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Buy Side Concerned Over FX Market Liquidity

In a survey, released last week by State Street, 43% of the
survey respondents said that they were concerned about declining liquidity in the FX market, while 70% said that they were
concerned about declining liquidity in fixed income.

This should come
as no surprise to anyone that has been working in or around these two asset
classes over the past year.

Sixty-eight cent  of the respondents – which comprised 110
portfolio and risk managers working at asset management companies,
banks/insurance, alternative managers, pension funds and sovereign institutions
– blame the regulatory environment for diminishing liquidity.

Again, not
exactly a shocker. Whether it’s the Volcker Rule, Basel III or any of the other
slew of regulations that the banking industry is being forced to comply with,
the simple fact is that banks now face higher capital requirements.

This reduces the
dealer’s returns on equity for the services that they provide, while at the
same time, liquidity requirements increase the cost of holding less liquid
assets. To compensate for this, the dealers are reducing their activities in
lower margin businesses and raising the price for the liquidity services that
they provide.

“The reason why
we have less liquidity is worthy of some analysis,” says one FX market veteran.
“It started with the financial crisis, after the G20 meeting Dodd-Frank didn’t
just look at the conduct of the banking business, it decided that it wanted to
re-arrange the furniture in the market place.

“The Volcker Rule
was conceived to stop banks hiding CDS positions in trading vehicles, it wasn’t
interested in market making in FX. And yet the unintended consequences of this
regulation for FX market making have been disastrous for liquidity,” the FX
source says.

If regulation is
the main driver behind diminished liquidity in these markets, then it makes
sense that investors are more concerned about fixed income than FX.

I think that
fixed income is uniquely in the frame for liquidity issues. Think about a fixed
income product where you have a range of different bonds, and depending on what
the bond is, they have different levels of liquidity. Liquidity is more
differentiated across a large basket of securities, and what you end up having
is liquidity focused on a few very liquid bonds and not so much down the line.

“That sort of concentration of liquidity has become even
greater with the intensification of the regulation.  In contrast, if you look at FX, EUR/USD is
just one product as opposed to a big basket of bonds where you have this
differentiation of liquidity,” says Fred Goodwin, senior macro strategist at
State Street Global Markets.

On the FX
side, there was a clear differentiation in the survey results between liquidity
concerns in major currency pairs, where 37% expressed concerns about diminished
liquidity, and emerging market currency pairs, where this figure jumped to 70%.

Lack of non-correlated liquidity

But away from the
broader regulations impacting banks globally, FX is still dealing with the
fallout from the allegations of collusion and market manipulation, and this too
is having an impact on market liquidity.

Rightly or wrongly, three years ago if a bank had a $300
million order, then that would probably produce about a yard of flow, because
we’d be buying ahead of it, chatting to someone in Bloomberg who says he’s got
orders below. Today $300 million produces $300 million, you can’t trade ahead
of it and you don’t have chats about it. 

“That might be good for the client,
but the long and short of it is that we’re seeing less liquidity being
generated, and especially less non-correlated liquidity being generated. 

“That’s why you’re seeing top of
book spreads on EBS for the euro up by about 23% this year and it’s worse in
the less liquid products. I know that the end game of the regulations is to
protect the client and have a well functioning market, but there are also
repercussions for what is occurring in terms of liquidity,” says the global
head of spot and e-FX trading at one major bank.

The State Street survey also showed that 78% of investors
feel that electronic trading systems have provided better price transparency,
and yet the rise of electronic – and with it automated and algorithmic –
trading is one of the reasons often cited for the sudden decreases in liquidity,
or mini “flash crashes”, that traders report are becoming more frequent in the
FX market. 

“Almost 80% of our clients are happy with the price
transparency that they see because electronic trading has led to tighter
markets, but this also creates problems when you have very large sudden moves
in markets and big blocks of securities need to be moved because there is limited ability to warehouse,” says Don Allison, senior
managing director, at State Street Global Markets.

Goodwin adds: “I actually think that liquidity in stressed
environments is worse than it has ever been before, because of the algo and
electronic liquidity.  We have better
liquidity than ever before in normal market conditions, but there is a
suspicion that when things become stressed that the liquidity provided by algos
is more voluntary, in the sense that the machines can be turned off.

“There’s also a view that sometimes the way that algos
function means that they become additive to major market dislocations. So
instead of providing a buffer, they’re amplifying those conditions,” adds

This is consistent with the idea put forward by staff at the
Federal Reserve Bank of New York in an online blog in October, that the modern market structure “implicitly involves a trade-off between
increased price efficiency and heightened uncertainty about the overall available
liquidity in the market”.

Mispriced liquidity 

Equally worth noting though, is the suggestion by Minouche
Shafik, deputy governor, markets and banking, at the Bank of England, that this
change could be part of the organic development of the market.

In a speech about liquidity in evolving market structure
delivered at the end of October, Shafik said: “The reduction in the relative
size of dealer balance sheets may also be a natural process of evolution as the
market making industry matures and emphasis is placed on using its warehousing
capacity efficiently rather than holding lots of inventory.

“Market making wouldn’t be the first industry to go through
such a change: Just in Time management swept through manufacturing in the ‘70s
and ‘80s with its focus on minimising waste, eliminating inventories, and
quickly responding to changing market demand. More recently, supermarkets have
reversed their once relentless expansion of retail space, and started moving
away from inventory intensive hypermarkets toward smaller retail units.” 

Perhaps the most surprising response in the State Street
survey came in response to a question about whether the respondents felt that
their risk systems were able to measure and account for liquidity in normal

Only 12% of investors responding to the survey said that their risk systems are able to measure and account for liquidity in their normal reporting and 44% responded that their risk reporting for liquidity needs to be improved.

“In a competitive environment where you have asset managers
trying to beat their competitors, I think what ends up happening is that the
cost of liquidity gets underpriced, because it’s all about chasing the higher
yielding return.  As a result, some asset
managers ignore that risk, maybe a bit more than they should, and liquidity
ends up becoming mispriced,” says Goodwin.

If there has been an increase in concern about FX and fixed
income liquidity over the past 12 months amongst the buy side, are these
concerns likely to intensify or diminish over the next 12?

I think a lot of
it depends on the macro environment,” says Goodwin. “If we’re looking at global
recession and a further deterioration of asset prices, then I think liquidity
concerns will intensify. However, if it doesn’t deteriorate, or in fact if we
continue to feel confident in central banks’ ability to backstop the global
economy, then I think liquidity concerns will depreciate. 

“So it depends a lot on the level of confidence in central
bank policy support on the one hand, and then the general macro growth outlook
for the global economy on the other,” he said.          Twitter: @Galen_Stops

Paul Gogliormella

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