The New FX Benchmark – What Does it Mean?

Colin Lambert muses on the broader significance of the latest BIS number for the FX industry as a whole.

However the number was arrived at, the FX market will, for the next three years at least, be known as a $6.6 trillion market – reinforcing its position as the largest financial market in the world. At a new peak, things would appear to be rosy in the FX garden, but how does this number actually translate to day-to-day activity?

“It’s fair to say it’s a stress-free number, although it is going to cause a few executing brokers a headache,” suggests the head of e-FX trading at a bank in Asia. “Customers see the number, think that no matter how much they want to do and when they want to do it, the market can soak it up. It can to a degree, but there is still the need for care and attention that sometimes gets missed.

“Not only is $6.6 trillion the number for all FX volume, not just spot, it was taken during a month in which not a lot happened,” the e-FX head continues. “There is still a tendency for liquidity to dry up during periods of mild stress and while volume doesn’t drop – it goes up – the cost of trading is higher and that doesn’t relate in the context of the $6.6 trillion number that will be bashed into the heads of clients.”

In spot terms then, it seems to be a question of timing and, to a lesser degree, luck when it comes to market impact. Flow fed into the market carefully is unlikely to trigger a fault line barring unforeseen events and participants with what are seen as more passive execution styles are largely happy with how the market operates. Or are they? As one senior buy side trader points out, if everything was OK then there wouldn’t be the push for more peer-to-peer matching on the buy side.

“Too many banks are pushing their algos, and therefore the market risk, onto the buy side and if that is going to happen then why bother paying the bank to execute the flow?” the buy side trader asks. “If the FX market is as deep as it looks then surely it’s a question of getting the right counterparties into one venue?”

That suggestion gets short shrift from a senior bank salesperson who observes, “We internalise because we can match different types of flow – clients with different motives if you like. The idea behind peer-to-peer appears to come from the institutional investor space and they think they can match off against each other in spot – well I can tell you they will, but not very much.

“For such a concept to work these investors have to face off against regional banks, corporates, retail aggregators and macro hedge funds,” the salesperson continues. “The credit issue is a nightmare and if they get a central counterparty that will involve a lot of cost for minimal improvement in execution quality.

“Besides,” the salesperson adds. “In a world in which more funds are analysing execution quality, how long are they going to accept being banged around by smarter, more aggressive players like hedge funds? They will find the experience a lot different to dealing with banks that treat them like clients. No, the only solution for them is trading with other funds, but accessing the right flow will be just as difficult because so much of their business goes in the same direction in the same time windows.”

The salesperson does point out that there are plenty of funds who could match with their peers but typically they are smaller – and smarter. “These funds look at the [WM] 4pm [London] Fix and see they are often against the bigger players so they let the fix happen and trade at the end when it is most advantageous to them.”

There is also the case that in an arm’s length arrangement, the liquidity providers in the market have no obligation to the customer trying to execute via an agent. “There’s a whole army of data rich, high frequency players – as well as other banks – out there looking to sniff business out and the volume they provide looks nothing like the $2 trillion per day that the BIS says goes through,” says the e-FX trading head. “In an agency world it’s pretty much all or nothing when it comes to volume – if you time it right you have no problem, but if one thing goes wrong…”

There are also doubts that the latest survey accurately picks up liquidity conditions in FX swaps markets where even in the FX industry’s deepest market the headline number of $3.2 trillion per day belies friction points, namely month and quarter ends. The latest survey was also taken before the US dollar repo market went into meltdown in September, an event that was immediately contagious in FX swaps markets. “We could have got a price in almost any amount in sterling/yen, but dollar/yen disappeared,” reveals a senior voice broking source. “Repo markets jumped and every dollar price was pulled – it was like a really bad month-end when liquidity disappears. Things have settled since, but you can sense a nervousness in traders and they are quick to pull prices on the slightest trigger.”

One positive aspect of the FX swaps data from the BIS was how the growth was not narrowly focused in the very short end. True, about half of the growth was in the ‘up to seven days’ bucket, but the same growth in notional terms was seen in the longer tenors to one year. It was an even more stark story in outright forwards where activity in maturities up to one week flatlined and all the growth was seen in the one week to one year bucket where there is, thanks to market structure, more potential spread capture for partricipants.

Overall then, the $6.6 trillion number is just that – a number that represents a snapshot to help guide people when trying to describe the FX market. The reality is inevitably more nuanced, especially when it comes to stressed markets. “$6.6 trillion is probably the best it can be,” observes the head of e-FX trading. “It represents a number that says ‘when things are good this is how big the market is and how easy it is to transact in’. The really important number is not captured by the BIS, however, and that is how much can you get done when things get rough.”

Colin Lambert

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