New Paper Challenges the Perception of Bank Liquidity in FX

A new research note from Pragma Securities is seeking to
challenge the perception that banks are increasingly stepping back from
providing liquidity to FX markets.

The firm notes in the paper that the “typical narrative” is that ?reduced
appetite for risk, controls on? capital at banks, as well as juniorisation of dealer
staff have all contributed to this withdrawal that led to an “increased
fragility of the FX markets”. The paper adds that the general consensus
seems ?to be that liquidity is getting more expensive, and while spreads
are? narrow in times of normal volatility, in? times of market stress dealers effectively
pull away from the markets, contributing to extreme volatility and events like
flash crashes. ?

The research note stems from work Pragma undertakes on a
regular basis to improve its algorithmic execution services, “We started asking
questions about the quality of the banks’ streams,” explains Curtis Pfeiffer,
chief business officer at Pragma. “The findings are pleasantly surprising and a
positive message to the market place so we thought this is something we should
share to help counter the perception in some quarters that banks often step
back from quoting in the FX market. The research also highlighted the value of
bilateral trading versus anonymous trading systems.”

Pragma draws
on a proprietary dataset of quotes from a sample of seven major banks as well
as two primary ECNs (Thomson Reuters Matching and EBS Market) and the firm says
that over the past two years, it could identify only three events when banks
stopped quoting altogether.

Whilst a
collective withdrawal from the market is indeed rare, it can be argued that
banks conduct a de facto withdrawal
from the FX market by widening their spreads to prohibitive levels. Profit & Loss has
previously reported on data from participants showing
some liquidity providers streaming quotes that were many magnitudes of the
day’s range.

Pragma also
seeks to dispel this theory as well – and it should be noted that P&L’s
report was specifically related to the sterling flash crash – by noting that
outside of the window around the New York close, when most dealers reset their
electronic platforms and are routinely out of the market, it is only on average
about three minutes per day when banks effectively withdraw from the market by
widening their spreads to larger than those on the primary ECN.

Unsurprisingly,
the only notable outlier to this three minute average was the period following
the Swiss Franc de-pegging in January 2015, the effect of which, Pragma says
was long lasting.

“We observe
a prolonged adjustment period in which the banks stayed out of the market far
more frequently than usual,” the note states. “It took six months before
liquidity provisioning by banks came back to normal.”

The second
most notable event in the research period – the sterling flash crash – was much
less severe Pragma adds, noting its effect lasted about a week.

“Although
we would expect spreads to widen in more volatile markets, it is not a given
that banks will widen more than the primary ECN,” the note says. “We observe a
general positive correlation between volatility and effective withdrawal from
the market by the banks. However, in the more severe market dislocation – the
de-pegging of the Swiss franc – this relationship broke down and the banks
became significantly less competitive in that one pair, for an extended period
from January through June of 2015.”

By
analysing data on how often banks withdraw from the market altogether, as
indicated by a gap in the stream of prices they provide to customers trading
bilaterally, Pragma finds only three occasions in the two year period when this
happened in the seven most active currency pairs in the FX market.

The first
two were the aforementioned Swiss franc de-pegging and the Cable flash crash,
the third was is in the much less liquid NZD on August 24, 2015, which the firm
says “may be related to the equities flash crash around the New York open”.

The note
states, “Overall it is very rare that more than one bank would stop quoting
except for technical reasons. Banks continue to provide liquidity even in very
volatile periods and only in a few extreme events do they withdraw from the
market.”

Another key insight from the paper is the importance of
aggregated liquidity streams, a point reinforced by Pfeiffer. “The research
reinforces something we tell our customers – it is important to have multiple
streams of liquidity. One bank
is not always going to have the best price and top of book size is going to be
limited, so it helps to aggregate multiple liquidity streams,” he says. “It’s
clear that some banks aren’t taking as much risk as they used to – some of that
has been forced by regulation – and that inevitably means they change the
nature of how they quote. The data show, however,
that the banks
are still in the market quoting consistently and for
only a few minutes a day are their spreads wider than the primary ECNs.”

The paper
concludes by reiterating its main lesson – that aggregated direct bank streams provide
an “extremely competitive liquidity pool through the vast majority of market
conditions”.

As to the broader perception of banks withdrawing from the
FX market, Pfeiffer accepts that it is hard to quantify – he suggests that if
asked, industry participants would estimate a collective
withdrawal multiples of what the research actually found over the two year period in question – and
acknowledges that, “
We were surprised it was only three.”

Where this latest research adds value, however, is in its
contribution to the industry debate. “This paper provides empirical data that discounts the
narrative that has been in the market place for the last several years. It
makes the conversation about the high quality of bank
streams concrete instead of just talking
in negative generalisations.”

Colin_lambert@profit-loss.com

Twitter @lamboPnL

Twitter
@Profit_and_Loss
    

Colin Lambert

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