Recycling is a good thing – just ask the environmentalists – but is it a good in FX? Colin Lambert thinks this year, it could be decided that it is not.

The phrase “liquidity mirage” is almost as old as e-FX trading, but it’s hard to believe that the originator of that phrase had today’s FX market in mind. In 2003, when many of us first heard then Bank of England chief dealer Martin Mallett use the phrase, even the e-world was a very different place. Technology had not yet democratised the industry, non-bank market makers were finding their way in equities and futures markets and yet to really enter FX, and there was a real divide between market maker and liquidity consumer.

Roll forward 15 years and the barriers to entry when it comes to being a liquidity provider are lower than they have ever been. Technology has not only levelled the playing field, it has empowered a whole new generation of traders. Some of these firms, however, rely upon being a liquidity consumer from much larger traders and, importantly, the liberal use of last look to cherry pick flow as a market maker – and that will come under greater scrutiny this year.

It is fair to argue that today everyone is a liquidity provider, although some draw the line at the phrase “market maker”. Several market participants that would traditionally have been known as the buy side now accept that they are liquidity providers. “That’s what happens when banks become agents,” says a senior execution manager at an Asia-based asset manager, who baulks at the suggestion their firm could soon be making two-way prices. “More providers are willing to let us become a part of their price stream and that’s as far as we want to take it at the moment – placing bids and offers in the right place, with the right level of anonymity, works well for us.”

This perhaps signifies a greater understanding of market impact – certainly 2017 was a year in which the phrase grew into the market’s consciousness – 2018 could be the year in which symptoms are addressed, and prime amongst those symptoms is recycled liquidity.

As noted elsewhere in this report, some major liquidity providers are getting more sensitive as to how their pricing is used. Specifically, they are aware they are seeing their own price come back to them more often than ever. This greater awareness – and a willingness to do something about it – alongside customers’ increased interest in how their flow is handled, is likely to lead to significant pressure on those firms whose business models are predicated upon recycling liquidity.

The last two years have seen the development and release of more analytical tools than ever aimed at helping larger traders understand their market impact – and the data these tools are providing is highlighting how the recyclers are muddying the pool for the client. Information leakage, signalling risk – call it what you like – has rarely, if ever, been higher…and ask around the industry and you get the same response. Too many LPs simply churn and burn trades – and they often exit risk on public platforms.

It is hard to know exactly how the industry will deal with the issue of liquidity recycling. After all, the voice generation often quoted prices according to what the voice brokers were quoting, but something is likely to be done, and it will be driven by the liquidity consumers – the aforementioned larger traders who need to minimise market impact.

Another driver could come from an unlikely source – the FX Global Code of Conduct. The re-write of Principle 17, which deals with last look, would appear to encourage the “quote and cover” providers to explicitly disclose their models. The language states:

“This guidance does not apply to an arrangement that features all of the following characteristics:

1. An explicit understanding that the Market Participant will fill the Client’s trade request without taking on market risk in connection with the trade request by first entering into offsetting transactions in the market.

2. The volume traded in the last look window will be passed on to the Client in its entirety.

3. This understanding is appropriately documented and disclosed to the Client.”

Although there will be plenty of smaller players who care less whether the LP is pre-hedging in the last look window (and some who would actively encourage it), more considered customers, typically those whose trades contain alpha, are more likely to shy away from such a provider. If this happens, the recycler is left with plenty of volume they probably don’t want, but much less business they do want (i.e., trades with information within them).

This pincer movement from the LPs actually supplying the recycler with the ammunition to win business and the customers with valuable business, will inevitably challenge the business model. The fact that the Global Code, while not explicitly saying so, appears to frown upon anyone recycling liquidity without disclosure is icing on the cake.

All of which means, we may end 2018 with fewer liquidity providers in the institutional space than we started with – but they are likely to be of higher quality and kept to higher standards.

Galen Stops

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