Much has been made of the sharp drop in spot FX volumes in the recent BIS Turnover Survey, but, Colin
Lambert asks, is what we are seeing merely a return to a longer term trend?

A regular theme in Profit & Loss over the past two years has been, since the traumatic events of January 15, 2015 around the Swiss franc peg, the return to relationship trading at the expense of the all-to-all model.

Analysis and data recently released by the Bank for International Settlements based upon its recent Triennial Central Bank Survey of FX Turnover appears to support the notion that the FX market is losing its infatuation with market share at all costs and is much more choosy about who it deals with.

The latest Bank for International Settlements Quarterly Report carries a paper, Downsized FX Markets: Causes and Implications, which suggests that amongst the many structural shifts taking place in FX markets, a move towards relationship trading is underway. The paper, authored by Michael Moore, Andreas Schrimpf and Vladyslav Sushko, also provides additional data on execution methods, which shows that while the overall e-ratio for spot FX has only risen slightly, there has been quite a shift within the electronic trading environment.

It is also noticeable, looking at a broader BIS data set, that while the 19.1% decline across the April 2013 to April 2016 surveys is pronounced, spot’s share of FX turnover has reverted to longer term norms. If this is the case it provides further evidence of what could be termed a “reality check” for foreign exchange markets that the days of all-to-all liquidity are over.

The three BIS surveys between 2001 and 2007 suggest that spot FX was responsible for between 31-33% of overall turnover. The 2010 and 2013 surveys had a spot ratio around the 38% mark. The April 2016 survey has spot holding a 32.5% slice of the overall FX pie.

One of the bigger impacts on foreign exchange markets from the global financial crisis has been of course the rise of the non-bank market maker – initially out of the high frequency trading space. Not only did this surge from a relatively new sector in FX boost apparent liquidity levels, it also gave a helping hand to volumes.

Further assistance was provided by the retail FX industry, mainly through aggregators, who found plenty of willing liquidity providers very keen to help build volumes – and their own market share – further. This appears to be at an end, and, as noted in these pages and also by the authors of the BIS analysis, the shock emanating from the Swiss National Bank’s decision to remove the euro-Swiss franc peg on January 15, 2015 played a huge role.

Although the authors say that the fall in global trade and capital flows accounts for some of the decline in spot turnover, they also highlight what they term the “decline” in prime brokerage, which has been associated with a fall in trading by hedge funds and principal trading firms.

The paper says that overall PB volumes declined 22% and in spot they fell by 30%. “Prime brokers have focused on retaining large-volume clients, such as large principal trading firms (PTFs) engaged in market making, while shedding retail aggregators, smaller hedge funds and some high frequency trading (HFT) firms,” it says.

The paper also notes, in what could be a “chicken and egg” scenario, that hedge fund returns have been under pressure post-crisis, with assets under management falling further after the Swiss franc shock. It also notes that the fall in PTF activity largely reflects the saturation of HFT strategies focused on aggressive fast trade execution and short-term arbitrage. The introduction of “speed bumps” in the form of latency floors by major inter-dealer platforms made such strategies less attractive, it notes.

The Rise of Disclosed Trading

Although the data from the BIS suggests that the overall e-ratio in spot FX rose by only 1% (to 65%) from April 2013-16, there were some significant shifts regarding how people interacted electronically. The share of spot FX trading held by single dealer platforms, which includes API channels, rose by 11% to 25% in April 2016.

Interestingly, other “direct” [disclosed] channels actually saw a fall in their share, by 6% to 18%. This suggests that liquidity providers, especially the major bank dealers, have become more choosy about how their liquidity is used in aggregation.

Overall, direct, or disclosed, electronic trading represented 43% of spot turnover, up 5% from April 2013 and easily the biggest channel in the industry (voice direct trading was flat at 25% and voice indirect – mainly via voice brokers – fell 1% to 9% of spot turnover).

Conversely the anonymous environment struggled across the survey period, with the BIS analysis showing Reuters/EBS volumes down 3% to a 13% share and Other ECNs rising 1% to 9% of flow. An interesting addition to the Indirect category in this latest survey is Dark Pools which the BIS says represented 1% of spot FX flow, or just shy of $17 billion per day.

“The data isn’t a surprise to us because we have – still are in fact – taking a long hard look at who we consider to be customers,” confides the head of e-FX trading at a bank in London. “Generally speaking, our sense is the banks have been getting harsher and harsher in their assessment of who constitutes a customer – it really is all about dollars and cents – and anyone in the grey area has a choice. Trade on our proprietary platform where we control the environment, or see wider – in some cases no – pricing from us.”

