The 20 for 20 Countdown – Part Two

It’s been a busy 20 years since Profit & Loss launched. Colin Lambert and Galen Stops have picked out 20 key events or trends during that time and asked senior industry figures for their perspective on them – here’s numbers 15-11.

15. Last Look

“Last look is a cancer at the heart of the foreign exchange market”

“Without last look, prices would be wider and liquidity would be thinner”

Two statements that adequately sum up the polarising effect that last look has among market participants. It is controversial to the degree that when asking around about where last look first really started, rival platforms blame each other in an effort to stain a rival’s name, and bankers profess no knowledge of how or why it started. One trader has an idea, however.

“Last look was a defence mechanism against predatory trading, initially the high frequency players who were latency trading, but then the more aggressive hedge fund clients,” says Dennis. “You would have firms on your platform seconds before big economic releases hoping to pick you off on a stale price, the only way to defend against it was to have the right of refusal. It felt uncomfortable to me as a voice trader that we could do that, but there wasn’t any other choice at that time.”

“Is it ethical? I don’t see why not – it was just LPs protecting themselves. Did some players take it too far? Absolutely – and they still do today, both banks and non-banks”

A senior e-FX banker believes that while last look may have emanated from dealers seeking to protect themselves, it was propagated on the secondary multi-dealer platforms.

“Still to this day, people predominantly price from the primary venues of EBS and Matching, now we have CME as well, but one of the reasons they were reluctant to price to the newer venues was they were getting picked off by clients on there who were spraying the market. One of the venues – it is hard to say exactly who – saw last look as a way the LPs could price to their platform off the back of the primary venue, and if the price changed, they could reject the trade at the secondary platform. Is it ethical? I don’t see why not – it was just LPs protecting themselves. Did some players take it too far? Absolutely – and they still do today, both banks and non-banks – some platforms also condone it,” they say.

Last look has provided the legal profession with a steady source of income, as it has certain regulators in the US, and there is a sense that as an issue it will not be going away.

“As long as clients try to abuse liquidity, the LPs will need to have a defence mechanism,” argues the head of e-FX trading at a bank in London. “Last look is the least worst option because it doesn’t negatively impact other clients, who probably have zero rejections anyway, it allows LPs flexibility.”

14. Icap Buys EBS

When bank ownership of EBS came to an end after 13 years, the general consensus was that the deal to sell the platform to Icap was a great one for the inter-dealer brokerage firm as it sought to get a toehold in the growing electronic market. Although the deals are a lot more complex than we have time to go into here, it does indeed look like good business given Icap paid $775 million in 2006 (just a year later State Street laid out $564 million for Currenex, which was not a primary ECN) and then built the business into the behemoth that saw CME Group shell out over $5 billion in 2018 for what was then NEX Group.

Although in monetary terms it looks a good deal, there are those that feel there were negative outcomes.

“When Icap bought EBS, the reins were removed and there was a dash for cash,” says the head of e-FX trading at a bank in London. “EBS was suddenly all about the brokerage and they didn’t care where it came from. This led to a deterioration in market quality on the venue and opened the door, in my opinion, for the other ECNs in the market to grab market share. Do we really think if EBS hadn’t chased the high frequency accounts that the banks would have supported so many other ECNs? I think that was the time that it lost its status in the industry – even though it took time for the numbers to show that.”

Certainly the volume data took a while to show any problems within the business, on August 16, 2007, EBS handled what is still a record $456 billion, and in September 2008 it achieved its highwater mark in terms of average daily volume for a month at $274 billion per day. Although the e-FX trading head is critical of behaviour on the platform, it could equally be argued that the catalyst occurred in the same month as EBS hit its peak, for post-Lehman saw a noticeable decline in activity, to the extent that while ADV in 2008 was just over $213 billion, in 2009 it fell to $134 billion and then steadied for the next few years around $150 billion.

