News review : Regulation

January 14, 2015

REGULATIONS TOPS THE LIST OF CONCERNS IN 2015.

BE27.Greenwich_McPartland Not surprisingly, the plethora of new rules that continue to sweep over the global financial community will remain high on the agenda, according to a new report by Greenwich Associates. The new equity brokerage rules in Europe combined with Basel III and solutions to the FX scandals are among the trends that will have a long lasting effect on market infrastructure this year and into the future. In addition, new bond trading platforms, an expected move by the US Federal Reserve to increase interest rates and a subsequent pick-up in volatility will also make their mark.

The report entitled 15 for 15: Top Trends in 2015 notes that although full global implementation of the rules will not be completed for several more years, US banks will finally get a real taste of Basel III with the required disclosure of Supplementary Leverage Ratios (SLR) – the American interpretation of leverage ratio requirements defined by the banking legislation. “This new disclosure requirement will finally give the market a more apples to apples comparison of bank leverage,” says Kevin McPartland, head of market structure research at Greenwich Associates. “As the last few years have taught us, disclosure brings with it questions, and questions often lead to change.”

Growth in corporate bond e-trading and further adoption of trading protocols that go beyond traditional request for quote will also come into play this year but the report does not expect a big bang market structure change to occur. While the dynamics are different, McPartland believes that client execution habits for trading US Treasuries will become increasingly self-driven.

One of the biggest uncertainties facing the industry this year is the fallout from the 2014 FX fixing scandal. The big question is why, in a market with over 80% of volume executed electronically, a model developed decades ago is still used to set the “official” price, according to McPartland. “It is not clear if the regulators will move fast enough or come down hard enough on the industry to drive real change to this process in 2015, but you can certainly expect third-party providers to come to market with new 21st century solutions,” he added.

News review : Fixed income

Ian Rycott

January 14, 2015

BONDS SLIDE AS OIL PRICES PLUMMET.

Be27.INVESTEC_DKendall The euro hit a nine-year trough and bond yields in several euro zone countries reached record lows at the beginning of the year as tumbling oil prices tipped inflation into negative territory for the first time since 2009, raising the prospect of outright deflation.

Overall, the average 10-year sovereign bond yield across the G3 – US, euro zone and Japan – is below 1% for the first time ever, even lower than during the 1930s Depression, according to figures from Citi. The decline in oil showed no sign of letting up with prices expected to drop again in January. Brent crude oil futures dipped below $50 a barrel in the new year – a level that has not been seen in almost six years.

Although the current scenario could bolster calls for embarking on the path to quantitative easing, the European Central Bank (ECB) may be reluctant to act aggressively before Greece’s general election on 25 January. A vote could raise the prospect of an exit from the euro zone if the left-wing Syriza party wins.

“The negative print on eurozone inflation was widely expected by the market and more importantly flagged by Mario Draghi before Christmas and was in line with market expectations,” says Dawn Kendall, Senior Bond Strategist at Investec Wealth & Investment. “However, the more pressing question now is; what’s next?

She adds, “Oil has fallen 30% since the beginning of December which is a short term dampener in inflation before the consumer boost can start to be realised. These factors are working against the ECB’s desire to kickstart the economy by talking of and preparing for QE. When and if QE starts, these opposing forces will impact the future direction of inflation. For the short term, deflation is the biggest fear.”

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FX trading focus : FX options : Russell Dinnage

Ian Rycott

January 14, 2015

FX OPTIONS LESSEN AS E-TRADING TAKES HOLD.

By Russell Dinnage, senior consultant at GreySpark Partners’ Capital Markets Intelligence practice.

Earlier in the year, GreySpark Partners released Trends in FX Trading 2014, a report examining the impact of both buyside and sellside e-trading and e-commerce dynamics on the structure of trading in the FX market which found that a long-running trend of product consolidation in the FX options instrument class could be the forbearer of a more electronic future for hedging tools.

In 2014, many market structure experts on both the buyside and sellside of the FX market believed that the increasing sophistication of electronic currencies’ liquidity production and consumption platforms are priming liquidity in the space overall, for rebirth in the near future as an equitieslike, all-to-all (A2A) market. The report found some evidence of an emerging trend within FX toward a sophisticated, A2A market structure model.

