Effectively navigating the FX markets today requires a greater level of knowledge, sophistication and expertise than has been previously required. Liquidity consumers across the spectrum from the buy-side to wholesale brokers are evolving beyond submitting requests for quote (RFQ) to 5 liquidity providers or accessing a single Continuous Streaming Price feed. An important question to review is whether you have the tools and operational ability to understand, control and manage your liquidity now?
Historically, liquidity consumers had limited alternatives for where and how to transact. Banks were the primary trading partners and sources of liquidity. Pre-trade analysis was limited to surveying the liquidity provider landscape to figure out what sources to include before selecting the best price. With the automation of the RFQ process, deals were priced on demand, delivering a unique price for each transaction request. However, on the downside, market data was indicative and prices were only delivered after telling a liquidity provider about the trade you wished to execute which required tipping your hand with the potential to create information leakage.
Although RFQ may still be effective for some trades and direct access to a continuous liquidity stream from a liquidity provider or ECN has become more prevalent, institutions are increasingly looking for solutions that offer more granular control over their liquidity functions when accessing the market.
To do this effectively now requires two key elements: understanding your own flow and anticipating its impact on the market . Knowing these two variables can help you to optimize the flow you direct to each of your liquidity providers, thereby enhancing mutually beneficial bi-lateral relationships.
Let’s explore these elements in more detail.
First, how can you accurately assess the value of your own flow?
It starts by understanding all the unique characteristics of your trades: size, pairs, markets, timing and impact. This requires both having access to historical transactions and understanding how prices changed in your available liquidity leading up to and following your trades. Once you understand how you have been executing and the impact your trades have made on the market, you can create a proxy to estimate the value to the liquidity providers to which you directed the flow through the use of markouts.
Markouts indicate the theoretical maximum profit opportunity available to your liquidity provider, both at trade inception and over the passage of time which may more accurately reflect your liquidity providers’ hedging horizon. Flow which retains a positive
markout over time is more valuable to liquidity providers because it increases their chances of mitigating their market risk from your trade without incurring hedging expenses by distributing that risk through both their proprietary channels and third party venues.
Understanding markouts enables you to have a more accurate picture of the opportunities your flow creates for your liquidity sources which allows you to ensure that distribution matches your desires based on the level of service you are afforded across your entire relationship. You may find out certain flows are less valuable than you expected which can force a redistribution of your trades so your distribution of business more accurately reflects your intentions. In addition, you can detect if there is market leakage when you show your hand to certain liquidity sources by identifying adverse market movements that are triggered in anticipation of your transaction.
Evaluating Liquidity Functions
Once you understand how you are currently executing, you will then be able to model alternative strategies. Rather than thinking about Liquidity Sources as monotonic liquidity functions, liquidity consumers are encouraged to have a deeper understanding of their sources’ capabilities and how they can be utilized most effectively.
As an example, banks and alternative market maker liquidity sources often are capable of creating purpose-built streams of liquidity to meet client needs. These unique streams are often designed for flow in the following varieties:
- Full amount trading
- Sweeping top of book prices
- Flow that is difficult to hedge
- Streams which show you position bias of the liquidity source (a/k/a skew or alpha)
For example, had you been typically executing with RFQ, you could compare those outcomes with either executing a full amount trade using streaming liquidity with a single provider or sweeping the top of the book across multiple providers simultaneously.
Transacting either of those strategies on ECNs may not give you the complete picture because your flow on those platforms is frequently matched with the subset of ECN liquidity streams selected by a liquidity manager at a trading portal who handles this task (based on what they feel is appropriate for you given your behavior and which may not be transparent to you).
As you might imagine, having an intermediary often creates an information barrier between the customer and the liquidity provider which could result in a mis-characterization of their flow. For example, if you sometimes swept the book, and other times traded in a full amount, your liquidity might reflect your worst behaviour because the liquidity sources would not know in advance if it was a sweeping trade or a full amount trade. Not understanding the differences between these different streams could result in losing access to valuable liquidity by inadvertently sending the wrong flow to the wrong place.
Using third-party technology providers may be more effective because they enable you to receive more than one stream from each liquidity source which can be designed to accommodate different types of flow. As an example, a liquidity provider could send you two different streams: one which was designed to be swept, and one which was designed for full amount trading, where the assumption would be that only one liquidity provider would receive the trade at a time.
Such a process would enable you to compare your historical and current theoretical cost of using sweepable streams versus the cost of a total-amount trade. It would provide a better picture of which strategy might be applicable given the size, currency pair and time of day you are trading to execute in the most advantageous paradigm. To get an even clearer picture, each provider’s prices could be adjusted by the other costs which may include prime brokerage fees or the historical cost of rejects for similar transactions if they are “last look” sources.
While Transaction Cost Analysis (TCA) and execution quality have provided more insight about timing, and regulations are now requiring more sophisticated measurement, simply reviewing your transaction impact after the fact is not enough. Tackling the analysis above requires keeping accurate records of all the liquidity that you actually have access to on a tick-by-tick basis, calculating statistics derived from that data, as well as using the data coupled with your transaction history to model effects such as rejects.
Leading trading technology vendors are capable of storing all of this information for you and enabling you to perform the analysis by either supplying their tools to do so, integrating with specialized third-party analysis tools, or making the data available so you can do that analysis yourself. Accessing these features now makes it possible to segment your liquidity in ways that enable the utilization of the appropriate execution mechanism for the flow at hand in the market conditions when it is being executed.
You can understand the attributes of your own flow so it can be segmented. You can generate liquidity functions composed of multiple purpose-built streams available from liquidity providers. By understanding which flows fit which liquidity function, you can then direct those flows accordingly to allow for greater optimization of your customer and liquidity provider relationships. Finally, by being able to proactively monitor and measure your outcomes, you can take control over your process.
Becoming a connoisseur
Having an in-depth understanding of your flow will enable you to go directly to your liquidity providers to determine what they can offer that is best suited to your use so that you can make decisions in an automated fashion on a trade-by-trade basis. As with most things that involve a level of taste and sophistication, customization is key, and it’s all in the mix. Trading is not unlike winemaking, as both require art and science to craft the perfect blend.
“The art of blending, to me, is to take individual pieces and make the sum of what you’re blending better than those individual pieces you started out with,” says Mike Macmorran, winemaker, of Mark Ryan Winery.
Sometimes you just need a basic table wine that’s easy and affordable, and any old red will do. However special occasions often warrant something unique, for instance a more sophisticated bordeaux (blended from both cabernet sauvignon and merlot) may be called for.
Profile your Flow
As you look to move beyond the basics of electronic trading, make sure to evaluate your trading solutions properly to ensure that they offer a turnkey toolkit which either provides or enables:
- Access to the trading destinations that are important to you
- Records of both transaction data and tick data from the liquidity sources
- Tools to help analyze and suggest ways to optimize the liquidity and hedging function
- High-performance architectures to maintain those functions in real time through all market conditions
With these components in place, your institution will be well equipped to know what your orders will do and route them accordingly to the best liquidity available while maintaining strong relationships with your liquidity providers and rewarding them for their service. After all, you should know your flow better than anyone else. Why wouldn’t you be best suited to control it? Taking control of your liquidity function enables you to optimize your trading and hedging strategies, to both improve your performance and reduce your costs and impact.