“…as EBS enters what is perhaps its fifth phase (the fourth being the brief tenure as NEX Markets) it remains a key trading venue and as such, any decision taken there does ripple down the industry”

“I feel that EBS made a mistake when it started offering different data services,” observes the liquidity manager at an ECN. “This disenfranchised the banks and gave the platform the feel of a shark tank where latency players were not only welcomed but encouraged. I think EBS realised that mistake in time, but it was too late, the banks had gone elsewhere. You feel EBS has been trying to put that genie back in the bottle ever since.”

One aspect of the Icap acquisition that is widely seen as positive is the transformation enabled at EBS itself. “You can probably pick out the third phase of EBS’s evolution to the time Gil Mandelzis took over,” says the head of e-FX trading. “There was an effort to rebuild trust with its core constituents – the banks – but also a broadening of the product set. They may not all have changed the world, but I don’t think a bank-run consortium would have backed the number of products Gil attempted to roll out – and that means EBS would not have achieved something I never thought I’d see, one primary venue stealing a market away from the other the way EBS did from Thomson Reuters in CNH.”

Like it or not, there is little doubt that EBS remains a highly emotive topic in the FX industry, possibly because many of those at the top of the business cut their teeth on using the product. The headline numbers may not be thrilling to its new owners at CME Group, but as EBS enters what is perhaps its fifth phase (the fourth being the brief tenure as NEX Markets) it remains a key trading venue and as such, any decision taken there does ripple down the industry.

13. The Bitcoin Bull Run

To many FX market participants, cryptocurrencies were something that a select few people were interested in, would never challenge the dominance of fiat currencies and, frankly, would probably disappear in a short while when a newer, shinier, toy came along. Bitcoin, the posterchild for the crypto generation, was something associated with dodgy dealings on the Dark Web.

Exchanges holding the tokens were prone to being hacked, and the price was pretty static around $900 per bitcoin level – a price nonbelievers thought to be unsustainable.

Given the reputational issues around the virtual currency, most chatter in this space in 2016 was around the technology that supported it; blockchain was going to revolutionise the world according to the faithful, even though, as was pointed out in these pages, to many it was a solution seeking a problem.

One source in the banking world says they bought some bitcoin in 2016 “around the $400 mark” to see how it worked. They sold out a few months later as the price went higher but, in what was a familiar refrain then, “selling it wasn’t as easy as people made out – you had to
wait for a buyer because there were no market makers.”

This source walked away from bitcoin, as many did, their curiosity satisfied, but then came 2017, the year it all changed.

It is quite remarkable that there is no one dominant argument as to why bitcoin took off on the bull run of all bull runs that year – from
sanction-busting sovereign states, through a giant Ponzi scheme that got away with it, to a good old-fashioned financial panic around missing out on a good thing, there are theories galore, but one thing is sure: in 12 months, bitcoin went from $900 to almost $20,000.

It wasn’t a smooth ride. China in particular threw an early spanner in the works by dampening the initial euphoria of breaking the $1,000 barrier (the more bullish were calling for bitcoin to hit $4,000 at that stage) by clamping down on local exchanges, but nothing was stopping it as it rode a wild rollercoaster with multiple large dips, to unforeseen levels. Such a surge in a tradable asset inevitably caught the attention of the institutional world desperate for something to consider away from the volatility-starved traditional markets, although it has to be said that the extreme volatility in bitcoin also probably scared a few players off.

Either way, 2017 was the year bitcoin really entered the world’s consciousness and although the rollercoaster ride has continued, with a swift dip to $4,000 followed by the rally to $10,000, interest in the cryptocurrency has been maintained, market makers have emerged and there are signs of a market structure developing along the lines seen in fiat currency markets. Liquidity and market functioning remain an issue, so bitcoin is not quite yet in a position to been seen as a reserve currency the way its fans believe it should be, but it certainly isn’t going away.

12. In the Legal Firing Line

It should be noted that foreign exchange dealers have faced trial, and indeed gone to jail before. The aforementioned John Rusnak in the US in 2003 and four FX options traders at National Australia Bank had all been behind bars, but in both instances, there were proven cases of fraudulent activity around hiding losses and producing fake trades.

