At the recent Forex Network Chicago conference David Mercer, CEO of LMAX Exchange Group, was interviewed by Colin Lambert about the foreign exchange and crypto market landscapes. This is an edited and abridged version of that discussion.
Colin Lambert: There is a view out there that FX is no longer a trading business, how do you sit in that debate?
David Mercer: My initial thought on that question – was FX ever a trading business? Few people have the balance sheet required to run serious risk and I think it’s been the same ever since the evolution of e-FX started. Before then traders typically traded customer flow, it was allowable and that was the information they used, but the number of traders who were able to step out of that environment, into a room on their own and succeed, was pretty low. So I would argue the FX market hasn’t changed much. I think there are more opportunities than ever.
Ultimately foreign exchange is a by-product of what goes on in the global economy>The world’s becoming a bigger place, which means bigger and bigger deals, hence why you look at the 2019 BIS survey and see FX volumes going through the roof. So there’s more opportunity than ever, but it’s a different opportunity. It’s not people running very large positions.
CL: How do these opportunities play out in the platform space?
DM: At the very simple level, this increased flow means more opportunity to match buyers and sellers, but its more complicated than that in reality. If you rely upon institutional transactional business only – you are challenged. It’s very hard to have an efficient and profitable business with a purely transactional model. If you look at the LSE, for example, 40% of its income is market data. The key is becoming the venue for price discovery and then adding a market data offering as a separate business. It also needs to be stressed that market data is valueless if it’s purely based on ‘last look’ prices, and that is why some recent acquisitions in the platform space have not worked. They have no market data because it’s purely ‘last look’ business, which doesn’t generate recurring revenues.
I think LMAX Exchange Group is pretty unique in the industry as we offer market and technology access to all customer segments in FX. From professional traders, retail brokers, HFTs, banks and all the way through to asset managers via the banks, we can target every segment. If you operate only in the bank space or the HFT space, it’s hard to have a viable business model. So first of all, you have to be able to access all segments of the market and then have some part of your business that is recurring – and the recurring revenue that you see in the big exchange world is market data.
CL: So how does LMAX Exchange compete in this environment?
DM: It’s only seven years since I bought the company so we have a fresh business model, a fresh tech stack and we don’t have expensive offices. I’m a FinTech business so I’m able to scale. Today we operate six exchanges globally, including the latest one, LMAX Digital. Four in London, one in Tokyo, one in New York.
The hard part with any exchange or venue business is printing the first ticket – that ticket cost $100 million, after that the second ticket costs nothing. So that’s how you compete.
CL: I look around the platform world and I’m not seeing much in the way of growth though…
DM: It depends on how you look at it and I take umbrage at that suggestion because LMAX Exchange is the fastest growing venue on the street, if you are judging on EBIDTA terms. LMAX is more profitable than all the deals you’ve seen. In 2017 we made $8 million; in 2018 we made $20 million and in 2019 we’ll make $30 million. Now if you run a business, and you’re in capital markets, that has to be a key metric.
CL: If profitability is a key metric, then how do you define being a good facilitator of trading, being a good market citizen? Isn’t that volume?
DM: The reason LMAX Exchange makes a profit is because of the service it provides, and then you can ask why we are at 20 yards a day and not 50 and that is a good question, but we are the only venue of all the ones you write about that has shown 20% growth year-on-year while everyone else stands still. The fact is we can’t go from zero to 50 yards overnight and there needs to be some evolution in the market structure for that to happen.
CL: What is that evolution?
DM: It’s the evolution from a quote driven market to a central limit order book and the problem is last look – and this is not about whether it’s right or wrong, it’s here, it exists and it’s been legitimised by the FX Global Code. That means people don’t transition from that quote driven market to an order driven market overnight. It is an evolution. I happen to think it’s an evolution that we’ll ultimately see.
CL: How does that work for those clients in the real economy – the corporates and asset managers – who are not that interested in FX, they don’t want to take market risk?
DM: Once you put the data in front of them, show them how much it is costing to transact and how much they are leaving on the table due to last look execution, I think they will evolve. It’s already happening to a degree because a big part of our growth this year has been from banks and bank algo desks that are executing for their clients – not taking risk themselves.
