“Eye on the Client”: The 2017 Profit & Loss Digital FX Awards

In broader society, the year 2016 was a dichotomy – it was a horror year in terms of global celebrities passing away, especially musicians, but it was a great year if you are a fan of sports teams like Leicester City or the Chicago Cubs.

Likewise, it could be easy to claim that 2016 was a horror year for e-FX in terms of product development and budget for anything other than compliance and regulation; however, there were pockets of optimism in the industry. It should also be noted that in terms of product delivery, the slowdown is natural and should have been expected – after all, if you already offer most products and services it is difficult to add to them.

So while 2016 was not a vintage year in the single dealer space in terms of product development – just about every bank seems to have spent the vast amount of their (vastly different) budgets on regulatory and compliance work “under the hood” – it should not be viewed in purely negative terms, because, and it feels strange to say this, the single dealer platform is definitely making a comeback.

Talking to customers in the FX market, the awareness of market impact has grown to the degree that an increasing number (not enough still, we need to stress) are looking much more closely at how to maximise their execution quality. One way they are doing this is through the use of the growing array of pre-trade analytics on offer and quite often these data indicate that a quiet execution is a good execution – think the old CIA maxim of “a secret shared is a secret squared”.

So although we found it surprising to hear, more customers are looking to a single dealer platform for certain types of execution. Sometimes it is risk transfer, increasingly it is through the use of algorithmic strategies.

The key driver of this change has been the growth of independent, third-party transaction cost analysis (TCA) providers. Although these providers do little more than tick boxes; they are offering, in this compliance-dominated world, crucial independent verification that the executing agent did the right thing. This has freed up customers, it seems, to use a single bank provider for certain order types – typically the larger tickets that will have meaningful market impact.

Across the industry, we still await the breakout of algo strategy use; currently, it remains confined to pockets of customers at certain institutions. One factor behind the delay is very old fashioned – customers don’t want to pay for using algos – another is more modern (although it has been discussed in previous awards), the algos on offer are either too simple or too complex. The FX industry is still searching for the key that unlocks the door to broader algo adoption.

Away from the use of algos, a key area for all banks in the coming year will be their pricing technology, for the other trend amongst users of FX liquidity appears to be the continued growth of aggregation. Sometimes this is through the multi-dealer platforms, however, the growth of bespoke liquidity pools shows little sign of ending – again thanks to the growing awareness of market impact.

What is a little surprising is how bank-owned aggregators have not taken off. In part this may be due to the quality of external pricing – few makers are streaming their best price in size to ECNs however – but again it is more likely a reflection of clients’ unwillingness to pay for additional services (which in turn adds to the complexity of rolling out MiFID II compliant services).

We are surprised by the lack of take up of these aggregators mainly because clients tell us that they seek to use algos that can interact with the bank’s internal stream and flow. If that is the case, then surely an aggregator that includes the bank’s stream would fit the bill? Obviously, it doesn’t and while this can be seen as clients wanting their cake and eating it too; more accurately, it probably reflects banks’ reluctance to allow too much access to their internalisation process.

This could be seen as good news for those banks that have not gone down the aggregator route as it is an unnecessary expense, but we are less sure, if only for the fact that we have seen good ideas take time to get off the ground several times before.

Another factor in some banks’ reluctance to develop aggregation capabilities is their lack of budget for product enhancement/development/renewal (delete as appropriate). These institutions have instead focused on their pricing capabilities.

This represents a challenge for us at Profit & Loss, because on one hand we are being told the product set on a platform is “tired”, but on the other we are told the pricing is “excellent”. Having looked at the issue, we have decided to stay true to the ethos of these awards, because while excellent pricing is great client service, it is also transient (witness the unseemly rush in years past on the part of banks to win as much meaningless tom/next business as they could in the hope of winning an industry award). To paraphrase a sporting cliché, “pricing is temporary – products are permanent”.

Something else that might mark 2016 down as the nadir of e-FX is how the year was characterised by banks turning off clients.

Several institutions explained how they had analysed their client flows and interactions and were cutting off the tail – it is not so much tail risk as the cost of that tail in plain dollars and cents. If nothing else, this reinforced our long-held belief that market share as a concept has a short shelf life – one that’s over.

