In 2019, the wholesale FX market is not the market of yore. Formerly, the defining characteristic of the currencies trading landscape was liquidity fragmentation and siloed pools of cash held within geography-specific currency pairings. Following the financial crisis, commercial, regulatory, trading technology costs management and technological advancement pressures eroded the broker-dealer centric market structure in liquid instruments, paving the way for new, exchange-like all-to-all (A2A) market structures within the leading liquidity centres. The formation of these A2A structures for FX trading – characterised by the disintermediation of investment banks as the leading brokers of access to spot FX liquidity and currencies risk – began to take shape in 2012, and non-bank brokers are now increasingly prevalent as the middlemen of choice for buyside counterparties (see Figure 1). As a result of these changing structural dynamics, capital markets consultancy GreySpark Partners believes that those buyside and sellside FX market participants that fail to evolve the technological sophistication of their trading franchises in light of new business models, roles and functions for different types of FX market participants will, ultimately, fail as businesses. Simply put, the biggest near-to-medium-term evolutionary challenge for sellside flow FX market participants is the need to adapt their business and trading models to a fundamental shift in market structure.
This transformation of the spot FX market in the past decade impacted banks and their buyside counterparties in different ways. The primary drivers of these changes are the increased number of market functions and opportunities that shifted from being the near-exclusive domain of large, technologically sophisticated sellside FX broker-dealers to being accessible to a wider range of firms, impacting the very nature of traditional market participant functions across the board.
On the buyside, asset managers, proprietary trading firms and long-only, real money institutional investors are consolidating their flow FX business and trading models and, at the upper end of the size-by-AUM spectrum, expanding those business models significantly. The increased scale of the FX business and trading models of the largest-by-AUM buyside firms led them, for arguably the first time, to become truly global in their scale and reach in terms of the capability to seek or provide pricing on spot FX brokerage venues. This is reflected in the use of consolidated, follow-the-sun trading desk models mimicking those adopted first by sellside institutions.
More broadly, GreySpark has observed that buyside FX trading is separating into increasingly distinct business models. Specifically, the centrality of FX trading to a firm’s overall cross-asset or multi-asset class trading strategy as well as whether the buyside trading desk seeks to be a liquidity and service provider in FX determine the business model – and associated technology requirements – of buyside firms.
In 2019, the FX trading business models pursued by buyside firms fall, broadly, into three categories (see Figure 2):
1. Strategic FX trading while stepping into the market roles and functions vacated by bank broker-dealers – an increasing number of buyside firms, predominantly quant-driven proprietary trading firms and hedge funds, are becoming FX liquidity providers, both at scale and in smaller volumes;
2. FX trading as a strategic concern – buyside firms seeking to generate alpha through FX trading but not necessarily provide liquidity on venues or through their own client portals; and
3. FX trading as an operational concern – primarily seeking to minimise the cost of the FX leg of the firm’s underlying trading strategy in other asset classes; this set of firms increasingly seeks to outsource the technology costs of the entire FX management and trading lifecycle.
A single buyside firm may pursue more than one of these business models as part of its FX operations, depending on the complexity and risk appetite associated with the specific FX products in question. For example, GreySpark understands that operational outsourcing is particularly prevalent in FX hedging due to the relatively low potential for competitive differentiation – and, consequently, upside – associated with performing FX hedging well when weighed against the significant downside if hedging strategy and execution are subpar.
On the sellside, and particularly in flow FX products, all but the largest banks have shifted to pure agency trading models in G10 currencies (see Figure 3). The cost of technology infrastructure to compete with the largest Tier I investment banks – the select few still capable of maintaining universal banking models – is simply unsustainable for banks that are not flow monsters, given the compressed margins trading in these instruments offers in 2019.
However, there remains space in the market for non-flow monster investment banks to position themselves as niche players for specific currencies or products. In doing so, these banks develop a position as – or remain – the market leaders in liquidity provision for niche currencies and products while passing flow products up the value chain to the flow monsters.
Those investment banks that move to niche specialisation continue to own the client relationship; clients may not even realise that the flow product pricing they receive from their sellside execution provider is sourced from higher up the value chain on the basis of an agency trading model. In 2019, an increasing number of Tier II and Tier III, and even some Tier I banks, are choosing to run such client franchises in order to continue to maintain significant non-G10 FX business and to position themselves as the bank of choice for e-FX execution in emerging and frontier markets.
Long-term viability for sellside franchise operators thus requires banks to undertake the arduous task of identifying the business segments in which they can provide their specific client base with value-add, and transition more commoditised business lines to an agency trading model.
Moreover, with the shift in the balance of power trading away from banks and toward their buyside client base – reflected in business models premised on ensuring the ‘best’ outcomes for those clients – banks operating under the umbrella of post-financial crisis regulatory requirements must evidence that value-add in a concrete, quantifiable fashion.