Not for the first time I have been copping some flak over a previous column, although, again, I have to say there was some support for my views on the lack of risk taking and its potential impact on the platform market. So, as I like to do when faced with opposition for my views, let’s double down on them and, into the bargain, talk about relationship breakdowns!
I won’t repeat my arguments from last week, readers can access those for themselves here, but let’s talk about where the growth is for banks in this FX market. Increasingly I am told it is in the credit space but guess what? This is again a broking function and we don’t even need to speculate on what happens to broking fees in this world, just look at the race to zero 10-12 years ago leading to the world’s biggest FX prime broker pulling the plug on some high profile clients this time last year. Yes, I accept the world has gone on (and, I am told, fees have risen slightly), but is this really a growth area? If I am looking at my FX business in comparison to its peers, do I really think there is upside in adding to what is already seen as an over-broked market?
So if that isn’t an avenue, surely there is always the client-centric business model? Well I am not sure there is to be honest, or if it exists it is very niche and unlikely to be a source of serious growth. The corporate world is pretty well tied up with funding and credit arrangements dictating the panel of LPs the corporate uses to hedge, so that will remain a valuable business. It is not, however, a big business as such. Yes, at the lower end of the spectrum there are wider spreads to be earned, there is also the fact that corporates rarely “time” their trades beyond what their hedging rules state, but can you build a growth story around that sector? I am not sure you can.
It has to be acknowledged that spot FX turnover with non-financial institutions (so not exclusively corporate) has risen by 47% since 2004, but the broader spot FX market has grown by more than 300% in the same time – and that includes the recent period of low volatility. Corporate turnover recovered in the latest BIS survey but it remains significantly below that in the 2007, 2010 and 2013 surveys. If the corporate world were a love interest in a film, it would be the old couple that have been together for 40 years and are pretty much done with doing anything radical to change things.
The banks’ love affair with the hedge fund is worthy of a Hollywood movie, and what a weepie it would be, because they are split between wanting to chase the big global funds to provide broking services for, whilst at the same time trying to sell them execution services that those same hedge funds can probably do better themselves. This changing relationship has prompted some introspection on the hedge fund side as to how they operate in markets (not before time a whole generation – or two – of traders say), but it hasn’t left the banks in particular any more willing to engage with them on anywhere near the terms they used to.
The peer-to-peer spot world is about shifting large risk in, preferably, one ticket, so have the banks not been listening to these customers as they continue to offer products and services that break the order up – and leave the customer holding the market risk
Which brings us to the darlings of the FX world at the moment, asset managers. From trying to grab the benchmark business to selling these managers algos, the banks have been keen on this segment for a few years now, but as with the hedge funds, the love affair could already be on the rocks, although this time with the banks being the rejected party.
I still struggle to believe that a spot peer-to-peer matching platform will work unless it is merely a netting solution (and there is never any market impact around the existing netting solutions like benchmark fixes…oh wait). That said, there are brighter minds than mine out there that believe it will. It could be these minds are clouded by a distrust and, frankly, dislike, of the banks for condoning the sharing of information prior to 2014 (and who can blame them for being a little bitter?) and as such are not thinking it through, but the very fact they are thinking about it means something could, just could, come off.
It’s the old “give an infinite amount of monkeys typewriters and one will write you Shakespeare” theory, but it should not be ignored that it would take a long time for that one masterpiece to emerge, just as it could take too long for some funds to find a match.
The thinking behind these initiatives intrigues me because fintechs are not usually in the habit of blowing some serious (and scarce) money on something without impetus from a potential user of that something. In this case, that impetus is coming from the asset management sector, which tells me that in spite of the careful language they use, these firms clearly believe they don’t need the banks anymore and will try to push what is often their most valuable business elsewhere. It’s effectively a customer cherry picking liquidity sources – when it’s docile liquidity it will match with a peer, when the market is moving and they want to execute quickly, they will go to a bank or non-bank LP.
This puts those LPs in a very interesting position – do they continue to offer these clients a premium stream and accept that the quality of the flow they are receiving is neither as good or as plentiful as it once was? Or do they throw their dolly out of the pram, tell the customers to be on their way (polite version) and look elsewhere for business? Therein, however, lies the rub – where is that business going to come from if it’s not the corporate or hedge fund world and they are tied up in a credit brokerage war which inevitably ends up in a race to the bottom?
I have mentioned before in this column that global FX turnover is still dominated by banks, with the BIS surveys indicating it is between 53-58% of all spot flow, so is that the last remaining sweet spot? Well it could be, but how ‘back to the future’ is that? If you look at the spot FX market in the 1990s it was heavily bank-dominated with a (larger than now) group of bigger banks who generally dominated. The big difference between now and 30 years ago is the ability or willingness to take risk – the brokerage mentality I wrote about in the aforementioned column.
It strikes me that with an important customer segment seeking to move away from the banks the latter has to have something unique on offer to keep them onside – and surely that has to be proper risk warehousing? It’s no good the banks offering algos and other execution services that hit their internal pools if the customer is already seeking a similar solution over which they have greater control and therefore trust more. The banks have to be able to reduce the execution risk for the customer by pricing more aggressively (and I think this has to be on an “only you” basis – there is enough data around to prove it was best price) and assuming the market risk. This cannot be done by a pricing algo using just data, it has to be backed up with a view – and one that lasts for more than just a few seconds, it has to be a serious intent to assume risk for a period of time. That way the client will have a big incentive to stay with their current provider rather than try out a peer-to-peer matching service.
It is hard to argue with the view that so much of this has been brought about by a toxic mix of regulation and fear, which has led banks to actively encourage their customers to break up orders into small tickets, for example. that can more easily be managed without having to have a view on the market for longer than a few seconds. The problem is, as far as I can tell, this is not what the customers actually want. After all, if a peer-to-peer spot trading network isn’t about shifting large risk in one ticket without market impact then what is it about?
It may be too late for this love affair to be resumed and if it is then the next stage people seriously questioning the scale of a lot of banks’ FX businesses. We have been talking about a smaller industry for a long time it seems (and it probably is ever since the euro became a serious prospect), but in reality it has grown in terms of the people and firms in it. If one of the core tenets of the business, servicing the customer, is diluted, however, then what happens next? Whatever it is, I can’t see how it doesn’t involve a smaller industry, meaning a real struggle for anyone in the volume game who isn’t in the top three or four.