However, the A2A look and feel in 2014 of the so-called flow FX space – which includes spot, forwards/outrights or swaps – from both the buyside and the sellside’s perspective can be deceptive, according to our report. In fact, when an A2A lens is applied to the FX options universe, specifically, evidence of convergence between e-trading technology, e-commerce business models and electronically-executed trades is hard to find.

This does not mean though that the electronic future of FX options trading is not a rosy one – far from it. Rather, if history is any indicator, then our analysis of the FX options product class suggests that it is only a matter of time before the right amount of market demand for e-traded FX options products will meet the ability of sellside broker-dealers to provide electronic liquidity, and the market will move into a more A2A state, akin to the current status of instruments traded in the flow FX family.

FX options: history repeating itself?

The report argues that participants in the FX options space won’t know how and where that space is heading from an e-trading, e-commerce market structure perspective until it knows precisely where it wants to go. And to understand where they want to go as new technology and liquidity dealing paradigms for buyside and sellside traders alike evolve out to 2016 and beyond, the FX options space need look no further than the lessons that can be learned from the electronification of flow FX.

Specifically, in the 1990s, the nature of flow FX liquidity began to slowly gravitate away from being consistently warehoused on sellside brokerdealer balance sheets toward – instead – a more cost-efficient, speedier, brokered state in which investment banks abandoned long-standing principal dealing models for the adoption of inherently more electronic agency dealing models. As such, our chief findings, in terms of the state of e-trading and e-commerce in the flow FX space in 2014, are as follows:

Of the top 12 spot FX brokerdealers in the annual Euromoney Foreign Exchange Survey rankings, four offer their buyside clients direct market access (DMA) into so-called dealer-to- dealer (D2D) spot trading venues like EBS Market.

DMA into spot FX D2D venues, as a competitive differentiator between one bank and the next in terms of ability to service buyside client liquidity demand, is only matched by the ability of a larger sample of banks to provide FIX or API connectivity for their clients into traditionally bank-only venues.

Advances in technology enabled this change – specifically, the launching in recent years of prime brokerage (PB) technology platforms, by many of the leading FX ECNs, enabled banks to enable their buyside clients to gain largely unfettered access to sellside spot FX liquidity in ways that allow the clients to trade on prices in the bank’s name.

Granting buyside clients access to spot FX D2D venues has essentially allowed buyside firms to directly exchange liquidity flows with one another, albeit within electronic trading environments wherein the regulation of trading activity remains managed – in a fashion – by the banks making markets and the inter-dealer brokers hosting the trading.

Far from being concerned about the presence in 2014 of algorithmic or high-frequency hedge funds within the hallowed ground of D2D spot FX venues, many of the leading brokerdealers are now encouraging their presence on venues like ParFX because, quite simply, what’s good for the little clients in terms of PB access to spot FX liquidity is even better for the large clients.

According to our analysis of the spot FX market, the level of buyside-to-buyside spot FX trading within D2D venues began to increase dramatically in 2008, when PB technology platforms operated by interdealer venues became more commonplace. For example, the report found that the leading ten non-bank participants by volume on EBS Market make up approximately 25% to 30% of the total average daily spot FX volume on the platform, which is around 75% of the overall nonbank average daily volume on the venue.

The remaining 25% of nonbank average daily spot FX volumes on EBS Market are made up of around 50 buyside firms that interact with other market participants on the platform using a variety of lowvolume trading models. The ten leading non-bank participants on EBS Market by volume utilise PB relationships with broker-dealers to gain access to the platform. Many of these non-bank participants are hedge funds and other types of proprietary trading firms that operate multiple trading models on EBS Market, many of which would commonly be described as high-frequency.

In this way then, the spot FX market is transitioning into an agency-only dealing model environment defined by a multitude of e-only products from which only a handful trade in any significant amount of volume on a daily basis, and on venues controlled by only the largest market participants on either side of the supply and demand equation. However – for the spot FX market to reach such a point – both the consumers and providers of liquidity spent several decades working toward not only a level of agreement on which currency pairs can and should trade in high volume on a daily basis, but also how that liquidity can and should be provisioned to the market.

The fact that advances in e-trading systems and accompanying e-commerce business models were the catalyst for a shift toward A2A trading to occur is almost inconsequential when compared to the ceaseless amount of whittling-down required by parties globally on all sides of the market to come to a collective agreement as to how liquidity should be provisioned. The result is that banks can now increasingly lean on their ability to grant buyside access to spot FX liquidity almost as if it were a simple service provision.

