very low.
Of course, yet again, the banks are inadvertently helping to fuel this pipedream with their silly marketing and wrong messaging. These clients are sitting there, reading and listening to the banks spout their nonsense about 90% internalisation rates and thinking ‘well if there’s that much matching, why I am paying a spread?’
The reality is of course, that real internalisation rates are nowhere near those levels, if you take out skews to client books, let alone to external markets (both of which are strong signals) the rate drops sharply. Throw in the fact that LPs may occasionally hold this risk for minutes and skew on and off during that time and you have a different picture to that being painted. Put bluntly, it just ain’t that easy and once again the gap between the marketing (this time of internalisation) and the reality (as measured by “true” internalisation that creates zero market impact for the client) is huge.
There is the question of timing as well – to hedgers like asset managers and corporates they want to do just that, hedge; they don’t want to be market makers. How long do you think it will be before one of them has to ‘fess up in their annual report that they under-performed their peers because they were wiped out on USD/JPY and how well do you think that would go down with investors?
How long does a corporate or an asset manager want to leave the bid or offer in the market before realising they aren’t going to get hit? And when that happens and they have to cross the spread, do you think it will be a fraction of a pip wide? More pertinently, we have perfectly firms like BestX and FairXchange offering acceptable independent mechanisms to judge execution quality in FX – use them.
There is also a huge downside to this idea that doesn’t seem to have been considered – what responsibility do the LPs have to a customer if they persistently deal away? I can answer that one – none. Do we really think that an LP is going to accept being hit on an ECN, or ignored totally for months on end, by clients, and then quote them a tight price in size on those occasions they are asked? We shouldn’t be, because the very fact they are being asked probably means that there has been a market dislocation and, guess what, there are no prices available!
Look at the WM Fix. It’s expensive (apparently) because of signalling risk. That is the price people pay for all trading in a targeted, relatively small window in which the only way to execute is via a TWAP which is easily spotted. But who is making money that these firms are giving away? It’s not the major banks, they are acting as agents for this business and in some cases are either not allowed access to the info, are not allowed to position on the back of these business, or both.
No, the people making money at the WM are those hundreds of firms with no obligation to the customer and who can easily spot ‘dumb’ flow in the market. Why would it be any different on a non-LP mechanism? Oh that’s right, it would be different – it would be worse. The second the flow goes public, not only would the independent firms be able to trade around the information, but so too would the major banks. Of course, the firms looking to transact could try and mask the business by trading at odd times but then they still have the problem of not finding a match.
Someone suggested auction windows to me the other day, and that is fine, but what about the exhaust flows? As WM shows, you can match off close to a billion dollars, but there could easily be another yard behind it left in the lurch – good luck getting that out into the market without impact.
Take a look at the last BIS survey (and yes I know it is horribly out of date but we shall see if it is radically different in a few months) in which the institutional investor segment executed $290 billion of spot per day. Non-financial institutions (largely corporates) executed $117 billion.
Let’s use those rose-tinted spectacles of the proponents of a buy side only mechanism and assume (laughingly) that all of that corporate flow matches off with asset manager flow at the appropriate time. That still leaves the small matter of 170 yards of volume to get through, but I’m sure that will also match off perfectly between managers…
Unfortunately this is just another example of some members of the buy side preferring to moan about their lot rather than actually doing something realistic to remedy it. They see the LPs (largely the banks thanks to the well-publicised misdemeanours in previous years) as to blame and seem unconcerned about their own shortcomings – it is epitomised by the group of funds suing the banks over “manipulation” where, they say, they have to sue the banks to protect themselves from investor lawsuits. In other words, ‘we know we dropped the ball but it wasn’t our fault…honest’.
There are solutions to this issue for the buy side if they are that concerned about execution quality. Start with dealing with the right LPs and they shouldn’t have this problem, especially as the latter have reformed. More importantly, use the data and analytics available and seek to understand where your information leakage is coming from, rather than continue to complain without actually doing anything about it.
I know I really don’t like the whole “customer is always right” mantra, but surely this is a case of that getting out of control? There are broad swathes of the buy side that are conveniently ignoring their responsibilities to investors or shareholders, but rather than accept they could do better they seem to prefer lashing out at third parties and backing people with pie in the sky ideas.
The data and technology exists to do a better job, so why oh why, don’t these firms use it? Answers on a postcard to the usual address.