Liquidity Thins Out as Conditions Take Toll on FX Market

Conditions in FX markets are deteriorating steadily according to market sources as liquidity providers (LP) ration precious resources and battle widespread shut downs of offices.

Spreads, which have been gradually widening over the past few days, have continued to do so Monday with dealers reporting top of book spreads on FX platforms anywhere from between 2-3 pips in EUR/USD and 5-10 pips in Cable. The amounts available are also much smaller with one buy side trader reporting a spread of 50 points being quoted by an LP on what would normally be a regular amount. “A month ago the spread would have been three pips, now it could be anything,” the buy side trader says. “If you hit a decent pocket of liquidity you can get business done, but if you don’t…”

With LPs operating with a skeleton staff at physical locations, some have throttled back their pricing engines and reduced risk limits. “We are probably pricing through six channels with any consistency,” says the head of e-FX trading at a bank in London. “Although generally things are working OK, we don’t feel we can risk overloading the systems with so few staff physically on the premises. You don’t realise it until it happens, but a lot of the day-to-day working routine, managing systems, involves quite a serious technology infrastructure and that can’t be spread around two dozen private homes and three or four countries.

“There is also a struggle with private Internet lines becoming overloaded, I have had staff tell me basic things are taking longer to load at home, that’s another reason we have to be careful,” the e-FX head adds. When asked if they think matters will become worse, the source is unsure, “I think we can operate pretty well at current levels, we have reduced service levels to what we think is the basics required by our customers, but can cut further if required.”

Volumes are still pretty high in the market, sources report, however trading is more sporadic and a little slower than it may have once been. “We are seeing pockets of liquidity in the market,” says a platform source. “There is more passive interest being posted and people are more reluctant to hit top of book – you can get business done, but it is taking longer and there is more slippage.”

The changing market conditions are encouraging more customers to use passive algo strategies according to sources in that business segment. “Spreads are probably twice the historical average and edging wider as risk pricing is coming under pressure,” says the head of algo FX services at a bank in London. “That said, they are not blowing out as much as perhaps we thought they would and that’s because we are seeing more aggressive skews from LPs and customers are using passive algo strategies that allow them to capture spread and that is keeping a lid on things.

“Clients’ approaches are changing,” the algo head continues. “In low vol environments they didn’t see the point of taking on the market risk when spreads were so tight and LPs were happy to reflect that in their risk transfer pricing. Now, clients are coming back to algos as they realise that taking on a little market risk can pay off in really good spread capture.”

The good news for algo providers doesn’t come without a warning, however, for as the algo head also notes, “At the extreme ends of the volatility spectrum, algos struggle. They did in extremely low vol and they will if volatility continues to the high extreme. At the moment they are in a sweet spot, but that could change if conditions deteriorate further.”

The head of execution services at another bank is seeing the same trend, but believes customers want one critical service. “Clients are happy to use an algo to post interest and capture spread, I agree, but they are only doing so if the provider can offer the ‘get me out’ function for the balance. We have seen several clients use an algo successfully, but the conditions have worsened and they have cleared the balance by risk transfer. If an LP can’t offer that, I don’t think the clients should be trading using their algos.”

The biggest challenge on the FX market at the moment remains in emerging markets, with the e-FX head describing conditions as “truly awful”, adding, “Clients looking to trade even modest amounts are struggling, top of book – where it even exists – is in the hundreds of points wide range and one trade has an exaggerated impact. I wouldn’t be surprised if some are shut down, especially if the local government doesn’t like what is happening.”

The e-FX head points to Asia currency pairs, especially Thai baht and Indonesian rupiah, as having the worst conditions, but adds that things are also tough in more developed pairs like the South African rand and Indian rupee.

The FX market generally is coming to terms with new operating conditions, paramount amongst which, are what one source terms, “A return to 2001” in terms of spreads, liquidity levels and technological capabilities. “We know the technology infrastructure can handle multiples more than we are seeing at the moment, but players are taking a cautious approach,” the source says. “Liquidity providers are dictating market conditions at the moment, and while some customers are complaining, the majority seem to appreciate the service being provided in tough conditions. “This is going to go on for a while, we need to find a new ‘normal’ for the market,” the source adds. “Once we do that, things will settle further – there will still be price gaps and periods of illiquidity, and the market will look familiar to people who grew up trading around the turn of the century, but it will function.”

Colin Lambert

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