The effect of this result allows the broker-dealers to charge their clients for the privilege of being connected with other, like-minded liquidity seekers rather than for the privilege of being able to access the bank’s balance sheet. While speculative in 2014, a similar chain of events could lead to the greater electronification of FX options trading.

Assessing the options

GreySpark believes that the market structure changes witnessed in recent years in the spot FX space will set the stage for greater levels of e-trading in other types of currencies instruments, such as FX options. For the time being, however, FX options will remain principallytraded by banks, with multidealer platforms remaining the venues of choice for calls and puts liquidity.

If the sellside principal trading of FX options is to become more electronic – and thus, agency-like – in the future, then it will happen as a result of broker-dealer attempts to offer innovative means of accessing FX options liquidity through single-dealer platforms (SDP), either by bolting on a third-party technology vendor solution to the platform or by building out specific dealing capacity using in-house expertise.

The most common route to market for these SDP innovations is through dynamic pricing, wherein the ability of large flow houses to combine retail FX flow with the rest of the bank’s primary currencies’ liquidity to skew pricing for FX options products represents the most successful model in the marketplace.

These price-skewing models gave some of the broker-dealers surveyed for Trends in FX Trading 2014 report the ability to standardise a wide range of vanilla FX options products ranging from the very-vanilla to more complex contracts that were commoditised over time as their geographical reach to buyside client bases increased.

Be27_Greyspark_Fig.1

For example, there is already some evidence to suggest that electronic demand for vanilla FX options could begin to outstrip supply. At the end of 2013, a record level of average daily volume for vanilla FX options contracts traded on CME Group’s Globex platform, exceeding a record level of open interest (see Figure 1).

On the surface, the alignment of demand and supply for the contracts traded on the leading electronic venue for standardised, vanilla FX options instruments can be interpreted as appetite by market participants to gravitate toward an EU- and US-regulated entity – CME Globex is registered with the CFTC as a SEF – to automate the hedging of risk exposure in the primary FX market.

However, another argument could be made suggesting that the products traded in volume on CME Globex were standardised by broker-dealers so that they could be more easily dealt electronically rather than via voice OTC.

This is not to say though that non-vanilla FX options are ripe for standardisation as well; we believe that there will always be a distinct class of FX options products – crosscurrency swaps or dual-currency deposits, for example – that all broker-dealers must voice price and which can only be dealt and processed OTC.

Nevertheless, potential exists in the future for broker-dealers to co-opt the characteristics of some emerging D2C FX options trading venue offerings into their SDP architecture, offering buyside clients specific capabilities to structure and test the viability of complex or exotic FX options contracts using advanced pre-trade analytics accessed within an SDP. But, for the time being, the sellside FX options dealing space and the market structures surrounding it remain within a transitionary phase.

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News review : Equities

Ian Rycott

January 14, 2015

A REPRIEVE FROM FULL UNBUNDLING.

Be27.IMA_DGodfrey In its MiFID proposals, the European Securities and Markets Authority (ESMA) requested greater transparency over the payment of broker research but stopped short of an outright ban on full unbundling.

Fund managers typically pay their trade execution and research fees bundled together out of dealing commissions. This has been a long running bone of contention with regulators believing this method has created conflicts, such as inducements to trade with the brokers that gave them the best research, rather than the best execution.

The proposals which are subject to approval from the European Commission, recommended that research can still be paid for with dealing commissions under certain conditions, such as increased transparency around research costs. They stated that investment firms would be allowed to accept third party research “only where they pay for it directly or from a ringfenced research account that is funded by a specific charge to their clients”. The technical advice also advised that charges should be “based on a pre-set budget, not linked to the volume or value of client executions”.

The Investment Management Association, a buyside trade group, supports ESMA’s decision to allow investment research to continue to be purchased by clients. Chief executive Daniel Godfrey issued a statement saying that the move would “raise standards and reduce conflicts of interest across Europe and ensure that payments for research are clearly distinguished from payments for trading”.

Reaching a decision has not been easy as there has been dissent in European circles. The UK’s Financial Conduct Authority advocated an outright ban on banks charging investors for research out of dealing commissions but some countries such as France were against the idea. Banks and asset managers have been lobbying for regulators to settle for more disclosure of costs through commission sharing agreements, but a halfway house solution could result in them having to specify and separate the costs of research and dealing commissions for each client.

