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29 November 2009

The "guru" war on the U.S. dollar - Forex - Futures Magazine

The "guru" war on the U.S. dollar - Forex - Futures Magazine

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FX trading: One market model won’t suit everyone

FX trading: One market model won’t suit everyone
(Source: EuromoneyFiX)

By Mark Warms, General manager of FXall's European operations. The constantly evolving FX market is once again entering a period of change that is potentially so significant that many participants are openly talking about the emergence of a new trading paradigm.

Whether this proves to be the case is perhaps debatable – history has repeatedly shown that the more things change in FX, the more they stay the same. But at the same time, the way the market is evolving should not be underestimated. It is clear that FX participants need to give thoughtful consideration to the structure of their business, otherwise they risk losing competitive advantage.

Consolidation and concentration within the industry are the main drivers of the shift currently taking place. This is nothing new – it is a trend that has been taking place for more than a decade. As can be seen in the BIS chart, fewer players are accounting for the majority of the volumes transacted.

In theory, the fallout from the sub-prime crisis could have allowed the emergence of some new FX powerhouses – those banks to have emerged from the turmoil with their balance sheets relatively intact have an opportunity. While that may yet happen, the evidence suggests that it will take more than a strong credit rating to break the dominance of the large FX trading banks. As the Euromoney FX poll showed this year, the market share of the top five banks remains remarkably steady at around 61.5%, even though several of them were high-profile losers from the sub-prime crisis. It is also worth noting that in the past year, the combined share of the top 10 banks rose from 76.3% to 79.7%.

Such figures underscore the role these banks play in the market, and this importance is not decreasing. At the time of the last BIS Triennial central bank survey in April 2007, much was made about the emergence of a new breed of market-maker. In reviewing the turnover, BIS stated: “By counterparty, the expansion in turnover in the inter-bank market was comparable to growth over the previous three years, but was outpaced by the increase recorded in the non-financial customer and non-reporting financial institution segments, which more than doubled in size.”

But BIS makes another key observation: “Consolidation of the banking system was identified in the past as reducing turnover in the inter-bank market through channels such as efficiency gains and the ability to net trades across related parties within an organisation.”

Three years ago, it was anticipated that the emergence of the new players would have the most impact. This, many argued, would lead to an erosion of the banks’ dominance on price making, leading to the long-anticipated move of FX on to a single, or at least fewer, centralised locations. But this has not happened, largely because of the ability of leading FX banks to internalise their order flow – or, as BIS put it, net their “trades across related parties within an organisation.”

Internalisation is a much-talked about concept in other markets; in FX it is a reality. The ability to match-up trades means banks are no longer so reliant on – and perhaps are even independent of – the main external platforms for reference pricing. Banks have rediscovered the true art of market making, albeit with a new, electronic twist. However, they will always have business that they cannot match up and that they need to offset.

But when they seek to do this, they sometimes encounter problems. Naturally, a good deal of thought has gone into how these problems can be overcome. While the spill-out business from the banks may be comparatively small, it can still be of sufficient size to result in quite big losses if it is not transacted smoothly and fairly. A concern is that this flow can be read, which leads to the market being pushed away from the bank as it tries to offset its risk.

When there is a concentration of liquidity, such as on a single exchange, it is easy to make the argument that a trading venue must have equal rules and access for everyone. But the structure of FX, which remains a fragmented market place, means that different venues will have different rules for different participants.

The simple fact is that the banks have remained the true liquidity providers in FX. The new breed of FX participants have played an important role – which is mostly welcome – but it is hard to see the majority of them ever stepping up to the plate and making a price in a $1 billion in competition for a demanding client. Naturally, the banks do not see why they should act as the ultimate suppliers of liquidity, only then to be picked off by someone who will not reciprocate and make a price in any meaningful size back when they come to transact their own flow.

A potential solution is to have a variation on dark pools, but a different approach is required than the one utilised in equities. In FX, the issue is not about moving block trades, but rather it is about transacting smaller packets as efficiently and profitably as possible. Banks want to be able to meet with counterparties of natural interest, which will invariably be other banks.

Older market participants will remember how inter-bank brokers were able to meet many of these needs of the banks; the fact that non-bank players could not access their prices is believed to be a major reason why. On the whole, the brokers were trusted. And trust remains a crucial part of FX, just as it was when a bank used to tell a broker he was on the bid or offer. Electronic trading has not replaced this. Now banks are not only analysing how they price risk and credit, but also how they price trust.

