Joe Morgan
Joe Morgan

Isolating signal from noise - What factors really are important when choosing your FX liquidity provider?

There is an increasing awareness among brokers and institutional trading firms that quality rather than quantity works best when sourcing liquidity. This has resulted in a shift away from linking to the maximum number of liquidity providers (LPs) on the basis of simply obtaining the best price to establishing deep and long-term relationships with a small panel of LPs. Joe Morgan reports.

First Published: e-Forex Magazine 86 / FX Brokerage Operations / May 2019

Lucian Lauerman, global head of electronic distribution at Saxo Bank in London, says that there is a greater awareness in the market now of taking a “fairly analytical approach” to managing relationships and for brokers and institutional firms to be more aware of their own market impact. “Clients are more aware of the challenges that they face if they want sustainable liquidity,” he says. “Our clients do think more about the sustainability of their market access now.”

While price is always important, a more holistic approach is being taken. Other key metrics include the overall spread, the depth of liquidity available, the capacity of an LP to reduce market impact and the provision of liquidity in times of market turbulence. In addition, sustainability is increasingly vital: More participants are considering whether the same level of access to liquidity obtained in the trading day will be available in six months time, according to Lauerman. As a result, brokers, prime of primes and liquidity aggregators are increasingly developing long-term relationships with LPs.

Lucian Lauerman

Lucian Lauerman

“We want  to make sure that we are fostering meaningful relationship that will have continuity of liquidity through some of the choppy markets that we’ve seen recently.”

Fostering relationships

Mohamed Hajibe, senior head of institutional sales, at Swissquote Bank, the Swiss leader in online trading based in Geneva, emphasises the importance of fostering relationships with LPs. The strength of a relationship with an LP will be enhanced by giving access to deep liquidity, offering the best pricing available on the market and finally by acting as an important counterparty for the LP itself, according to Hajibe. “This will enable the LP to see the relationship from a global point of view and to better support you for your challenging flow,” he says.

Whilst MichaÅ‚ Copiuk, CEO at X Open Hub, a multi-asset liquidity and technology provider based in London, says: “Choosing an LP is a demanding process. Therefore, a detailed analysis of pricing, economic efficiency, effectiveness of the trading infrastructure, surveillance of the IT systems, legal aspects and due diligence of the vendor should be conducted.”

Copiuk also points to the cost benefits from using a small panel of LPs, which can result in less manpower and lower monthly maintenance costs to manage LP connections. “This way you can also consolidate positions in one place for more efficient use of collateral while trading performance can be enhanced as a result of sending larger orders to a lower number of LPs,” he states.

Raj Sitlani, managing director at ISAM Capital Markets, which includes IS Prime and IS Risk Analytics, says sourcing liquidity from a wide pool of LPs can result in “multiple inefficiencies”, including reductions in the quality of pricing and execution. “Brokers and institutional trading firms that opt for multiple prime of primes risk poor fills, delayed execution, high rejection rates or even worse, disappearing prices when you need them most,” he states.

Mohamed Hajibe

Mohamed Hajibe

“An LP might have a risk management approach that matches well with that of its clients, and be willing to create several streams, or dedicated streams,”

Sustainability trumps price

Saxo Bank leverages customised bespoke liquidty relationships with its banking partners to offer its clients a wide range of LPs. Essentially, Saxo Bank has two FX liquidity offerings: A market making service and a direct market access offering. Of paramount importance for both the bank’s own liquidity and for the agency execution offering is to be able to provide competitive pricing, depth of liquidity and reliability of pricing in all market conditions. “When liquidity is thin we want to be able to make sure that we are fostering meaningful relationships that will have continuity of liquidity through some of the choppy markets that we’ve seen recently now.” says Lauerman.

Current FX market conditions - which Lauerman says are characterised by sudden “occasional shocks” in volatility - are unstable, thereby heightening the importance of being able to obtain sustainable liquidity. “The danger is the unknown unknowns,” he says. Rather than political events that can be priced in such as the UK’s Brexit vote or the election of US president Donald Trump, LPs are vulnerable to unforeseen incidents. “That’s what we saw at the beginning of the year in January in Yen where for a significant period of time Yen liquidity completely disappeared,” says Lauerman. “That is the kind of event that concerns us and where we are looking to make sure that we have the right type of liquidity relationships so that we can sustain access for our clients during a shock like that.”

