In the FX market of today, liquidity depends on the currency pair, volatility, a bank’s position in the market, as well as its customers. Without liquidity, all the high priced traders and state-of-the-art dealing systems in the world won’t help you unload a position. Julie Ros looks at current market conditions and how the major market players access liquidity.
Liquidity – the ability to buy or sell a large amount without significantly altering the market price, or more simply, the ability to exit a position without a significant loss – is the single most important function of the markets. A liquid market means you can take advantage of opportunities, offload maturing obligations, earn discounts and benefit from a good credit rating.
In a recent survey of 1,000 traders and treasurers, the EBS Partnership found that its users rank liquidity as its single most important “value contribution” – above cost, personal relationships and system functionality. While there were slight regional variations in the value placed on liquidity, it’s a narrow range from 81% in the Americas, 77% in Europe and 74% in Asia-Pacific. “Liquidity is by far what [dealers] consider to be the greatest contributor of value,” according to the EBS survey, which was conducted by an independent consultancy.
“State-of-the-art technology and cheap delivery come way behind liquidity as the determinant of success for any dealing service,” says Bill Moran, head of product marketing for EBS. “It’s not so much vorsprung durch technik [advancement through technology], as having the right price, at the right amount, at the right time.”
Taking liquidity as a given, EBS found that the regional variations in the scores for the other key “value contributors” had an interesting composition. For example, cost is considered a greater contributor of value in the Asia-Pacific region than is system functionality, whereas the situation is reversed in the Americas, points out Moran.
EBS also asked its users to rank the matching service against a range of specific performance criteria, including functionality, reliability of technology, depth of prices, availability of credible trading, problem solving ability, accountability of broker/primary contact, electronic interfaces, liquidity, strength of personal relationships, system innovation, credit support and cost.
The results show that EBS’s main competitor is now direct dealing, above both Reuters Dealing 2000-2 and voice broking. Both treasurers and traders ranked EBS higher than any of these three competitors in terms of liquidity, availability of credible trading and depth of prices. Functionality and system reliability also rated highly relative to alternative dealing services.
However, those surveyed did say that EBS needs to improve liquidity outside of the major currency pairs (EUR/USD, EUR/JPY, USD/JPY, USD/CHF), as well as in terms of cost (workstation per million).
“Improving liquidity is our number one strategic objective,” says Moran. “In February, we introduced incentives to boost sterling, making it free for six months. Volume is critical for us, so we are trying to boost liquidity in cable and euro/sterling.”
Reuters (which launched its matching service in April 1992) appears to dominate the electronic marketplace in terms of sterling, the Commonwealth currencies, Scandis and the emerging currencies. But EBS, which launched in September 1993, has become the de facto marketplace for liquidity in the major currency pairs, at the expense of first the voice brokers, then Reuters, and now, it appears the interbank market.
While interbank trading is admittedly not what it used to be, some dealers believe that direct dealing is in danger of falling by the wayside altogether, thus reducing the number of liquidity pools to the two electronic systems and what’s left of the voice brokered market. However, others say that so little actually goes through the direct markets these days, that few would actually notice a difference.
“In my opinion, the interbank electronic broking platforms have evolved from true broking systems into very efficient marketplaces and primary sources of price discovery, as evidenced by dealers’ reliance on them when the market is at its most volatile,” says Peter Mesrobian, global head of FX for Bank One in Chicago.
Scott Gallopo, managing director and head of FX trading for Chase Manhattan Bank in New York, adds, “I’ve been in the market for 15 years, and every year dealers have moaned about liquidity – it’s not unique to this phase of the market. In fact, the market is deeper now than it ever has been for certain currency pairs. Liquidity conditions in the euro, for example, have actually improved. Liquidity is also a function of volatility, and there has been less volatility in the major currency pairs over the last several years.”
“I believe that if you dig into the concerns about reliance on a single liquidity source, you’ll find dealers simply bemoaning the loss of our traditional market making role,” Mesrobian adds.
Industry sources say that while this phenomenon has largely stayed within the spot FX market, the currency options market is likely to undergo similar changes once Volbroker.com, the planned Internet-based interdealer broker, launches later this quarter. Volbroker.com is being developed by Deutsche Bank, Citibank, UBS Warburg and Goldman Sachs.
Smoke & Mirrors
Given that EBS is widely recognised as the spot marketplace, some dealers say that true, global market makers no longer exist. “Some people say the interbank market is all smoke and mirrors,” says one trader. “That might not be true, but it certainly does not exist like it used to. It’s often more about the perception than the reality.”
Direct dealing in general, is no longer the avenue of choice for liquidity access, adds Chase’s Gallopo. “The level of intra-day volatility simply does not warrant paying away the spread to move size. Direct dealing has become more of an ‘insurance policy’ against volatility spikes and liquidity gaps that may occur during the course of the day. In the past, direct dealing was more hard wired into the dealer’s jobbing strategy and trading methodology. If this trend continues, we will soon see dealers stop making interbank rates to each other over Reuters Dealing altogether, as the premium for maintaining this ‘insurance policy’ becomes either too expensive or too annoying,” he says.
“The interbank market has become a less and less efficient way of transacting business,” adds Matthew Spicer, director, head of spot trading for Credit Suisse First Boston in London. “One can even exacerbate the moves by buying or selling a currency interbank. There is still the exception that the interbank market is important – for those vacuums that occur – which gives interbank some chance to survive. But even then, you cannot be 100% sure that people you quote all day will be there for you when you need them to reciprocate.”