The changes taking place have been given very careful consideration. They will not suit everybody, but as with most of the developments in FX over the past decade, they will almost inevitably result in an even more efficient market. The FX market has shown itself to be very capable of overcoming conflicts when they arise.

Only a wise man or a fool will claim to be able to predict the future, but looking at the market’s history should provide some clues. There is something in FX to satisfy the needs of most participants, and technology should allow different platforms to survive with very different business models. There is no single way to trade: some will prefer ECNs, others will prefer bank-streamed prices and, sometimes, dark pools will be chosen where shared interest can be matched. Some platforms will offer variations on all of these, and this could prove important.

Banks are looking to diversify the venues they trade on as they seek to diffuse their risk, but at the same time, in seeming contradiction, they are looking to consolidate where they place their business to extract efficiencies and savings. Single market-model platforms still have plenty to offer, but there are real opportunities for those that can offer multiple ways of execution. Ultimately, FX will continue to thrive because it offers real choice for its vast array of participants.

Special Feature: Have Reuters and EBS lost control of FX?

Special Feature: Have Reuters and EBS lost control of FX?
(Source: EuromoneyFiX)

The limited effects of a system breakdown at EBS suggest the two interdealer brokers no longer dominate FX price discovery. They had better watch out, there’s a new market paradigm on the block and it is hungry for their lunch. Lee Oliver reports.

In a recent article for Euromoney's weeklyFiX, Mark Warms, general manager of FXall’s European operations, highlighted the fact that many participants in the foreign exchange market believe that a new trading paradigm is starting to emerge. Does this mean that Reuters and EBS are losing their dominance in price discovery?

Until recently such a suggestion would have been summarily dismissed. The consensus was that although numerous viable trading platforms exist, ultimately they all depend on Reuters and EBS. The two electronic interdealer brokers have been routinely described as the market’s hubs, with every other platform effectively spoking off them. Pricing on every other platform was little more than a variation on the rates shown by the two brokers.

But a big system outage suffered by EBS in early March is evidence that a new market model is rapidly emerging. Such an event would once have resulted in a general loss of liquidity and a widening of prices but on this occasion some platforms, including those at the retail level, carried on working as if nothing had happened.

As Tim Cartledge, co-head of Barx FX trading, says, this might well be because there are now so many viable alternatives to EBS and Reuters. “In the past, if EBS or Reuters went down, there were real problems in pricing,” he says. “I think people have looked for more protection and are connected to other platforms. If it [a system crash] happens now, it has less effect. It still has an impact, but it doesn’t take the whole market down. If a platform goes down, business switches elsewhere. There are plenty of platforms out there.”

Cliff Lewis, chief executive of Currenex, is blunter. “I’m surprised at just how small the impact of the EBS crash was earlier this year,” he says.

Not surprisingly, Dave Rutter, deputy chief executive of Icap electronic broking, of which EBS is part, disagrees, and an incident on September 23 suggests he has a solid point. A rogue order to sell €1 million in euro/Norwegian krone two big figures below the market on Reuters by an institution with a credit rating so poor that no other counterparties could take the offer affected many banks’ auto-pricing. The result was that they resorted to quoting wide euro/Norwegian krone rates. However, the impact would undoubtedly have been smaller in the major currencies and, tellingly, some banks simply screened out the bad price, underlining just how important smart technology is becoming.

Plenty of reasons have been put forward why Reuters and EBS might have lost some of their dominance of price discovery, including the fact that some banks are resentful that both brokers had opened up to a non-bank audience, especially high-frequency traders. Another issue is that while they allow credit screening, all prices on their platforms are theoretically good for everyone. Other platforms, including Currenex, are more flexible with their rules and if a bank decides it does not want to trade with a particular counterparty for reasons other than creditworthiness, it can do so whether or not that player is hiding behind a prime broker.

Direct dealing

Cartledge says the issue is that some business is not viewed as friendly by the banks. As a result, they have reduced the amount of hedging they do through EBS and Reuters and a modern version of direct dealing now exists. “We have reciprocal agreements with other banks to show our prices. That can be in a dark pool or through a stream over an ECN [electronic communications network]. But to do that, you have to be able too chose who you can deal with,” he says.