CL: You mentioned ‘last look’ there, is your position shifting on that?
DM: No, I haven’t changed my view. I still don’t believe in last look, I don’t believe an efficient capital market needs last look. I believe the best way for anyone to trade is on firm streamed limit orders, but I can’t be the lone voice and the global FX committee has come up with the Code that legitimises last look. It is what it is.
My view hasn’t changed on last look but I am a realist and I have to exist in a market, especially in the US, that is driven by that optionality.
What I would say is that last look abuses have declined dramatically over the last five years, so hats off to everyone involved. It has made it harder for LMAX to compete because hold times are shorter and there’s no pre-trade hedging in the’ last look’ window, but I still fundamentally believe as long as there is a speed advantage and as long as the customer keeps writing options to liquidity providers, they will be disadvantaged.
We shouldn’t believe the balderdash that we need last look for credit checks – we can do seven million risk calculations a second on LMAX Exchange and a credit check in about 100 microseconds. So if you haven’t done the credit check by then, waiting 10 milliseconds isn’t going to help – in fact it’s going to make it more difficult because more trades have gone through. So that argument is nonsense – it’s easy to build technology for last look, it’s harder to build it for central limit order book with streaming firm liquidity only.
So my view hasn’t changed on last look but I am a realist and I have to exist in a market, especially in the US, that is driven by that optionality.
CL: You mentioned LMAX Digital a short while ago and we had a session yesterday in which there was a lot bullishness around the institutionalisation of crypto, but I would also observe that that bullishness was around two years ago and little has changed. You launched LMAX Digital with a view to capturing that institutional business – how is that story evolving?
DM: We have to be patient. I can’t be the evangelist. I can’t be sitting at a big crypto show and saying this is going to the moon today. It isn’t. In the last year there’s been no new money – It’s a static market at the moment. The big firms in the room, who might be trading crypto, are effectively trading the arbitrage, which happens to be massive credit risk between one exchange and another, whereas LMAX Digital is an institutional price discovery venue. So today it’s static because we haven’t had the advent of real money and bank customer money coming in and we need that. I believe it will happen, but I can’t say it’s going to happen in 2020.
CL: What do you think will actually be the driver when it does happen?
DM: It’s as simple as ABC. Adoption, Banking and Credit. You need adoption and acceptance of the crypto market by the rank and file out there. It starts with buying coffee in Japan in crypto then escalating the size of asset purchase. Then, we will need proper banks coming in – and I don’t just mean banks trading it, I mean firms banking the crypto business. The last part is credit – at the moment LMAX Digital is the trusted third party, which doesn’t work at an institutional level. Asset managers are not going to send money to LMAX Digital with the size of its balance sheet – they want to send it to top tier banks with multi-billion dollar balance sheets. The banks that are winning at the moment in the crypto space have balance sheets of $70 million and there’s no one in this world who is going to send that money to a bank with a $70 million balance sheet.
So the first real driver will be a big asset manager, a big fund, telling Bank A, ‘I want to buy $200 million in Bitcoin’ because that will drag the other banks in as they will want to cover the same customer.
CL: This sounds to me more as a five, maybe 10 year path?
DM: It might be, but as Bill Gates says, technology never moves as far as you think in two years but much further than you think in 20 – and that’s crypto today.
LMAX Digital is my fastest growing exchange but recently it’s been static in ADV terms and so we need to shift it. At the moment, it’s 8% of my workforce and it’s not going to be 25% until something happens out there. I believe crypto is the future of money. I believe it will change capital markets. I believe as you see more initiatives around using the blockchain technology itself, that you will need digital assets to be transferred on those blockchains. But that’s not going to happen overnight and it might be five years. I honestly think we will all be trading digital dollars, digital yen, maybe bitcoin in five years from now, and using blockchain technology.
CL: So you’re still optimistic?
DM: Yes, but there are still challenges. There are a lot of companies that have 100 people in a business they built when bitcoin was doing three times today’s volume and it was up to $20,000 and going to the moon. Those businesses aren’t making money anymore and you’ve seen some big names where all of the management and all the desks have changed. People are reassessing their business models and we have to anticipate and react to that.