In a recent poll conducted by Extel, over four-fifths of asset managers – responsible for £1.7tn of assets – said they believed any measure that prevented banks from lumping fees for analysis and other services together would affect the ability of small-cap companies to access the capital markets. Other bankers said it would prompt wide scale job losses at equity trading desks as fund managers and their clients reassessed the value of the research they were paying for.

News review : Derivatives

Ian Rycott

January 14, 2015

GMEX AND EUREX JOIN FORCES.

Be27.GMEX_HMisra Instead of launching its own platform, Global Markets Exchange Group (GMEX), a European derivatives start-up backed by Deutsche Börse, has thrown its hat into the ring by licensing its swap futures product to the German exchange’s Eurex market.

Under the agreement, GMEX will use Eurex’s execution and clearing arrangements enabling buyside firms to trade the product through their existing membership with the exchange. Although transactions will be arranged through GMEX, the rest of the trade will be subject to the same rulebook and clearing arrangements as Eurex’s own products.

The London-based group, which recently won approval from the UK’s Financial Conduct Authority, is one of a number of derivatives initiatives that have emerged as a result of over the counter regulatory reforms that will push more swap trading onto exchanges and through clearing houses. The move will provide a major boost to participation in GMEX’s eurodenominated Constant Maturity Future (CMF) which is based on the Interest Rate Swap Index Average (IRSIA) and accurately tracks the interest rate exposure at each point on the yield curve by removing the expiry date and marking the contract to market against an IRSIA Constant Maturity Index on a daily basis. The aim is to manage interest rate exposure without a constant need to re-adjust and maintain the liquidity of a given maturity from 2 to 30 years.

According to GMEX CEO Hiranda Misra, “We continue to make very good progress with our launch and this new licensing arrangement with Eurex provides firms with a well-established mechanism to trade and clear our CMF contracts. We are getting very strong support from the trading community particularly the buyside.”

GMEX is not alone as competition is intensifying. Last September, Eurex became the first European exchange to launch a swap future, backed by a patent belonging to Goldman Sachs. More recently, the Intercontinental Exchange penned an agreement to license swap futures developed by Eris Exchange, a Chicago-based exchange founded in 2010. ICE Futures Europe, based in London, will list euro and sterling-denominated interest rate swap futures based on Eris’s design in 2015.

The London Stock Exchange is also planning to debut a swap future in conjunction with some of the largest investment banks, including JP Morgan and Goldman Sachs, through an initiative called Project Rita. Meanwhile, NASDAQ OMX’s NLX venue is also considering introducing a similar product.

FX trading focus : Digital currencies : Simon Hamblin

Ian Rycott

January 14, 2015

2015: BITCOIN’S YEAR OF ADOPTION IN FX?

By Simon Hamblin, CEO of Netagio.

Over the past few years, bitcoin has generated a great deal of buzz. It has certainly come a long way since 2008 when the digital currency first made its debut, capturing the imagination of the retail investor. Institutions though have remained wary although this could change if regulation is introduced. Europe, UK and US policymakers are following different paths but I believe that new legislation is not needed. Rules can be devised that slot into existing legislation, but if the grip is too tight, Bitcoin will lose its innovative touch.

Bitcoin, in its nascent stages of development, has seen out 2013 as the ‘Year of Storage’ and 2014 as the ‘Year of Exchanges/ATMs’, whilst 2015 is predicted to be the ‘Year of Adoption and Regulation’. With prices in decline since the heady days of early 2014 and no sensationalist media headlines of late, the world of digital currencies finds itself in a strange standstill.

The lack of regulation is the big culprit. Rule-makers are trying to grapple with the workings of digital currencies, though legislation takes time to develop. In the meantime, large financial institutions are treating digital currencies with an extremely heavy dose of caution. Risk is the main reason since lack of regulation means that systemic risk regarding virtual currencies remains unquantified. Furthermore, the very nature of the decentralised infrastructure of digital currencies translates into a stack of challenges for the back-office. The self-clearing nature of cryptocurrencies, for example, means that there are no mechanisms in place for custody and clearing to process them.

Development is clearly the key, but only once the regulators have decided how to treat digital currencies can institutional investors build appropriate types of management infrastructures. The European Banking Authority (EBA) issued a statement in July 2014 warning financial institutions (and identifying 70 associated risks) from buying, holding or selling virtual currencies until legislation is in place. More positive noises have been heard from the UK with the Chancellor indicating he would like to see whether the UK could embrace innovation “to see whether we can make more use of them for the benefit of the UK economy.” The deadline for a Call for Information by the UK Treasury has passed with a statement expected in the Budget Speech next March.