Given the focus on regulation and compliance it is no surprise that another big theme of this year is MiFID II compliance. Some institutions seem very comfortable with where they sit in terms of incorporating the demands of this complex – and some would say unnecessary – regulation, others are less so. As was the case last year, banks that have been on the receiving end of fines seem the most eager to ensure they comply fully with MiFID II and that is only to be expected – the follow-on cost of another transgression could be catastrophic for some FX businesses.

One outcome from 2017, assuming the regulation is put into place of course, will be a vastly different approach to research. Banks are going to have to think differently about how they create, deliver and even make available, the output from their research teams. Indeed it is hard to believe there will not be a cull of analysts among the banks as a result of the implementation of MiFID II.

Although the focus on regulation is not new – we were writing about it in 2012 – we do get the sense that there is an opportunity for those that were ahead of the game in developing products, services and the framework for compliance. The end game in regulatory compliance surely has to be a non-competition – if nothing else, the past decade has shown us how we don’t want to be “clever” and “innovative” when coping with compliance requirements.

So if the future is in the uniform, perhaps utility, approach, the real opportunity is for third party “RegTech” providers to shine, rather than the banks’ own platforms. Project Sentinel is one example of the utilitisation of regulatory compliance (in this case MiFID II) and if projects such as this do take off, the focus will once again move back to the product set. It was noticeable that a number of banks acknowledged that their product set could do with updating, the differentiator was the different levels of optimism that they could actually acquire the budget to do so.

Where some institutions have budget firmly in place for 2017 (and beyond in many cases), others are still in a state of limbo. This is not an issue for those banks’ e-FX teams, rather it reflects poorly on the level of commitment by the organisation as a whole. Over the past three years we have witnessed – and to a degree tracked – the levelling of the playing field in the e-FX business, with some providers pulling back or plateauing and others stepping up their game. This has continued through 2016 albeit at a slower pace, and we fully expect 2017 to be the year that highlights those institutions willing to invest, as opposed to those seeking to either sit on their laurels, or worse, pull back from the FX business more generally.

The simple fact of the matter is that some institutions have now had three years without serious investment in the products and services on their platform and as we have noted before, there is something like a three-year window during which the benefits of previous work can be reaped. Pricing is the number one priority given the increased competition in this space, but given that we do seem to be heading back towards a commoditised price – and also that customers are looking to single dealers for certain types of transactions – those platforms that continue to lack investment in the product set will start to look dated and, more importantly, make the institution vulnerable to competitors luring some of their key clients away.

Holding onto key clients is likely to be another theme of this year, albeit at the lower end of the spectrum, for while the bigger banks face the choice of cutting costs or cutting clients (or both), those banks further down the ladder are likely to have to face the challenge of those bigger banks chasing their top clients.

Generally speaking, fewer banks down the ladder have chased market share, meaning their FX businesses have generally been more profitable on a per-client basis. Local market operators in some areas still have an advantage – the Scandinavians spring to mind immediately – but others are seeing that advantage eroded.

This erosion is happening because an increasing number of valuable local clients are coming around to the benefits of trading online. The starting point for so many of these clients is the multidealer platform, however, the cost of this method is prompting some to look to either hit the private liquidity pool (aggregation) route or to reinforce their relationship with their key providers. If the latter route is the chosen one, then several banks with local specialities need to lift their game and get in the single dealer platform business.

This does not mean they have to invest the huge sums laid out by some of the bigger banks (money, we accept, they will struggle to ever make back), but they do need to do something in the form of having a basic platform on which they can price electronically and clients can execute in an STP environment. So many valuable local clients are mechanistic hedgers that it makes perfect sense for them to do so electronically. With that in mind, we expect to see more institutions translate their better pricing capabilities into a better service in the form of a single dealer platform for their core clients.

Our methodology remains unchanged for these awards. Winners are decided based on qualitative criteria, not quantitative – as we have repeatedly stated, being the biggest does not necessarily make you the best. Equally, as we state each year, the difference between the winners and the field is razor thin. We continue to be heartened by readers’ appreciation of the report card as we feel this validates our attempts to align a comparative analysis with an awards process.

Here then, with our profound thanks to those who shared their developments with us, we present the 2017 Digital FX Awards.

Galen Stops

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