The “buy side” is a hydra – we use the phrase for convenience rather than accuracy – and indeed as more buy side firms face holding more risk and, possibly, seek to match with other firms, even this generic description may be out of date soon. So with the caveat that what I am about to write does not apply to a fair few firms in that segment, let’s get down to business. The buy side doesn’t care one jot about FX.
This is about more than the observation that a manufacturer cares about making things and investors care about owned assets, it is to suggest that a great number of firms that do use the FX market regularly still don’t care or think about how they use it. There is a general lack of engagement from this segment that has always been there, but over the past two decades as we all got obsessed with client-centric business models we have ignored it.
There was an interesting survey published by Greenwich Associates a couple of weeks ago that found that the majority of buy side respondents were concerned about US equity market fragmentation and thought that there should be barriers to entry for new exchanges. Obviously a big factor that supports new exchanges is regulation, specifically around best execution and the requirement to route an order to the venue with the best price, but this was also driven, in part, by those same buy side firms playing the short game and embracing the idea that hitting top of book was preferable to slippage – it’s easier to justify an execution if every deal is at top of book, and just as easy to gloss over the five points slippage caused by that same strategy; it’s box-ticking 101.
I’d be fascinated to know what regulators and indeed trustees, feel about the suggestion that obstacles should be put in the way of new ventures – specifically that they need to hit a volume threshold before being granted protected quote status – in the rather litigious atmosphere within the US. I’m no legal expert as I have noted (and proved!) on several occasions, but that looks like monopoly and restraint of trade to name just two laws that would have lawyers’ antennae twitching.
Of course, the US regulators could change the rules to impose such a threshold, but would that stop any litigation? I can’t believe it would, and in today’s risk-averse climate, who is going to be brave enough to suggest it?
So to bring FX into this discussion, on one hand we have this concern about fragmentation and the requirement to trade on the smallest lot size if it is best bid/offer – and clearly the real concern here is signalling risk – whilst on the other we have a refusal to move away from an execution model, in the 4pm Fix, that is the epitome of signalling risk. Either these firms care about best execution or they don’t and brief enquiries over the past week lead me to believe that even when they do, they tend to adopt the same measures across all markets traded. In the instance of the Greenwich survey clearly they care about market structure and best execution in equities, but I can’t say I know of similar concerns in FX where they have let tracking error dominate all other considerations.
Another example of the buy side’s lack of interest in FX can be found in the lukewarm response to the FX Global Code. Yes, a few leading lights have supported it fully by adopting it, where relevant, in their own businesses, but generally the response has been a collective “meh”. The problems were not at their end, so why should they adopt it? All the Code has to do is make the banks behave better and the job is done. Those are their arguments and it’s hard to know where to start on the inferred arrogance of that mindset. For starters, the exchange of information, whilst totally wrong, was the result of buy side firms insisting on executing unrealistic amounts within a one-minute window. I apologise for this (again) but when I was trading, the phrase “pre-hedging” never existed. It has only come about – and created no end of trouble for thousands of people and dozens of firms – thanks to unrealistic expectations on the part of the buy side, and those demands were driven by an ignorance, or lack of care, over how the FX market structure works.
Equally on the sharing of information, why did dealers do what is for a certain generation of traders, the unthinkable, and share knowledge of hedge and sovereign fund activity? They did it because certain members of the buy side were allowed to operate in a fashion that left dealers holding sizeable losses because the former were not asking “only you” for the full amount. That is, how can I put it? Lying: so where does that sit when discussing conduct?
The buy side collectively is clearly concerned with the cost of trading, as it should be, but there also seems to be this mentality that service providers cannot make money out of their business unless it is a pre-agreed fee. Under normal circumstances I could shoot down the argument made by some that if a dealer makes money out of a buy side trade (beyond a fee) then that is money the buy side firm could have saved. After all, the only way the dealer could have made some money is by taking risk for a period of time. The problem is, as banks become brokers, then this argument suddenly gains validity, so am I now arguing against my own premise in this column – such is the life of a columnist!
Notwithstanding that, whether it be the result of the sell side effectively giving up on the banking function and becoming brokers; regulation; or the buy side’s continuing indifference to foreign exchange generally, it is hard to see the level of engagement with FX that we do in, for example, the Greenwich survey. Look at the recent JP Morgan survey of attitudes towards FX by investors where the biggest concern remained liquidity – in other words, they just want to get the trade done and forget about it – there is no engagement.
I think this is wrong because if the buy side did engage more in FX, for example through the Code, then it may understand the nuances of the market structure much better. As I have argued before, for a sizeable chunk of the buy side that the banks and other dealers want to engage with, FX is not an asset class – it is an administrative trade.
And that, potentially, is where the problem lies. Nobody is really interested in admin, it will all be automated at some stage anyway. The difference here, as far as I am concerned, is that the admin involves billions of dollars, but no-one seems to be thinking of that.