Even though liquidity conditions in FX markets remain sufficiently robust to ensure a reasonably functioning market, sources say that different mechanisms are now being seriously considered – especially as the market eyes what could be a tricky quarter end benchmark Fix on Tuesday (March 31) – a time when volumes submitted for fixing are significantly higher than on other days.
Month and quarter end fixes have long been a challenge for managers seeking best execution as imbalances tend to be larger as more index-trackers in particular use those fixes, this has been exacerbated more recently by the need of G-SIBs, (global systematically important banks) to reduce their funding profile at month and quarter ends to alleviate the regulatory capital burden on their trading businesses.
That may not represent an accurate picture for the quarter end, however, as this will be the first of those fixes since the pandemic crisis drove a volatility spike across all financial markets. As one senior FX trader at a bank in London observes, “The Fix is a different animal to what it was last time we saw anything like this level of volatility.”
Specifically, the senior trader points to the decision by banks not to engage on a principal basis during the five-minute window. “Some banks have walled-off execution teams dedicated to the Fix and that allows the trading business to operate normally,” they explain. “Even so, few want to get really involved at that time, it may be a coincidence, but if you trade in a fashion that pushes the Fix against a client of your agency business, at the very least you’re going to face some awkward questions – who needs that? It’s easier to stay out.”
This scenario, then, means that higher volumes generally go through the market at a time when a major source of liquidity – the banks – are reducing their participation, although as one buy side trader puts it rather cynically, “Do the banks provide risk absorption anymore? Does their withdrawal really make a difference at the Fix?” Either way, several sources express the opinion that at month ends especially, slippage is significantly higher than it was before the reform process of 2015.
As reported by Profit & Loss earlier this week, banks are seeing increased usage of algos by customers, although as Giuseppe Nuti, head of data science at UBS, observes, while the use of algos is higher, it is not proving to be the dominant execution channel. “Algorithmic execution is up significantly since the volatility regime changed – which has, not surprisingly, reduced liquidity and increased spreads – but if you remove the vol beta, it is in line with the FX volume increase more broadly,” he says. “It varies across strategy type, we are seeing more interest on the faster executing algos for example, but I don’t think the use of algos has outperformed other execution methods.”
Meanwhile, Asif Razaq, global head of FX automated client execution at BNP Paribas, is also seeing increased use of algos. “We have seen a ramp up in volumes executed using our algos; specifically, clients have been using those strategies that help them capture spread,” he says. “The increased volatility has seen spreads widen out to more than twice the historical average and clients are happy to take a little market risk to improve their execution quality.”
Razaq explains that the type of algos being used depends largely upon how the client’s decision making process is structured. “Where execution desks have little or no discretion they are using faster, more aggressive strategies – this includes risk transfer – whereas if the PM is part of the process and has a view we are seeing them deploy passive, alpha capturing strategies like Chameleon,” he says.
As noted earlier this week by Profit & Loss, clients are also looking more closely at the liquidity pools available to them. “We have also seen clients take a greater interest in interacting with BNP’s principle liquidity via our internal exchange, BIX,” says Razaq. “We have built the governance and risk mechanisms around BIX to enable clients using our algos to interact with multiple internal sources of flow in a transparent fashion. Fill rates using BIX have risen and continue to grow, as clients look to minimise their information leakage in such volatile markets.”
Another idea that Razaq says has really resonated with clients is BNP’s robo-advisor Alix, which was unveiled last year. “Many of our clients are managing multiple executions across several markets and often this means calibrating the algo and then letting it run. If liquidity conditions change – and at the moment that is happening quite regularly – then they are alerted by Alix to the change, along with a suggested change to the strategy, which is actionable.
“This makes the FX execution an exception-based process, which leaves clients free to focus on other important tasks,” he continues. “It reduces the complexity of their job in a small but crucial way. We are also finding clients who are less comfortable with algos using them thanks to the guidance and alerts they get from Alix.”
The increasing use of algos and desire to internalise as much flow as possible has also seen attention swing back to a recent hot topic in FX markets – peer-to-peer matching utilities. Few solutions are currently available in spot markets, and dealers report that some 4pm fixes, which is probably the closest the industry has at the moment, have seen varied conditions with some witnessing higher than expected slippage and others less.
Evidence is available in one crucial area of the market, however, thanks to the recent launch of FX HedgePool (FXHP) – a utility that matches FX swaps among peers, which safeguards institutional investors against widening spreads. FXHP specifically matches the monthly roll requirements for passive hedgers, who are mandated to maintain hedging strategies on an on-going and therefore, predictable basis.
“Right now, the peer-to-peer space has a chance to solidify itself once and for all.” says Jay Moore, CEO and founder of FX HedgePool. “Given the predictable and recurring nature of the monthly rolls, trading desks have the luxury of planning ahead to manage their costs, making peer-to-peer a highly viable solution in the swaps space.
“Due to current market conditions, the spreads we’re currently seeing are frightening. Our clients are being quoted 10 to 20 times normal market spreads.” Moore continues. “Accessing peer liquidity at fixed, pre-determined spreads that are not influenced by market volatility is providing safety in the storm.
FX HedgePool launched with Standard Chartered Bank as its initial credit provider in January, with a sizeable portfolio of pilot trades, and already, with March month end quickly approaching, it is set to match tens of billions in volume in just its first three months of operations.
Moore says that Standard Chartered and numerous other banks have stepped up to the occasion, accelerating credit provision to FX HedgePool’s members. “This week, we’ve had an additional bank join the credit panel in time for the March month end roll cycle, which will significantly increase our capacity, with others quickly moving towards participation in April.” Moore reveals. “It’s been a pleasure to see how, even in these challenging times where resources are being pulled in many directions, the banks have rallied to keep things moving.”
As the exploration of different mechanisms indicates, there are genuine concerns in the FX market over how well it can handle a surge in activity such as that associated with a quarter end Fix, for while the fixing mechanism itself can meet the challenge, it is still reliant upon underlying liquidity being suitably adequate. Several market sources report that their asset manager clients are talking to them about mitigating the risk and seeking alternative methods, Profit & Loss also understands that some are talking to their trustees or oversight function to get approval to change the benchmark for at least this month end, possibly more.
The concern is most easily reflected in the Global Foreign Exchange Committee seeing the need to issue a release in which it reminds market participants of their responsibilities in the lead up to, and execution of, the March Fix. “There have been a lot of discussions about this at FX committee meetings,” says one member of a regional FX committee. “Clients are worried about it and while the banks are comfortable in how they handle Fix business, the very fact that their customers are worried is enough for them to engage. It will be a nervous market on Tuesday.”