The US is grappling with discussions ranging from the Financial Crimes Enforcement Network’s (FinCEN) money laundering and terrorist funding concerns and the Internal Revenue Service (IRS) treating Bitcoin as property for tax concerns, to the New York Department of Financial Services (NYDFS) concocting specific BitLicences. The NYDFS approach being contrary to what the other US departments are proposing, which is to integrate digital currencies into already existing legislation.

The thing to remember is that digital currencies are very much an internet-based business, and as such, borderless. It is only when the virtual currencies are exchanged into traditional fiat currencies that regulations can truly take hold. If the EBA’s proposed ‘Scheme Governance Authority’ were to be enforced (meaning a legal person would be responsible for the integrity of the scheme – diametrically opposed to the decentralised make-up of Bitcoin’s infrastructure), digital currency businesses would simply up sticks and move.

The UK Digital Currency Association is calling on the government to incorporate digital currency exchanges into the existing payment services laws, noting that if the UK Government were to be too heavy-handed, highly scalable digital currency businesses would simply move to Hong Kong or Singapore with their favourable tax laws, liberal economic agendas and HK’s current practice of regulating Exchanges under standard money remittance laws.

As the Bitcoin market develops we expect to see much more product innovation and transaction, and to this extent Bitcoin (XBT) could well be incorporated into FX markets. Pairs of USD:XBT, GBP:XBT, and CNY:XBT would be completely feasible and traded like any other currency based on the principles of supply and demand. Bitcoin businesses could even be expected to legitimately hold a business bank account (currently a tenuous issue). However, until regulators declare a position, the banks remain in a state of inertia.

Growing demand will pave the way towards development and product innovation, and with the likes of well-known entrepreneurs such as Peter Thiel, founder of PayPal, and Sir Richard Branson backing Bitcoin, it doesn’t look like digital currencies will be a passing fad. The regulatory stance of digital currencies needs to be ascertained by governments without delay. The only way this can be done is by incorporating them into existing, proportional laws, ensuring innovation is not snuffed out. Financial institutions will then be able to properly manage the risk of digital currencies, as well as work out back-office systems.

The prediction about 2015 being the ‘Year of Adoption and Regulation’ for digital currencies – and their potential role in FX trading – is entirely dependent on the regulators.

Deutsche Börse AG : Intraday auctions : Miroslav Budimir

Ian Rycott

January 14, 2015

The Xetra intraday auction: Growing potential for strong price discovery.

by Miroslav Budimir, Senior Vice President, Deutsche Börse AG

Several weeks ago the London Stock Exchange (LSE) announced the introduction of an intraday auction in late 2015. This way the LSE intends to meet the demands of market participants from the buy-side, and to answer the challenges which will arise as consequence of the Dark Pool Waiver Caps.

To be introduced in 2017 as part of MiFID II, the caps on dark pool trading for both the Reference Price Waiver and the Negotiated Trade Waiver will limit the opportunities for the buy-side to execute their small orders in the darkness and thereby adversely affect the expected outcome of a trade. One solution to this dilemma might be to increase the size of child orders beyond the large-in-scale thresholds and to migrate them to block trading venues. Another – and probably better – solution would be trading these orders in the deep liquidity pools of the home market, especially in auctions.

Traditionally, the intraday auction has been standard procedure on Xetra® for the last 15 years. It is an ideal facility to trade large sizes at fair and reliable prices, formed by a multitude of market participants interacting with each other in the process of price formation. The Xetra intraday auction takes place at 1pm CET each trading day and serves the same purpose as the opening and closing auctions on Xetra. In contrast to continuous trading, auctions batch liquidity and calm down the market. They contribute significantly to price discovery: Prices determined in an auction have proven very reliable since they are a result of strong demand and supply conditions. A recent study* by the University of Frankfurt has shown that, especially during an intraday auction, Xetra is the price leading venue for German shares. A major finding was that the indicative Xetra auction prices were more informative than actual trade prices on competing platforms

In an auction, large trades can be executed. In Q3 2014, the average trade size in the Xetra Intraday Auction was almost eight times higher than in continuous trading (see Figure 1). These are precisely those execution opportunities that the buy-side is currently looking for.

