Analysis, Analysis>Industry
Banks, BIS, credit, Flow, Liquidity, Market Making, volumes
FX: Still a Banking Market
Colin Lambert
Much has been said about how the banks' influence in FX markets is much reduced, but is that accurate? Colin Lambert says the data suggests it is not.
It is easy to get wrapped up in the rhetoric of the "customer being at the centre of what we do", but is the reality a little different to that? In value terms the answer is "probably not", but when it comes to the hard data a different picture emerges, especially looking at the latest BIS Triennial Survey.
Taking the phrase "customer" literally to mean non-bank participants, the largest segment in the foreign exchange industry in terms of volume transacted is Institutional Investors, who are responsible for 11.8% of all activity. Next up is the Hedge Fund/Prop Trading Firm segment with a 9% share of activity, followed closely by the mysterious "Other" in the report with just under 8% of flow. Non-Financial Customers are next in line with 7.2% of activity, there is then a sharp drop off to the last segment, Official Sector, which barely registers with "just" $89 billion for a 1.3% share.
It has to be noted that a great number of regional banks are seen by their larger brethren as "customers" and as has been the case for several years now, this segment's influence continued to grow, it being responsible for $1.6 trillion per day or 24.4% of all volume (and, importantly for the make up of the larger players' sales teams, almost 45% of the Other Financial Institution turnover). Several of these banks are, however, primary market makers in their core markets and therefore not all of their flow can be considered "customer".
One number that is often overlooked in these surveys is the actual volume between Reporting Dealers. Yes, it is on what seems a permanent and inexorable decline, but it remains, at over $2.5 trillion and 38.3% of all activity, easily the largest single counterparty segment. The story is, however, not one of spot, where activity continues to decline, although even there it remains the biggest single counterparty segment, thanks in no small part to the larger dealers' prime brokerage businesses.
"It's a question of where you can clear risk," observes the head of trading at a bank in Asia. "Internalisation is very much a spot story, when it comes to forwards and options where risk is managed in buckets, the picture is more like the traditional interdealer market – it shows up in how the voice brokers are still doing good business. It's also a question of dealers wanting to deal at or close to mid. Credit and balance sheet may be constrained but it's still strong enough for the banks to hold risk long enough to get a good match that suits their capital and risk ratios – and more often than not it's a bank on the other side."
There is also, according to banking sources, a misnomer that as a group they don't hold risk anymore. "I wouldn't suggest that to my forward desk," laughs the head of trading at the Asian bank. "They're holding as much risk as they ever did. It is a little different in spot but for the right customer we are still quoting for large tickets and holding the risk – fulfilling the traditional role of the risk warehouse if you like."
Although the headline numbers do indeed suggest that banks remain at the heart of the FX market – cash and credit are king still – there is little doubt their position is being challenged. From the push on the part of several clearing houses to grow their FX franchises to the claims of some non-bank market makers to be holding risk for longer than the banks in spot, the banks are likely to come under pressure in the coming years.
That is not to say that pressure will bring about change, however, for as one senior buy side trader recently told Profit & Loss, "We want to trade to certain dates and we want payment. We do not want to have to post collateral, exchange for physical or go to public venues to execute."
Given the focus on analysing the value of flow it is likely that while the overall numbers may not change, where certain participants execute their flow will. For the "good" customers who are less aggressive in their execution style and do not "time" their trading, there is little doubt that the banking industry will pull up trees to keep the flow.
"There is a group of very valuable clients to the banks that will stay there," says the head of FX sales for a bank in London. "Not only do these clients not want to clear, but the banks will ensure they leverage their balance sheets to quote tighter in larger amounts than the other players can – they will also use their balance sheets in other ways, by linking FX business to other activities like the provision of funding and credit
lines in other markets."
This of course raises the question, what about the "bad" clients?
The head of sales gives a metaphorical shrug and says, "They'll struggle to find places to execute and when they do they will see more slippage because they'll have to go to the public market or change their execution style. The days of banks allowing clients to abuse their liquidity for the sake of volume rankings are over – it's all about value now."
Although the BIS has yet to publish the execution method statistics, it will do so in its next Quarterly Review, data from the UK and US FX committees would suggest that the sales head's argument is correct, for both centres have seen a shift in how Other Financial Institutions execute their FX business. This segment is widely seen as covering the trickier flow from more professional players like hedge funds and prop trading firms and as such can be instructive in terms of how the banks in particular are treating them.
From the 2016 to 2019 semi-annual surveys there was a definite shift on the part of Other Financial Institutions towards venues where not only could they put dealers in competition, but also trade anonymously with them. In the UK over that period, the percentage of Other Financial Institutions' flow on ECNs grew from 12% to 14%, while on multi-dealer platforms it also rose, from 35% to 43%. In the US the change in terms of ECNs was even starker, with this segment's share of activity on these venues rising from just over 13% to over 20%.
The head of sales believes this is just the start of the trend. "As the banking industry gets even better at picking out dodgy flow more customers will be pushed towards the public market," they say. "There they will, ironically perhaps, rely upon meeting banks' natural hedging flow to get out of their risk. The big change will be how this is done on the banks' terms now, not on the customers'."
Interestingly the head of e-FX trading at a bank believes that broader market structure changes will also help the banks and has quite a punchy message for some participants. "There is little doubt that the BGC dark model is working well for the banks and that a lot of risk is hedged there. If this increases, that will take further liquidity away from the primary venues and satellite ECNs. Then we will see how well the alternative liquidity providers stand up and how those customers who have refused to think about their execution styles like it."
Sources at non-bank market makers are quick to refute the notion that they will be impacted by a reduction of bank activity on certain venues, however privately one or two express concern.
"There is a lot of pricing that we can provide that is correlated to other markets," says a source at one firm. "But we rely upon data a lot and on a certain level of bank activity. If the banks pull back from certain markets then we would naturally have to reduce our commitment."
There is also the question of credit. This year's survey was taken in April, before Citi, the industry's largest PB, pulled the plug on several major market participants. That led to a scramble, that is still going on in some quarters, to maintain market access, and while it has not had a noticeable impact on market functioning, sources say that if Citi's move is copied by one or two other PBs, then several non-bank firms will be mortally wounded as far as their FX businesses are concerned.
Citi has followed that announcement up with plans to cut the number of platforms it connects to according to sources familiar with the matter.
"The bank has had enough of supplying liquidity to these platforms and being charged for the privilege," says one source, while another adds, "This could be the start of the banks exercising their muscle – they'll play ball as long as they think it's fair and they get suitably rewarded. The days of giving FX liquidity away are over and it will be interesting to see how that alters the market."
Without doubt prime brokerage is a massive part of the FX business. From $887 billion across all products in April 2016, $1.49 trillion was executed via prime brokers in the latest survey, a massive 67.8% leap. In a BIS report of many paradoxes, this is just another – how, at a time when credit is widely accepted to be constrained, did so much more get executed in this fashion?
"I think this is the high water mark for PB," says a source at a major player in the industry. "The next survey may show an increase but what it won't show is the higher price customers will have to pay to access credit and the market. I wouldn't be surprised to see the number drop in 2022."
It is probably wrong to suggest that the banks will return to the dominant position they held in the 1980s and '90s, however the pendulum that is the relationship between banks and clients is likely to swing back to a more neutral position. For customers that add value to the franchise not a lot will change, indeed they may find their business attracts even keener pricing, but elsewhere there will be dramatic changes as LPs flex their muscles. The headline BIS numbers may not reflect it, but behind the data may lie a very different FX market to that with which we have become familiar.
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