In its recent report “Trends in FX Trading 2015: The Decline and Rebirth of the Inter-dealer Spot Market’, consultancy GreySpark observes that the number of trades with a bank/broker dealer as counterparty will have shrunk to 31% in 2016 from 87% in 2007 signalling a massive shift away from dealer-to-dealer trading. While the increased range of counterparties allows for more diverse trading partners it also creates a challenge in the ability to find alternative trading partners.
Where the market has found a solution is in the development of trading eco-systems, built up within data centres and around telcos. A trading eco-system is defined by those participants who are dependent upon each other to conduct electronic trading. Within that are the service providers for the sell-side, the buy-side with capital to invest, and the venues providing the facilitation of trades from exchanges to the single-dealer platforms.
This hub provides a source of business for the firms who provide services around those market participants the market data providers and technology providers who provide very fast calculation engines such as servers and field programmable gate array (FPGA) cards which were all of the rage about five years ago.
Managed Service Providers
The facilitators of FX trading for many firms are the managed service providers. By offering a ready-made and managed technology infrastructure the traders can get all of the benefits of the environment with a reduction in the overall set-up cost. That also creates a broader range of counterparties to trade with.
“The managed service providers are very important,” says Robin Manicom, director of financial enterprise at Equinix. “Finally, and this sometimes gets overlooked, the network companies are extremely important. Inside of a trading eco-system there are many trading venues but there will always be other trading venues you need to be able to quickly get out to, whether that is supporting arbitrage strategies or access to other currency pairs.”
Yousaf Hafeez, head of business development, financial technology services at BT says, “We can provide anyone with access to currency pairs and multiple venues around the world. If they want to go to more exotic locations for more exotic currency pairs, we can take them directly to brokers in those countries. Or indeed to brokers who trade those exotic currency pairs in London and New York. They don’t necessarily have to go to a country to trade the local currency.”
A variety of network vendors transport prices to buy-side clients or banks, either as traditional telco’s or extranet-type network providers. Software aggregators also provide liquidity-sourcing type applications that look to create a single price book out of that data.
“It’s a very fragmented market both in terms of market data price and distribution but also in terms of the number of vendors serving the market place,” says Jay Hibbin, technology strategist for Financial Services EMEA at CenturyLink. “I think the benefits of a managed service are the ability to abstract yourself from the IT services and focus on your core trading model. You do not have to worry about the management of the IT infrastructure, the operating system, the network and all of the hardware side. Focussing on what’s important to you – the best access to liquidity and the best access to pricing distribution.”
Hafeez notes that the fragmentation which is now occurring in FX is similar to that which was seen in equities in 2007/2008, and consequently firms are applying the models they applied in that market to FX as well.
“Fragmentation in FX is a good thing and a bad thing,” he says. “It’s good in that it has reduced cost, and tightened spreads, so more and more people are coming into trading FX. The trading participants are challenged if they want to be able to access multiple venues and this is where firms like BT can provide a managed service to help them. We allow people to come into the market and rather than having a big fixed cost, we provide them with an operating expenditure model. So it’s a monthly cost rather than having to invest a big chunk of capital expenditure upfront.”
More established institutional clients are also under pressure to demonstrate to their end users that they are giving them the best possible deal possible, whether that be through transaction cost analysis (TCA) or lower fees.
“There are two sides,” says Hafeez. “There is the cost pressure, which our customers are facing, and then there is the pressure our customers face in demonstrating to their clients that they are giving a great service, with the best execution possible, at a very good cost.”
The last twelve months have been a rollercoaster ride for FX traders with the ending of the Swiss Franc cap, the revaluation of the Renminbi and the will-they-won’t-they rate hike from the US Federal Reserve. Whether directly affected through losses or indirectly by the impact it has had on the trading environment and other firms, traders are facing a different set of challenges than they were a year or more ago. Chief amongst these is the need for greater risk management and resilience.
Ganesh Iyer, global product marketing director for Financial Markets Network at IPC says, “Financial trading ecosystems can minimise the impact of black swan events. Not ‘eliminate’ them, because we don’t know when a black swan is going to happen, but through having access to a ready-made ecosystem and connectivity throughout the trade lifecycle we can minimise the impact of black swan events.”
One example of this from the FX market stems from the Yen being a very popular carry trade. With low interest rates, firms were borrowing in Yen and investing in currencies like the Australian dollar or in high yielding assets such as asset-backed securities and mortgage-backed securities.
“When the prices of high-yielding assets came crashing down, this Yen carry trade had to be unwound and that was a big issue during the global financial crisis,” Iyer says. “Similarly there have been flash crashes in some currencies, for example the yen-dollar flash crash right after the earthquake in Japan. The Swiss National Bank abandoning the Euro cap was the biggest black swan in recent times.”
At present there is a crisis in the emerging markets including a slowdown of the Chinese economy. With lots of money invested in the high yielding emerging markets there are US Dollar carry trades that could unwind at any moment.
“Firms are borrowing in US Dollars at low interest rates and subsequently investing in emerging market currencies or other high-yielding assets. These trades can rapidly unwind at any time leading to a crisis,” says Iyer.
The danger that firms face – and as experience has proven even in liquid markets such as that of the Swiss franc - is that trading out of positions can be difficult when a shock hits the system.