Trading in auctions is naturally slower than continuous trading. A Xetra Intraday Auction is initiated by a two-minute call period (or at least five minutes on Eurex Settlement days), followed by a “random end” phase which can last up to 30 seconds. This phase is required in order to prevent gaming of the auction price. Eventually, this intentional slowdown of trading leads to a situation that some investors might highly appreciate: the liquidity batched during an auction is usually not provided by speed-savvy players, who prefer the low-latency environment of the continuous trading phase during the rest of the trading day. This fact might be perceived as highly attractive for the buy-side.

As of today, Deutsche Börse’s auction concept has already proven very successful. On Xetra, some 28% of the overall daily trading volume are executed during auctions. The vast majority of this figure stems from the closing auction, whereas the intraday auction still has significant growth potential. Currently, around two per cent of total daily volumes in DAX shares are traded via the intraday auction. Since the intraday auction offers institutional investors an opportunity to execute large blocks at fair and reliable prices, this is also a solution to the problem many market participants will have when the 4% cap for dark trading in an instrument per venue respectively the 8% cap overall will come into effect. With this in mind, Deutsche Börse expects a strong growth for its Intraday Auction. With other markets picking up this trading form more and more market participants will almost certainly adapt the idea of intraday auctions and start participating, eventually creating a virtuous circle of liquidity.

Another important factor that will influence how fast and to what degree the intraday auction model will be adapted by market participants would be the trading fees. In contrast to some other trading venues, Deutsche Börse does not make a distinction between continuous trading and auctions on Xetra when it comes to transaction fees. Thus, auction trading costs far less than half a basis point on Xetra.

The restrictions expected with MiFID II coming into force should pull trading volume from dark pools to regulated and transparent trading venues like Xetra. The current change has the potential to shift more trading to the lit venues, which will eventually further strengthen the existing transparent liquidity pools and thereby their price discovery function – a feat that is of paramount relevance for both investors and the general public.

www.xetra.com

*Benjamin Clapham: “Price Discovery in Fragmented Markets – An Event Study Based on Trading Data from Deutsche Börse and BATS Chi-X Europe.” Johann Wolfgang Goethe University Frankfurt, 2014.

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FX trading focus : Dan Barnes

Ian Rycott

January 13, 2015

CHANGING OF THE GUARD IN FX

Dan Barnes looks at whether HFT firms will become the new liquidity providers.

The fallibility of trading FX via a voice broker was exposed in the benchmark rigging case, for which six banks were fined $4.3 bn in November. Electronic trading provides a potential safe haven for traders seeking to bypass cartels but in a growing and fragmented market, this poses a technological challenge.

Patrick Fleur, head of trading and execution at Dutch fund manager PGGM says, “With senior traders and most of the big banks being put on garden leave, it is hard to replace those sort of risk takers. Therefore clients had to look at electronic trading. What initially looked like a short-term loss became a benefit as they developed more efficient, cheaper execution, more transparency of trading and more automation. We have seen a move in that direction.”

However for firms to trade electronically, they must invest in a considerable amount of technology. Whether trading as a traditional long-only firm or a high-frequency market maker, capturing and processing the data necessary to deliver sound trading decisions is ever more challenging. Sellside firms have had the will – but not always the resources – to support such developments observes Matteo Cassina, head of all business lines at Saxo Bank.

“When we look at how we interact with big banks we see spread compression, which is good for everyone,” he says. “We also see them talking about investing more in technology in order to prevent the sort of issues that have happened before, but behind the scenes they are paralysed by legal and compliance issues which is soaking up a lot of spend. As a result they are not able to react quickly.”

Reaction time becomes increasingly important as the market grows in volume and changes shape. According to analyst firm Celent, spot FX volumes increased by 38% from 2010 to 2013, while swaps grew 27%. At the same time the market share of the two main platforms, EBS and Thomson Reuters, has been falling since 2011. In Q1 2009 Celent pegged EBS and Reuters interdealer average daily FX spot volume at around US$140-150bn each where by Q1 2014 it was closer to US$80 bn at EBS and $110 bn at Reuters.

Major dealers’ market share has fallen from 58% in 2001 to 39% in 2013 in the opposite direction to the market growth, but the top five banks still dominate trading and internalise the lion’s share of order flow, according to buyside traders.

David Holcombe, head of FX Product, at market operator NASDAQ OMX says, “It’s a fragmented market, I’ll go and ask five different people for the same trade and they will price me differently based on who they think I am, what time of day it is, whether I am long/short, profitable, and whatever else they know about me.”

