As we reported at the start of this week, Citi formally confirmed what most of us knew, that it was cutting the number of connections to its FX business. I see this as the start of a process, however – nowhere near the end – one that also reflects what is likely to be a period of greater pressure on providers of aggregation technology.

I have written often in these pages about the challenges of fragmentation in markets, and more recently at what I thought was a growing mood to turn back the tide – indeed I wrote something saying exactly that after Forex Network Chicago last year and just weeks before the Citi scorecard was revealed to the world. This mood is not going to end with one bank trimming about a quarter of its connections, not only do I expect Citi to trim further, but I expect other banks to follow – and they may be helped by the regulators.

It has been a regular complaint of people I speak to in the multi-dealer platform world, that aggregation providers, many of whom are offering a very similar service, are not subject to SEF or MTF registration. At face value, you have to say this seems unfair, especially if the liquidity provider (LP) is being charged for the “privilege” of streaming a price under “winner’s curse” conditions, i.e. when a customer only deals with them when they are worse price.

Just look at the models involved; one offers users the ability to put their LPs in competition and trade with a single connection, the other offers users the ability to put their LPs in competition and trade with a single connection. Where’s the difference and how come one set of providers has to adhere to regulation whereas the others don’t? It doesn’t make sense.

I accept that some aggregation providers out there offer a technology solution to the liquidity consumer (LC) that is bespoke to that firm and they do not charge the LPs to stream and I agree these players should not be subject to the regulation, unless they also offer the same model to multiple clients. If that is the case then surely they are offering a generic connectivity solution to multiple clients, across multiple LPs – how is that different to a multi-dealer platform? I am no fan of regulation, but I do believe in a level playing field, and this seems to be one area where there is an unfair tilt.

I am told by people familiar with the matter, as I have written before, that a big driver of the Citi scorecard was a desire to cut those venues who charged the bank to stream its own liquidity, who were not subject to regulatory oversight. There is no suggestion of impropriety on the part of platforms to be cut off, but I do find it interesting that while Citi’s press release on the subject highlights adherence to the FX Global Code it also observes the need for “the availability of SEF & MTF venues”. This tells me it also believes there is an unfair playing field.

The network of communications that have grown up around the banks and other LPs is quite remarkable, but it is the result of these firms exhibiting a lack of control in how they grew their business more than a decade ago when they were happy to be led by “clients” dictating where they should stream to win their business. As the value of many of these “clients” has been better analysed – resulting in them being repapered as “counterparties” – inevitably the connections through which they came are coming under scrutiny.

I likened the situation when discussing the issue last week with a senior banking source as “the lunatics taking over the asylum”. We went through a period where a relatively small (and occasionally large) technology vendor felt comfortable dictating to a major LP how they connected. There was no thought that without the LP’s stream that vendor would have a decidedly inferior product to offer its clients – but then why should it when even the major LPs were caught up in the scramble to price to everyone in the desperate grab for market share?

That has changed, and Citi’s move is the first public step in the process, although it would be very remiss of me not to point out that there are a few banks that did not get involved in the rush for connectivity in the first place, and who, therefore, have no need to conduct such a review. These firms have been careful with how they distributed their liquidity from the start and the market seems to be coming back to them, rather than them having to catch up with the market.

I also think that the pressure will be ramped up on those market participants who use the aggregators. Generally speaking there is a link between the type of participant and the aggregator they use. The more aggressive players typically don’t have limited, bespoke, pools of liquidity, because that makes it too easy for the LPs to analyse their impact on the market and their value to the franchise. That limited model also, into the bargain, makes it a lot harder to sweep the market and conduct other “friendly” (sarcasm alert) methods of executing trades. Several bankers have told me recently that they are starting to see a link between certain types of market behaviour and the channel being used – if it ends up getting costly the liquidity will be thinned out in the channel, and will not be as cheap as it once was. What does the LC do then?

The bottom line in all this is – and this is something I identified last year – the growing realisation amongst the major LPs of the value of their liquidity. As they are better able to watermark their liquidity and thus identify the channels through which it is being recycled, so the pressure on recyclers and those channels that support them will be ramped up. The result of that, inevitably, has to be a reduction in the number of channels and in the modern world the first line of defence for such a conduit is going to be a rule book. It’s a simple question; how many aggregators have a public rule book and can prove they are balanced between LP and LC? I am sure several can prove the fairness angle, maybe a few less will have a rule book and even fewer will have it public.

The foreign exchange industry has always been good at self-regulation – it may have been late to the party a couple of times but generally speaking it does the right thing eventually. What we are seeing at the moment is the actions of a few LPs imposing self-regulation on the market. In an ideal world the pendulum doesn’t swing too far past the even. Either way, this evolution poses serious questions for some service providers in this market, but if the outcome is a fairer, more balanced market, we should not complain.

Twitter @lamboPnL

Colin Lambert

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