As an example, one spot trader says he recently had interest to buy an esoteric currency pair. “It’s a transparent currency pair – I put up a few bids 5 million, 5 million, 5 million – all given on Reuters by one bank, so I called direct. I said, ‘If you have interest to sell, I have interest to buy.’ The trader on the other side said, ‘If I did have more selling interest, I wouldn’t tell you’,” says the dealer.
“Banks have become blind to transacting any other way,” comments another dealer. “There are fewer bilateral relationships nowadays. In the old days, it wasn’t just, ‘I’ll quote you if you quote me’, but I could alsogo to an Aussie bank for Aussie and they could come to me for my bank’s domestic currency. That was a slightly more co-operative way of trading. Those bilateral relationships can give you more liquidity when you really need it, which may be why we see these jumpy markets and hear more and more stories about big P/L swings.”
Such shifts in market practice have led to more creative ways of trading. Sources say dealers today will go interbank to “spoof” the market. “An interbank seller is actually a buyer – if you sell a few dollars in the direct market, you can create a wave, and then go bid on EBS to double your liquidity,” says another trader. “Or just as common is manipulating the price on the machine to make it look more bid or offered before going out on an interbank call-out – and hoping your counterparties show a higher or lower price accordingly.”
It has been said that the top 10 interbank players now consist of just six banks, rounded out by a few banks and investment banks depending on particular centres or currencies. Chase, Citibank, CSFB, Deutsche, HSBC and UBS, sit comfortably at the helm. Then banks such as ABN Amro, Bank of America, JP Morgan and NatWest are also included, while the investment banks, such as Merrill Lynch, Goldman Sachs and Morgan Stanley Dean Witter, are noteworthy due to the sheer flows that they see.
“Throughout most of the ‘90s, the interbank market was a three-tiered market. But
today, the middle tier has virtually disappeared. This is due in part to mergers
and a reduced appetite for risk, but also because FX has become so commoditised
that the margins are no longer there to support interbank trading for these
firms,” says another source.
CSFB’s Spicer agrees that two tiers have emerged. “There are probably about 25 banks that will make a market in any G-20 currency pair to their customers, 24/5. But how many of these are prepared to make markets interbank in more than four currency pairs? Definitely far fewer,” he says.
Spicer believes CLS (the continuous linked settlement bank being formed by a consortium of the world’s top banks) could create an even wider divide between the two market tiers. “There will be a price for CLS members and another price for non-CLS members. Once it’s up and running, the price for CLS members will be tighter than for non-members. Credit is always an issue, so the key that CLS addresses is diluting credit risk,” he adds.
“The market is different from what it was 10 years ago, when we had a very large number of banks with ambitions to be leading global market players,” says Clifford Smout, head of the Bank of England’s FX division. “But there is a price at which doing this business makes sense, and a price at which it doesn’t. The FX market is now more akin to other markets and industries.”
HSBC is a good example of how a bank can maintain its position at the top, and yet concentrate the number of dealing rooms it operates. In October 1996, the bank shocked the market when it shut its interbank FX trading operation in New York, cutting 25 traders. The bank started a late night shift in London to cover the New York hours and has not deviated from its stance, despite early concerns that it would suffer from its decision.
“The cost of being a market maker is huge,” adds David Barnett, retired co-head of global FX for RBC Dominion Securities in London. “To be a market maker you must have reciprocal arrangements – so you have the cost of four or five extra people who are just ‘calling out’ people. Probably more than 65% of interbank trading is just banks passing around other bank’s positions. This can be a huge cost to maintain. One of the biggest costs in a dealing room is the peripherals (for example, the Reuters conversational screens). If you are a market maker or interbank trader, you need Reuters. If you’re not, then you don’t. Therefore, the cost of maintaining an interbank presence as a liquidity provider has to be constantly reviewed.”
One FX trading manager believes that over the next 18 months, many more banks will have to rationalise the number of terminals on desks. “I think there will probably be a 50-70% reduction, because having dozens of Reuters Dealing screens on a trading floor will become unnecessary as doors open to other vendors offering similar services in a more cost efficient manner,” says the manager.
EBS is reported to be developing its own conversational system, EBS Direct. “One of the things EBS is doing is looking very hard at the needs of the trading community, and how we can bring more products to market to meet those needs. The direct market is a competitive channel, so we’re looking to expand our product offering beyond just spot broking,” says Moran.
E-commerce is really about upping the percentage of business you see during the day, says CSFB’s Spicer. “It makes your position in the top tier safer as it moves from 10 banks, to eight, to six. And the bigger market share you have, the better liquidity you can offer to your customers.”
While e-commerce is enabling banks to shift large amounts of their business onto Internet sites that customers can access for themselves, some FX managers feel many customers do not appreciate that there is a cost for this service.
“Most customers forget that everybody has to make a living,” says another FX manager. “Spreads are wafer thin, but customers still want a two pip spread, transparency and research, all on the Web for nothing. If we did this, there would be no banks doing FX.”
“The bank/customer relationship is about credit,” the manager continues. “What large corporate users want is a virtually unlimited ability to trade at extremely tight prices. Anything less gets labelled as poor liquidity. Banks have to charge for credit and access to liquidity.”
“Where we can make a difference in terms of what liquidity we offer the customer base is in two areas – our risk appetite in terms of absorption of flow, and our order book – which means we have inherent demand at certain levels,” says Spicer.
“A lot of customers perceive that the best price in the market for any currency pair no longer comes from one bank, but from the electronic broking systems, ” adds another dealer. “What often is not understood is that you can only see a small part of the market at once and can only guarantee a minimal fill. There are no prices on demand like there is in interbank – and this is where banks come into their own in terms of providing liquidity.”