However, he says that the model is changing, with client preference for choice in order flow taking precedence over the banks’ own trading requirements.

“Banks are talking publicly about offering the client the choice between principle pricing or agency. A couple of banks at an event I attended recently said they have a slide control on the single dealer platform that lets the client decide whether they want a risk transference price or an agency model for each order.”

Cost of independence

Rosario Ingargiola, CEO at Seabury FXone, a provider of execution services and technology, says that as firms become more focussed on self-trading and independent transaction cost analysis (TCA), they are having to weigh up the costs of technology to support the process.

“Most anything you want to do requires tick data capture,” he says. ”Whether it is TCA or back-testing of alpha or execution algos, all of this requires capture of tick data, and much of it requires full market depth. Tick capture and storage together with high-speed query capabilities is non-trivial to build. There are good commercial solutions but they are extremely expensive to license for a single firm let alone for redistribution.”

In October analyst firm Greenwich Associates reported in 2014 Foreign Exchange Trading Desk Staffing and Budgets that budgets had been flat over the previous twelve months for buyside trading desks, limiting their ability to develop tools in house.

There are constraints to the roll-out of technology in the trading space, says Fleur, with spot at around 95% electronic but swaps and forwards being relatively unsupported electronically given the tenor and size of PGGM’s transactions.

“If you look at our FX data, swap volume is roughly 85% of what we do, with tenors of over a month and a clip size of minimum of 500 million,” he says. “Yet there are no streaming prices in those amounts and tenors due to lack of interbank liquidity. It is electronically booked and confirmed but the risk transfer is voice, and heavily dependent on the relationship with the traders at the larger investment banks.”

Holcombe says that even where banks receive orders electronically, the pricing of any responses required and then agreement to execute at that price is still manual.

There is still a human that is configuring and triggering most of the buyside activity,” he says. “For example, there is still someone typing in to a screen or looking at whether it’s a single dealer platform, a multi-dealer platform or their own trading engine.”

New liquidity providers

Technological innovation is found in the high-frequency trading environments, where the capacity to deal with data from the many fragmented sources poses considerable challenges. Celent reports that 44% of trading platforms now offer co-location to support low latency data and trading services. However for traders, real-time data both in the context of HFT-type strategies or other latency sensitive information is difficult to deal with, says Ingargiola.

“There is high variability on the message rates across different liquidity providers (LPs) and once you do aggregation on a significant number of LPs you end up with very high message rates,” he says. “All of this data needs to be parsed and processed and acted on within tens of microseconds in order to have a meaningful edge. Solutions that do aggregation and publish a consolidated order book to downstream consumers have to be able to parse incoming FIX messages within a few microseconds and they should have binary APIs to deliver that data to consumers and accept orders for the lowest possible latency.”

Those big firms that can afford the investment are likely to end up replacing the big banks as LPs says Cassina, a trend that can be seen as already having taken place in the listed products businesses.

“Banks lost the ability to make markets in listed products a long time ago, losing out to Getco, Knight and Citadel on Chi-X,” he says. “Five years from now a lot of the electronically traded FX instruments will be handled by electronic market makers, typically hedge funds or prop trading shops and there is a chance for an organisation like ours to be part of that ecosystem, aggregating retail flow and internalising some of it. In FX liquidity is very deep and concentration of instruments is very high, so if you are a market maker and you work on some of the biggest crosses, making the business work through internalising doesn’t take a genius.”

Holcombe believes that as firms move towards agency trading there is a greater opportunity for an exchange-type venue to operate in FX in order to aggregate flow that might once have been internalised, however with regulation such as MiFID II still outstanding and new models being tried out, there are no clear winners yet.

“We are not near the stage where one model fits all,” he says. “Exchange, OTC or something in between? We are in transition. When all the rules are finalised and everyone knows how everything works we will see a joined up market again, but with some fundamental changes.”

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FX trading focus : Buyside perspective : FX benchmarks : Patrick Fleur

Ian Rycott

January 13, 2015

A YEAR OF LIVING DANGEROUSLY

A personal view by Patrick Fleur.

Last year was volatile not only in terms of market movements but also around claims of market manipulation and collusion, with the focus on FX benchmarks. An initial article on the topic appeared on Bloomberg in June 2013 but the reaction was relatively subdued. But when it was published again some time later it sparked off all manner of questions and initiatives.