An interesting inference from the BIS data, as well as from anecdotal evidence gathered by Profit & Loss, is that even within the disclosed segment of the market there has been a re-assessment. “We have further refined our pricing in favour of those channels where we are in less competition,” says the

Europe-based head of e-FX at another bank. “We are saying to ‘true’ customers, if you want a better price, check out our single dealer stream rather than a multi-dealer platform. On the latter, we are paying fees (as is the customer on some occasions) and it’s too public. To get best execution the customer has to either spray the market and get a wider spread next time, or risk slippage through signaling risk.”

When asked about aggregation channels, the e-FX head is slightly evasive, merely noting that pricing quality varies by circumstance “depending on the quality of the customer, number of competitors and visibility of the order”.

The Fundamental Question

Although the evidence suggests that the major liquidity providers are making it harder for what could be termed “troublesome” counterparties and also that a great number of
professional traders such as hedge fund managers are getting
caught in the crossfire, the data also indicates a rise in activity
from the “real economy” or hedgers.

In April 2013 activity involving institutional investors and nonfinancial
customers was responsible for around 22.2% of spot
activity – in April 2016 this had risen to 24.6%. The rise was
entirely due to more activity on the part of institutional
investors, who collectively were responsible for 17.5% of spot
FX flow, up from 13% in 2013.

Non-financial activity actually
declined to 7.1% of volume from 9.2%.
The BIS paper, noting that overall FX trading with nonfinancial
counterparties has fallen 20%, suggests this is a
reflection of reduced global trade flows. It argues, however,
that conventional macroeconomic drivers alone cannot explain
the evolution of FX volumes or their composition across
counterparties or instruments.

This is because fundamental trading needs only account for
a fraction of transactions, the authors observe, adding that
instead, the bulk of turnover reflects inventory risk
management by reporting dealers, their clients’ trading
strategies and the technology used to execute trades and
manage risks.
Although it could be ascribed to the uncertain macroeconomic
environment as well as geo-political shifts, the paper
signals a change that has seen the composition of participants
changed in favour of more risk-averse players.

“The greater propensity to transact FX for hedging rather
than risk-taking purposes by these investors has led to a
decoupling of turnover in most FX derivatives from that in spot
and options trading,” the paper states.

Looking Ahead
If there is a “buyer beware” attached to the BIS analysis it is
that since April 2016 when the survey was taken, the FX world
is a very different place. The UK has voted to exit the European
Union, Cable has seen a flash crash and the US election has
generated tremendous uncertainty.
The authors of the BIS paper have, to a degree, been able to
take this into account.

They note, “Tentative evidence suggests
that market participants rush to traditional anonymous multilateral trading venues when market conditions
deteriorate,” which appears to have been reaffirmed during the
aforementioned events. Anecdotally, market makers tell Profit
& Loss
that their volumes were significantly higher on those
days, but that internalisation rates were lower.

This is also evidence of a broader trend, the BIS paper
noting, “Patterns of liquidity provision and risk-sharing in FX
markets have also evolved. The number of dealer banks willing
to warehouse risks has declined, while non-bank market makers
have gained a stronger footing as liquidity providers,
even trading directly with end users.”

The paper adds, however, “Some of these technologically
driven players have also emerged as flow internalisers, but the
majority of non-bank market-makers often do not bring much
risk absorption capacity to the market.”

So while the longer term trend does appear to suggest
that liquidity providers are more focused on their core
customers, the FX industry is still likely to see short periods
of intense activity across the anonymous venues. If, as
suspected in many circles, a number of trading venue
providers are up for sale, this could have implications for
their prospects. The more event-driven the world becomes,
the more likely these venues are to see more volume – and
hence more buying interest.

For the broader industry, the BIS paper’s authors suggest
that this shift, along with the changes in the composition of
market participants and their trading patterns may have
“significant implications for market functioning and FX market
liquidity resilience going forward”.
“While relationship-driven, direct dealer-customer trading on
heterogeneous electronic trading venues delivers lower
spreads in stable market conditions, its resilience to stress
may be tested going forward,” it adds.

“For example, non-bank
market-makers may have higher exposure to correlation risk
across asset classes.
“There are also indications of rising instances of volatility
outburst and flash events,” it continues. “Hence, the risk sharing
efficacy of the evolving FX market configuration is still
uncertain. Any major changes to liquidity conditions might have
consequences for market risk and the effectiveness of the
hedging strategies of corporates, asset managers and other
foreign exchange end users.”

Galen Stops

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