There is still so much “spin” around liquidity, for as we have noted in our In the FICC of It podcast, while the platforms and liquidity providers would have us believe there is no problem, the occasional flash move and, more pertinently I would argue, survey results indicating liquidity remains a very high concern for clients says otherwise. There would appear to be a rather large disconnect between what the service providers are telling us on one hand, and what the consumers think.

Part of the problem is that in spite of various pieces of academic work, there is no real way to measure liquidity in FX markets – and even if there is, it is likely to be a historical estimate – just ask any trader on the wrong end of a move, liquidity is great until it isn’t. It used to be the definition of liquidity was “You can get as much done as you like when you’re wrong”, that has changed in the modern era to a degree (it still stands up to scrutiny during larger moves) and should now probably be something like “Liquidity is great…until the market actually moves”. The nature of the FX market now is, as I have noted for some time now, one of long periods of inactivity during which everyone has a price in the market in their desperate need to get flow to turn for half a tick, interspersed with brief moments of extreme short term volatility during which hardly anybody can get anything done. It’s the ultimate feast or famine.

I have to say I have always believed that to the hedging community especially, low volatility was a good thing – there is plenty of liquidity to get their business done apart from the rare occasions when one of their hedges is caught up in (or triggers if done badly) one of those bursts of volatility, but a comment from an acquaintance on an execution desk recently disabused me of that. Apparently lower volatility can make it harder for them to show their worth and execution skills – because suddenly everyone thinks the market never moves and as such one pip slippage becomes an issue! It’s always tough when laymen suddenly become “experts”!

Liquidity is more of an issue for the speculative traders because they are the ones most likely to be desperate for it when things get very busy. I am not sure there is much that can be, or needs to be, done to help them, it’s just the changing nature of the market. It is also certainly not helped by the narrowing of focus amongst the speculative community – there is a real lack of breadth of trading styles at the moment and everybody appears to be chasing the same dream, with a few variations along the way. In a world in which everyone is looking to make small, short term, gains we inevitably get the herd phenomenon. It used to be traders would be at risk if they were in a crowded trade, now the problem appears to be a crowded strategy – yet another impact from the technological revolution that continues apace.

I also believe that another change brought about by technology and the market structure is less than helpful – the vast number of firms claiming to be liquidity providers or market makers who are, in fact, merely recycling someone else’s price. This has bred a belief that every price constitutes liquidity to the market when it is clearly apparent that often it is anything but. Not only are many prices last looked, others are subject to continuous cancellation – I recall an academic paper last year that looked at trades on EBS (the issue is the same for other platforms, however) in which it was stated that 85% of orders submitted are for the minimum amount allowed – at the time one million units. The paper also noted out of 2.3 million order submissions studied, 99% were cancelled before trading. Again I ask, is this real liquidity? Obviously at times there will be genuine interest from someone looking at to trade in a small amount, but those numbers tell me that the vast majority of prices on a public platform are not backed up by genuine interest – they are either a lure to get someone to trade so that the LP can make a quick turn or an attempt to learn of larger orders that can be traded with of course.

So perhaps we need to think about redefining liquidity, actually try to achieve a consensus on what good, robust liquidity really looks like? There are ways to measure levels against a historical norm (nearly used the “B” word there!) just look at any algo execution provider. Their data is based upon expected outcomes using historical data and takes into account whether last look is in play or not and what reject rates and historical slippage levels look like. Perhaps this data can be anonymised and aggregated to give an industry-wide picture? There are a couple of issues of course, the first being that so many LPs price across multiple venues that inevitably hitting them on one will see at least five cancellations elsewhere – multiple quotes would need to be filtered to some degree at least.

The second issue would be, like Turkeys voting for Christmas, I am not sure what is in it for the algo providers if they take part in a venture that will inevitably dent the FX market’s image as an incredibly liquid place in which you can get just about anything done if you have the time. It is, of course, but the critical phrase there is “if you have the time”. Overall though, smart order routers use this data to make decisions all day, every day, so we have the basis for measurement.

If we can more accurately judge those venues on which liquidity is historically robust, with more resting orders and less price cancellations at top of book, we would go a long way to achieving a more transparent landscape. Clients would be able to make a better judgement on where to place their trade and, to me this would be a real positive, we could winkle out some of those LPs who are anything but. I spoke recently to a firm that was boasting about their “Tier One liquidity” and who referred to themselves as a “liquidity provider”. They were, and are, anything but – they rely upon other market participants for their pricing and in this case didn’t even have a dealing function! How can you provide liquidity to the market if you don’t generate the price yourself and have no view of the market? That is not an LP, it is a broker and should be labelled as such for all to see. As things stand there are quite a few clients who have not thought this through sufficiently who are buying this bull.

Technology has been a huge enabler for the FX industry but it has brought challenges – one such being what can only be described as a false picture of liquidity in the market at any given time. Perhaps now would be a good time to use that technology to lift the veil on this issue and show people – specifically clients – exactly how things look.

Twitter @lamboPnL

Colin Lambert

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