Never, in my almost 20 years in FX, have I received so many phone calls and emails on a topic, and it hasn’t gone away yet. On the contrary, it looks like 2015 will continue to be dominated by issues around FX benchmarks.

The 4pm London fix

After recommendations by the Financial Stability Board (FSB) the first movers were the UK, who developed the Fair Effective Market Review (FEMR) committee, a joint initiative by the Bank of England, the Financial Conduct Authority (FCA) and HM Treasury. This has been followed with great attention by other regulators and industry bodies around the globe. In the meantime, though, a great deal had already changed in the FX market.

Many of the allegations centred on the pivotal London, 4pm foreign exchange fix, a daily rate determined by trades in a 60-second window. In an attempt to address this, there are a number of new initiatives around netting facilities, with the first two going live in Q4 2014. It is attracting some liquidity but the matching figures are still not high enough to prevent some substantial swings around this still increasingly popular fixing time. It is frightening to see that some participants wait all day and execute the majority of their trades just before 4pm instead of spreading their risk over a longer timeframe. The good news is that WM Company (a provider of the WM/Reuters benchmark fix at this time) plans to widen the existing 60 second window to 5 minutes, based on the average suggested time from feedback to the FSB paper. Unfortunately some of the other suggestions haven’t been followed. For example, greater transparency on how it’s being calculated and also optimising the venues used to make the calculations haven’t been implemented in the most ideal way. The request for consultation as conducted by WMR certainly wasn’t optimal. In the first place, hardly anybody had seen the request, and secondly the time offered to reply was so short that many people were unable to respond due to internal compliance policies. There’s room for improvement in this New Year.

Changing behaviours

Another big theme, correlated to benchmark issues, concerned behaviour. Most sellside organisations updated and implemented numerous internal procedures on client interaction, sharing of client information and fixing procedures. Unfortunately, communication of these procedures to clients is not formalised and hence only happens rarely. This is one of the main reasons why I am a firm advocate of the ACI Model Code (a formal attempt to encapsulate the best possible practice and code of conduct in the financial markets industry). It is the only document that gives a good description of proper behaviour for all market participants (not just those poor bankers!). While not new, there is an updated version on its way, which will also address recent issues such as: last look, barrier protection and behaviour around fixings. Needless to say it contains a section on information usage and sharing, more reasons why we will be talking about benchmarks through 2015.

Adopting standards

Alongside the ACI Model Code the major central banks are working on their own code of conduct. Hopefully the awaited abstract will capture most of the issues and reduce the differences between individual codes. A few central banks have already adopted the ACI Model Code, and who knows, perhaps the new version can ‘seduce’ the other banks into adopting it as well. I do believe these codes should be the standard for all participants in foreign exchange and should form the base upon which to construct internal policies. Only when you know what the policies and minimum standards of behaviour are can you create a level playing field – not only around fixings but throughout the 24×6 FX market.

Market data

One of the missing pieces of the puzzle is transparency around market data. The European Market Infrastructure Regulation (EMIR) partially addresses this by relinquishing all swap transactions to a trade repository. However, this is not applicable to spot FX, which is where the crux of the problems have been. There are some commercial activities emerging to create something which starts to look like a consolidated tape in FX, but the willingness of the bigger players will be crucial if these initiatives are to survive. I am actively lobbying for this wherever my voice is heard, but costs are still the main argument against this, as well as the lack of clarity about which problem it will solve. At least it would create more transparency around mid-market and give TCA more meaning. Plus, it would allow users to have more independent TCA rather than from the vendor used for execution. It would also give more insight into what the added value of dark pools and internalisers is.

Agency or principal?

The final topic which gained momentum last year is the way price makers are dealing with the order flow of the other market participants. Currently it is not always clear whether they act as agency or principal, what happens with the transactional data, and who has access to the information on this flow? Not only should this become more transparent for end-users, but the regulator should be looking more closely at how banks have set up their internal Chinese walls. They should be asking whether the internalisers of these institutions are treating the client flow in a fair way when their internaliser acts as a dark pool?

2015 will be an interesting year in which many of these topics will again dominate the FX world. After the new WMR fixing window goes live in February, it will be interesting to see how successful some new initiatives on matching engines, exchange-traded FX and the new versions of the different codes of conduct will be. The microstructure of FX is changing rapidly and it is finally moving in the right direction. Despite all its issues the FX market is still a wonderful world in which to work.

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