The illiquidity in the market following the
Swiss National Bank’s (SNB) decision to drop its peg to the euro raised
numerous questions about how liquidity functions in the modern FX market, and
particularly how it functions in times of market stress.
With a UK referendum on whether or not to
remain in the Eurozone that is expected to spark volatility, questions have
once again arisen about how the liquidity conditions in the market change as a
result of this volatility.
They key difference between the to events
is of course that the SNB decision was largely unforeseen whereas the Brexit
vote has been on the cards for quite some time. And yet, because there are
still so many unknown factors surrounding the vote, it could still serve as a
good barometer for how FX liquidity functions in stressed market conditions.
One of the biggest questions is who will be
XTX breaking into the top 10 in the
Euromoney FX poll and Virtu winning the best market maker award at the FoXys
appears to be confirmation of what many have suspected for some time, that
non-banks are filling the gap left by some of the banks that are shifting from
a principal to agency business model.
But while the banks are less inclined to
take principal risk, there are concerns that the non-bank market makers have no
incentive to remain in the market during stressed market conditions, such as
could occur around the Brexit vote.
“On the day, HFT liquidity could vanish
quite rapidly, given the opportunistic nature of the way that they trade and
that they have no underlying clients that they have to execute, which is going
to be a concern,” said says Javier Corominas, head of economic research and FX
strategy at Record Currency Management, on a webinar hosted by Profit & Loss today.
He added: “Turning to the banks, a problem
that we still have is that due to regulation increasing volatility feeds into
VaR, which means that essentially the banks will be unwilling to warehouse as much
risk other participants that might require higher margins from their underlying
clients, like retail clients.”
Certainly there are many questions for
banks to consider going into events like the Brexit referendum.
“I think that the market will gap, because
if it’s a vote to leave the Eurozone then everyone agrees that there’s going to
be a lot of volatility, but even if the vote is to remain we still don’t’ know
how many positions are on the opposite side that people will try and close. So
then the question is: who’s going to be there?” says one global head of
e-commerce at a bank.
“People forget that one pip on ten million
dollars is worth one thousand dollars and so if you put a price out for ten
million as a principal and the market gaps five hundred then you’re down five
hundred thousand. This can happen in a split second and so banks need to decide
carefully how many people they’re going to stream ten million dollars to at a
time. Then they need to decide how wide they’re going to quote, what size
they’re going to quote and which clients they’re going to quote to. These are
important questions because it makes you think about what is real liquidity and
what is phantom liquidity.”
The conclusion to these questions, the
banker muses, might simply be to act purely as an agent during big market
events. Rather than streaming a range of last look prices, offer clients a
service whereby the bank will tries to source the liquidity they need, whether
by algo or voice execution and then charge a fee for that service.
“I would argue that it’s better practice to
call a spade a spade and say “look the liquidity isn’t there and not I’m going
to pretend it is and stream ten million dollars to one hundred people but I
will act as an agent and do the best I can with the liquidity and the credit
that I have”. Then charge a commission for that, to me that seems like a very
clear-cut and transparent model,” they say.
Relationships remain key
But while acting as an agent during times
of market stress might seem like a better option to some banks, a senior figure
at one non-bank market maker rejects the idea that these firms can simply leave
the market because they have no clients.
“I disagree with the notion that as a
non-bank we don’t have to be there for our clients,” they say. “Maybe on
anonymous ECNs it’s easier to pullback, but with our bank partners it is almost
like a client relationship and we have to be there in terms of providing a real
Although volatility is unlikely to be as
extreme as after the SNB decision, the Brexit referendum could well prove to be
a useful way of determining both the extent to which banks are pulling back
from principal risk taking and the willingness of non-bank firms to keep
pricing in difficult markets.
One thing that it is almost certain to
highlight though is that voice trading isn’t dead yet, and that relationships
still very much matter in FX.
Corominas noted on the webinar: “Having good relationships on the voice trading
side as e-liquidity disappears is particularly important during events like these.
For us, on the day we’re going to perhaps be doing less business on e-platforms
and moving more towards voice trading, working our positions slowly with banks
that we have long-standing relationships with to make sure we achieve the best