The legal challenges faced by FX traders over the past five years have been very different, for they faced trial over activities that were part of their daily routine. It is not only the headline cases surrounding former HSBC head of cash FX trading, Mark Johnson, who is awaiting the result of his appeal against a conviction and two-year jail sentence as this is being written; or of the high profile “Cartel” case in which three former FX traders had the case against them thrown out by a jury. The past few years have seen several traders take their former employers to court to claim unfair dismissal – and the majority of them have won their cases.

“We ran a thorough check of all pending or recent regulatory actions before we would allow certain senior FX people to travel to the US after Johnson was convicted. You can’t take the risk that someone will be arrested at the airport the way he was”

It is the case of Johnson, however, that caused the biggest shock to the system. “I don’t think I ever considered the chance of Mark Johnson being found guilty until the moment the news broke,” says the head of FX at a bank in London. “We’ve been through the arguments a dozen times about how he did nothing wrong, but the fact is he has been found guilty – subject to appeal – and that is a scary prospect for everybody in the FX industry.

“It’s an interpretation thing, and the people making that interpretation don’t understand the market,” the head of FX continues. “We ran a thorough check of all pending or recent regulatory actions before we would allow certain senior FX people to travel to the US after Johnson was convicted. You can’t take the risk that someone will be arrested at the airport the way he was – you have to look after your staff and if there’s the smallest indication that they may face action for something we all think was OK, you stop them travelling.”

The final impact of the Johnson case is yet to be felt and in many ways it is a binary outcome – if he is successful in his appeal then the market will continue to operate as it does now, largely in accordance with the FX Global Code (especially on the sell side); if he loses, then there are genuine fears over a bifurcation of the market.

“There are people who see an upheld conviction as the trigger to pull back from providing services to US clients – who will have to deal with US banks only,” says a senior figure heavily involved with the creation of the FX Global Code. “That could create liquidity issues but if it does, it will only be for US participants – the rest of the world is happy to engage on existing terms. Is there a chance the market could split along US/rest of the world lines? I don’t think so, but you can’t rule it out – look at how several banks declined to deal with US names after Dodd-Frank was passed.”

11. The Inexorable Rise of the Non-Bank Firm

There are several themes running through this countdown – regulation, technology, credit and market access – and all of them are embodied in the rise of the non-bank firm in FX markets.

In the 2005-2012 period, the perception of these firms was largely negative – they were often associated with latency arbitrage, had been linked with the 2010 flash crash in US equities, and were seen as predatory participants that added nothing to the ecosystem. Some of the arguments may have been unfair – the flash crash was triggered by an asset manager using a dumb algo for example – but the mud stuck and, not for the first time, the FX industry did something about it.

“The answer for many of these firms was to exist in the shadows on the largely retail-orientated platforms or to retreat from FX altogether…. Others chose a different route, and became not only providers of liquidity, but risk absorbers”

The challenge for these non-bank firms was the dominant role of the OTC FX market. Yes, they could hide behind a prime broker, but the banks in particular merely chose not to price to the venues on which these firms were operating, or if they did, they did so on their terms. The HFTs were left with other HFTs for counterparties in some liquidity pools – the last thing these firms wanted – and thanks also to last look and some serious upgrades to banks’ pricing and risk engines, the threat from latency arbitrage, if not latency trading itself, was largely dissipated.

The answer for many of these firms was to exist in the shadows on the largely retail-orientated platforms or to retreat from FX altogether – the money simply wasn’t there anymore. Others chose a different route, and became not only providers of liquidity, but risk absorbers, albeit in spot only and in smaller amounts than banks historically handled.

The poster child for this move has been XTX Markets and it can be argued, as several participants do, that this firm sits in a niche on its own – it’s most definitely not a bank, it doesn’t have the capital base and balance sheet, but it does conduct itself very like a bank in seeking to build relationships with clients and hold risk on their behalf. It could be the stable of talent accumulated at XTX or the fact that it has raised its profile considerably over the past three years, but the firm’s star has most definitely risen, to the extent that it holds a position as one of the biggest players in the public market – something that, as a non-bank firm, was unthinkable 20 years ago.

 

Next week we’ll be publishing numbers 10-6 on our list – “Brexit”, “Sterling Flash Crash”, “China”, “CLS” and “Precision Pricing”

Galen Stops

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