Rutter feels such criticism is harsh. “It’s not fair to say that high frequency traders spoil a market – they can provide valuable liquidity and many of these high frequency traders are actually units of the banks. When we opened the system weworked in close collaboration with the banks when we opened the system up.. We’ve made changes on the system to address any issues and the need for balance between manual and high frequency traders.“

Another issue is that Reuters and EBS do not, as yet, offer fractional pricing, once regarded as a gimmick. According to Lewis that has now changed. “For a long time, the dealers thought that the introduction of decimals was horrible,” he says. “But then they realized that they could jump to the top of the order queue far more cheaply.”

Although these issues are important, the main issue would appear to be the way that many banks are able to internalize their flow. “Internalization has totally transformed the market – that’s the real story,” says Lewis. “It’s inevitable that volumes will be challenged on certain platforms. The inter-bank venues no longer control price discovery.”

The ability to match up buyers and sellers internally has allowed banks to rediscover the art of market-making. “We internalize the vast bulk of our flow,” says Cartledge. “We show tighter prices than the platforms, so it makes sense for us to do that. That impacts on the likes of EBS and Reuters, which have sought liquidity from other participants.”


Rutter recognizes the development. “I think some of the banks have become more astute at internalising their flow and the market has fragmented as a result. The challenge for EBS is responding to this new paradigm. But the question I ask is whether it (the new paradigm) is good for the market in the long run,” he says. “A lot of flow goes through the aggregation engines built by the banks. However we remain at the centre of the FX market and our prices are the benchmark. Perhaps the real question is whether the centre is getting bigger or smaller. When the market is volatile, we see a spike in dealing activity.”

Jas Singh, global head of treasury at Thomson Reuters, expresses similar sentiments. “The big banks are now internalizing a lot of their flow and when the markets are stable, it’s easy to do that,” he says. “When they start to move though it becomes far more difficult. The banks still need to dissipate risk. Our overall volumes have gone down over the past year, but we don’t believe there’s been any change in our market share. We remain a core venue for the market, which is underpinned by our huge footprint and rich history.”

Lewis puts it more bluntly. “There is a completely new market paradigm and it was invented by the banks,” he says. “Where the market goes from here will be led by those same banks. There are now three choices for platform providers: operate as an IT company; work as a cooperative or mutual; or compete with the banks.” He adds that if you want to know what the market’s structure will look like, you need to ask its main liquidity providers.

“Banks are internalizing flow by using robots and then something like 20% of their business goes to a hedging outlet that’s no longer necessarily the interdealer broking platform,” Lewis says. “The robot wants to know its fills and it wants rapid information as well. The big banks are in the exchange business and compete with Reuters, EBS and Currenex.”

Eating lunch

Another senior market figure is even more forthright, and although he declines to have his comments attributed, they will no doubt strike a chord with many FX players. “The brokers have failed to realize that the banks are eating their lunch. Their typical solution is to say: ‘Let’s organize a piss-up’.”

This is harsh. It suggests that it is not just the technology of Reuters and EBS that may be stuck in the past. But history has shown that, when challenged, the incumbents in any market fight back, at least once they realize they are under threat. And Rutter is under no illusions. “We’re not immune to the fact that the markets are changing,” he says. “We have invested in our technology and we’re no longer a closed system. The platform is much faster, it shows the order book and in some ways this has made it easier for the other platforms to exist. We’re in interesting times but we won’t be pushed into reacting to every development. We have to remember that we are there for the benefit of the whole market. We have to operate a fair, equitable market.”

Although it is too early to report the demise of Reuters and EBS and the emergence of a totally new market paradigm, the two brokers are clearly facing a degree of competitive pressure that was unimaginable until recently.

“We’re certainly in a different place now than where we were three or four years ago,” says Cartledge. “Back then, EBS and Reuters could both say they were the market. But to get a correct view of the overall market now, you can’t just look at those two venues. We’re on a journey where we could end up with eight or so major trading venues that are all as important as each other. These could be a mixture of ECNs and bank platforms.

“You can’t say any more that there’s just one ECN for the whole market. There’s not going to be one dominant player any more and platforms have to work out which niche they are catering for.”

28 November 2009

Welcome to The FX-University

Welcome to the FX-University!

We hope that you will find this blog both informative and helpful towards the aim of enhancing your forex body of knowledge and trading skills.

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As the analysis is produced in advance of any given trading day, it is a very useful place to start planning your trades.

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