Back in the day there were certain “clients” who would flat-out lie to their LPs about their trade being “full amount”. Nowadays, thanks to better data and analytics this type of behaviour can be spotted fairly easily and this has meant that now clients are quite open about the “full amount” not actually being “full amount” if you get what I mean? The problem for me is, this “full amount for you at this moment” approach brings with it potential risks for both parties.
I raised this issue during panels at the recent P&L events in London and Frankfurt and I’ll say now what I said then – I just don’t get it. Why would a client want to give away such valuable information to an LP – what benefits are there?
It could be argued that if the client is happy to deal with one LP for the entire parent order and breaks that down into “full amount – only you” clips, then that is fine, but to me that is a client working an order. What happens, however, if the LP’s hedging of the order falls behind? Or the client accelerates the clips? In the instance of a client working an order they are taking the market risk and it shouldn’t be an issue, but we live in different times in terms of the LP-client relationship, as I shall return to later.
Back to the “full amount” trading, though, what about when the client decides to trade the clips through different LPs? There would have been some discussion ahead of time because if the client is looking for tighter spreads in slightly larger amounts then they are going to have to reveal to the LP(s) that they will be breaking the order down but only trading individual clips with one player. This discussion will also involve ascertaining how long the respective LPs feel they need to feed the risk out to the market after being hit. Obviously this changes by currency pair and time of day so the discussions will be quite detailed.
The thing is though, the client is effectively giving information on their order to the LP – it may not be specific to a particular instance of course, but how hard is it to work out when Client A gives you larger size on a “full amount” stream, that there is more to be done?
This raises a moral dilemma to me because how is the LP to act on that information? The initial clip will have been done and as I understand it, the LP is then free to act upon that information. If the client is dealing only with the LP then perhaps there is a case to state that the LP should do no more than clear the risk into the market, shouldn’t skew the client next time and certainly should not take a position on the back of the anticipated flow (which will obviously be called “pre-hedging”)?
If, however, the client deals a clip away from the original LP then surely it’s all bets off? The LP can act on the information and skew to their heart’s content and, if there are any risk takers left out there in e-FX land, take a position? If this happens then execution quality may be degraded for the client and while I happen to think this is an issue only for that client, in this litigious age how long will it be before someone takes a punt on a lawsuit?
This bastardised version of “full amount” trading is the result of the tensions that had been growing between LPs and clients over immediate market impact. If a client was spraying the market then LPs were getting hurt and were unhappy. Likewise, if the client tried to trade in “proper” full amount, the spreads were often too wide for their liking and, especially in bigger tickets, getting a large amount done in ones just isn’t going to cut it. Throw in the push for clients to use more algos – and let’s not kid ourselves, this new “full amount” trading is a TWAP in larger size – and you have the solution. Deal with one LP at a time, give them time to clear the risk and then hit them again.
If everything works perfectly this should work, as I noted, it’s just a larger ticket TWAP algo, but how often do things work perfectly? More pertinently, when using an algo the client is often dealing with a segregated agency team at the LP with barriers between that and the principal business – in the “full amount” instance they are dealing with the principal business.
Effectively the client is giving the LP information and then relying upon them not to do anything with it – even if said client deals away (but adheres to the “full amount” strategy agreement already in place)? If the LP, due to other factors such as other client flow, fails to hedge out the risk in the window, what are they to do? Sit with the extra risk, knowing that the client is going to hit the market again in seconds, and then again and again? If the client deals away, then how does the LP know when the client has finished the order? Should they care?
This entire process of giving information to the LP and then expecting them to do nothing but act as a personal broker until the order is finished is both unrealistic, given the client numbers involved in FX markets and, more worryingly, a throwback to a darker time. In this instance the client is expecting the bank to clear their risk and do nothing with the information, something some people might call unrealistic.
In a previous instance, clients gave their banks orders to be executed at the Fix. These were typically very large amounts and had to be executed in a one minute window – something that was proven to be equally unrealistic.
In both cases the LP is being placed in a position of risk (no pun intended) because they are potentially hamstrung by information they don’t really want, or in the case of the Fix, a trade they physically couldn’t execute according to the rules. More worryingly, if a client gets it in their head that an LP or group of LPs are using the information, potentially against them, history now shows it is not unrealistic for them to call the lawyers.
To me, the use of this “full amount” strategy by the clients is silly – as I said earlier, I just don’t get it – but the problem is some clients are proving themselves very good at blaming someone else for their own shortcomings, what’s to say the same won’t happen again.
I understand that the GFXC is doing more work on disclosures and hopefully to at least a degree that work will cover this, but we cannot and should not ignore the fact that the foreign exchange industry, in its continued search for customer solutions, may well be sleepwalking into its next conduct crisis.