“On the day of the SNB action you couldn’t trade electronically or find your counterparty through a screen with ease,” says Iyer. “The event taught us that you often have to pick up the phone during times of financial stress. Being able to find your counterparty becomes crucial and both voice and electronic trading can play a significant role in minimising contagion risk. We have been seeing active black swans justify having connectivity throughout the trade lifecycle and access to a ready-made financial ecosystem.”
A ready-made ecosystem should offer a large community of market participants as well as diversity in buying and selling interest. While the support that this sort of ecosystem can provide is of value both to portfolio managers and buy-side traders there are other consumers of market data within firms for whom an ecosystem can provide a considerable boost.
“Risk managers want to get prices independent of the portfolio managers and traders, because they want to get their own assessment of risk and pricing, especially for illiquid products,” says Iyer.
Resilience is expressed in other ways as well. For example, the risk that firms face from cybercrime can be crippling. According to consultancy Accenture’s ‘2015 Global Risk Management Study: Capital Markets Report’, 58% of capital markets firms believe there will be an increase in the severity of cybercrime attacks. Concern about the risk of attack can affect the choice of service provider, with some market commentators identifying the risk as a key selling point.
“There is not a regular hosting company, co-location provider or ISP that can and will protect you from a distributed denial of service (DDoS) attack,” says Jubin Pejman, founder and managing director at FCM360. “I have spoken to experts at DDoS mitigation companies that charge the banks US$20 to US$50 million dollars a year to protect their networks. There is absolutely not one ISP or hosting company that does this. So when you look at what an eco-system is if you are a publically facing entity such as a bank, an e-commerce platform, or a broker responsible for transaction processing, you potentially could be subject to attacks.”
These can threaten massive downtime as coordinated events, and attackers are often fully researched, with all of a firm’s IP address information already been determined, with executives of the company known and the purpose being to achieve financial gain.
“They are trying to hurt you or your industry to benefit theirs,” says Pejman. “In the eyes of somebody who wants financial gain they will look at financial firms, and foreign exchange is no longer in the dark; for the last ten years FX trading has been pushed to the public. When we are talking about an eco-system, hosting has become a commodity to some extent. What has to be done better as part of the eco-system is start providing DDoS mitigation services. We have been installing unified threat management (UTM) systems in New York and London.”
When selecting service providers it is critical to have access to all of the tools that are needed for a full service offering, says Manicom, and this encompass a very comprehensive level of technology management.
“To be neutral providers of services we don’t want to really create anything which locks other people out,” he observes. “This is why we have worked very hard with managed service providers because they can provide you know services in bundles to other trading participants who may not have the business case to spend money directly with Equinix.”
If a trading firm does not have the capacity to build and run things directly themselves they can effectively come into one of the managed service providers who will provide them with cabinets, servers, storage and connectivity to the electronic markets, wrapped up in a monthly package.
“They will also look after your service and manage those services maybe up to the operating system or even up to the data level. Effectively you can install your trading software on that platform and not worry too much about how its all put together and maintained but concentrate on building your strategies and having as much access to the markets as some of the major players, who can build all this stuff themselves,” he says.
Not only does this level the playing field with larger trading participants, by being closer to the markets it has an effect on latency. Cross connects inside data centres are much shorter network connections than network cables between data centres. That efficiency also gives an advantage to service providers located within data centres.
As trading strategies evolve between asset classes, the level of technology required to support a firms can change, for example the need for low-latency data feeds might reflect a move towards high-frequency trading or event-driven trading algorithms.
Hibbin notes that a flexible service provider prevents capital investments from taking trading firms into an operational cul-de-sac.
“We provide the benefit to our clients of a hybrid IT approach which is one of our unique differentiators,” he says. “By not being locked into a single IT infrastructure platform, you can migrate from co-location at one end where you are just buying space and power through to fully a managed public cloud and managed applications at the other end and everything in-between. A lot of our clients and clients in this space go on that journey with us and maybe have some user acceptance testing (UAT) systems in a full cloud environment with other systems that are managed and others that are collocated. It really depends on the client’s need but having that flexibility to move within hybrid platform, is from an infrastructure perspective what a lot of clients use CenturyLink for.”
The electronification of trading in equities and FX then on to derivatives and even to over-the-counter (OTC) markets requires market participants to build an environment and architecture that connects to all of these markets. Manicom believes this will increase the demand for hosted environments and rich trading ecosystems.
“To have complete access with free market data and full transparency so your trading strategies can develop and evolve is the goal,” he says. “To set that up from your own data centre is extremely costly, complex, and difficult to manage and you know potentially an unreliable way of connecting to the markets because you are completely dependent on one or two network cables that come into your own building in which to access the global markets.”
Where once the key to success was latency, now firms are looking for reliability and accessibility to ensure maximum up-time and a constantly tradeable market. They need several FX venues, bank supplied FX rates and they need the option of connecting to these directly or from a consolidated feed via a market data provider.
“They may want to build their own servers and run them, or want someone to provide them with some server capacity so they can run their software on them, Manicom says. “The main thing is that I want to be able to do that all in one location and know where my data is, know that it is all locked down under one roof and the physical security is there. The trader has to keep an eye on what is going on with their financial regulator who wants them to be able to control this environment and know who they are connecting to, with assured data security.”