Those of you who stayed with me to the end on Thursday’s column would have seen the teaser over why I think this is not the time to be buying an FX platform – so here is my thinking, and it’s pretty bleak.
I have been asked in the past why I have such a thing about risk taking – it’s a fair question, I do have a thing about risk taking. People argue with me, saying that the nature of risk has just changed in temporal terms – institutions still hold risk, it’s just not for as long as they used to. That’s fine – to a degree – but that’s not what I am talking about, I am concerned at the lack of risk taking in FX markets. That is where I think the threat lies, and not just to the FX industry, but the broader financial economy.
The problem is, as I have noted before, very few people in a position of power, both institutionally and regulatory, seem to understand the different nature of FX markets. In equity and futures markets there are plenty of risk takers, and the vast majority of them are very small players – in equities there is also that underlying demand from investment funds as well, which helps boost demand.
Traditionally in FX this risk-taking function has been fulfilled by the banks and, occasionally, other trading firms, to help their customers offload large FX risk easily, but that function is dwindling, no matter what people say. Just last week I was told that Lloyds was cutting back on its trading activities to focus purely on G10, I couldn’t get a second source on the story but Reuters News did and had something similar to report. This highlights the issue to me, because what is a bank in G10? It’s a broker, nothing more, nothing less. It is in those markets away from G10 that most opportunities exist – if a firm is willing to take some risk. Clearly in this case, assuming Reuters and my own sources are correct, Lloyds isn’t – it’s going down the same rabbit hole as so many other banks have in merely facilitating customer business.
And this is where the problem lies – banks merely facilitating customer business. In a risk-taking environment, a bank trader or trading function would have a view on the market and if a customer dealt against that view they would be happy to wear the risk. That view could be a few minutes, an hour or two, days or even weeks; now it is milliseconds, seconds, or a few minutes – if it exists at all.
Fine, you say, there is no real problem here, the nature of risk has merely changed – but has it? I would argue that what has changed is firms’ willingness to take any risk that can be outsourced back to the customer via an algo or cleaned out in the quickest possible time to other clients – and that is a broker, not a bank and that is risk-washing, rather than taking.
This leaves us with a market structure in which more and more banks in particular are going towards an agency-style model, thanks to their lack of appetite for risk, which means all the business gets concentrated in the hands of a few major players, who warehouse it to a degree, but themselves become de facto exchange-type mechanisms (with the associated risk of heavier losses on those occasions the market does move).
That may work, who really knows, I suspect it won’t but I have been known to get the odd* thing wrong. The problem for those banks seeking merely to facilitate business is that in reality we don’t need all of them, especially in heavily banked markets like Europe. If I am looking to do an FX transaction and I am, for example, French, I have more local banks that I really need, not to mention a few dozen other Eurozone banks with whom I can deal without regulatory hurdles. How do these banks expect to compete in the FX market for customer business when all they are going to do is push the business further down the line to a big player, who can probably facilitate the business themselves, thus eradicating not only some latency in the chain but the value that the local bank wants, needs, to chisel out.
Effectively everyone becomes a broker and we all know what happens to brokerage when there is heavy competition. The fictitious aforementioned bank finds that not only can the ultimate LP provide the price to the customer (especially as credit intermediation improves), thus removing all of the regional’s margin, but there are probably a dozen other banks in the same region all pushing to get the business. The result is the same either way – margins get destroyed because the model simply will not work unless there is a heavy domestic retail and niche customer base to dig it out.
So the regional banks, unless they have a genuine niche which so many do not, get squeezed out and their FX businesses get cut and cut again as revenue streams simply disappear. There is a potential answer to the issue, which would allow them to be more valuable to a client occasionally and, in the right circumstances, create another revenue stream, and that is to have a risk-taking function. This would allow them to make money when markets do move – and they still do in spite of the hype around low volatility and, when it suits, to show the customer a much better price because they are willing to get out of their risk at market.
Of course, this means that bank overseers need to understand that it is OK to make money out of customer flow if it is held for more than a few seconds – the customer does not always have to be right, especially when it comes to picking market direction. There are some out there who believe if an LP shows a good price, the customer deals and the market goes in the LP’s direction then the customer should be given an improvement. That is not financial services, that is charity and while the tax breaks may be decent, I don’t think we should be confused about the business the LPs are in.
It is hard, therefore, to see how the tier two and three banks, without that original franchise, can continue in the present environment and make no mistake, more volatility will not dig these players out of a hole. In fact more volatility, especially of the random and violent nature, could make things worse for a lot of firms if they don’t have the ability to wear risk and a loss.
This leaves us with that top tier who, as I have explained, will try to internalise as much as they can – and again, without taking on too much risk. Just look at the BIS paper I reviewed recently on liquidity in FX swaps markets – G-SIBs deliberately pull back from the market at quarter ends to ease the regulatory burden on their bottom line. That does not signify a market segment looking to add to the risk it takes, so effectively these firms are brokers as well, just on a much vaster scale. They are the ultimate ECN or exchange where everyone goes to match.
Which brings me, finally, to the point of all this. What are the FX platforms? They are brokers; they match buyers and sellers and source liquidity for certain counterparties. That’s fine, the model is needed and works with both buy and sell side (more the former of course but the customer is at the centre of everything we do whilst making $6 billion per quarter). Do we need so many platforms, though? Of course we don’t, and that is why I think the timing is wrong to be a buyer in this industry. Overall spot volumes went up according to the BIS last year, but most platform volumes are flat to lower on the same three year period, with the exception of a few that were in growth phase. The only way to be a buyer in this game, surely, is if there is a swaps opportunity?
In the last two weeks on our In the FICC of It podcast I have been labelled an “FX geek” and “uncle”, which suggests a certain maturity (in temporal terms not behavioural) and there is indeed a big lesson from history that is applicable here.
We had an industry that was suddenly empowered to trade much easier than before and a large number of intermediaries sprung up all over the world to facilitate that trading. There were global players and regional specialists and things were good – everyone was going OK or better. Then the number of firms trading the product started to diminish, mainly through mergers and acquisitions, and the pressure on the intermediaries started to be felt – brokerage was repeatedly cut and when the pain became too much there was both M&A and closures in the industry. Advances in technology piled on the pressure and businesses that were once employing thousands of people globally were down to a few dozen, most of them in small specialist areas – and brokerage continued to be pressured. Now, there is, with the exception of a few centres, nothing left.
This might sound like some dystopian vision I have had, but it isn’t – it is the story of the voice brokers in spot FX.