In addition, Hajibe of Swissquote Bank, which offers both agency and principle execution styles based on client’s risk profiles, also highlights the importance of an LP’s “risk appetite” in determining the quality of its offering. Being able to make an accurate assessment of risk requires devoting a sufficient level of resources to a client, along with an accurate assessment of their liquidity requirements, according to Hajibe. “An LP might have a risk management approach that matches well with that of its clients, and be willing to create several streams, or dedicated streams,” he says.

Meanwhile Copiuk of X Open Hub gives warning of the inherent risks that come with enlisting the services of an LP with lax regulatory controls, particularly during periods of market turbulence. “You can encounter companies registered in high-risk jurisdictions without financial supervision which attract brokers with extraordinarily easy KYC processes and a lack of anti-money laundering procedures,” says Copiuk. “However, many brokers do not realize how much these LPs can jeopardize their business.”

Copiuk says such LPs may raise commission charges in challenging market conditions where volumes are low, or even stop pricing altogether. “In unclear conditions you find a thinner liquidity pool and wider spreads,” he says. “There may also be unexpected technical issues. A broker may find itself in a dispute with the LP after a technical failure on the provider’s side. As the process of connecting to a new LP takes on average two to three months a broker will find it extremely challenging to quickly find an alternative solution.”

Michal Copiuk

Michal Copiuk

“Choosing an LP is a demanding process. Therefore, a detailed analysis of pricing, economic efficiency, effectiveness of the trading infrastructure, surveillance of the IT systems, legal aspects and due diligence of the vendor should be conducted.”

Cross-asset class trading capabilities

Lauerman of Saxo Bank says that there is an increasing take-up of multi-asset class trading services among Saxo Bank’s client base – especially those acting as intermediaries to the retail market – bolstering demand for Contracts for Difference (CFD), cash equities, futures and fixed-income products. Broker clients are demanding more range of instruments to diversify their earnings through other asset classes, he says.

“We are in a fortunate position to service a wide range of instruments,” says Lauerman. “It is very important to offer CFDs on a wide variety of assets. We also offer cash equities,listed futures and ETOs, and fixed-income products.”
Saxo Bank’s agency execution offering also provides customised solutions to a wide variety of clients, according to their specific requirements that may include high frequency trading (HFT). “We need to be able to offer those clients a wide range of liquidity providers, venues and models in order to custom those relationships - no client is the same,” says Lauerman.

Its important  to be able to obtain sustainable liquidity during unstable FX market conditions
Its important  to be able to obtain sustainable liquidity during unstable FX market conditions

Hajibe also says Swissquote Bank has seen a significant increase in demand among its client base for traditional asset classes across its multi-asset class accounts. In particular, he highlights CFDs on indices. “Low volatility on FX markets encourages actors to trade other asset classes such as forwards, swaps or NDFs,” he adds. Offering a multi-asset trading service enables Swissquote Bank clients to access over 3 million financial instruments, to manage multiple trading strategies with a strong pool of bank and non-bank LPs that are not exclusively focusing on FX spot markets. Working this way allow them to better manage their exposure and to access dedicated banking & trading services.

Richard Elston

Richard Elston

“Those liquidity providers who have invested heavily in proprietary technology will typically offer an API to plug directly into a broker’s existing systems, providing a seamless solution.”

Analytics 

“We create custom liquidity pools,” says Lauerman. “and to make these sustainable,  we give our clients extensive support in terms of analytics. This can help explain the best way to make use of available liquidity to our clients. We have invested heavily in our analytic tools to explain to our clients what is happening.”

As a means of fostering long-term client relationships, services that manage risk and provide data analysis such as post-trade analytics are helping Saxo Bank to strengthen relations with its client base. This enables a two-way discussion between the bank and its clients – with more data tools facilitating a more informed choice of how liquidity in the market is obtained – while also increasing levels of transparency. Lauerman says that while Saxo Bank takes a “very quantitative approach” this still requires a “qualitative interpretation” for its clients. Saxo Bank’s clients are able to use this process to make informed decisions on whether to obtain new sources of liquidity or withdraw from the services of an LP. “Being able to show to clients which liquidity providers are the most valuable and how valuable the liquidity provider is to them is important,” says Lauerman. “We are also able to do the opposite and explain to the liquidity providers what is happening from our clients points of view.”

Swissquote Bank also shares in-depth analysis of liquidity flow with its clients as part of its service offering. The bank’s analytical tools monitor a variety of key criteria, including market impact, spread evolution and market share. “We are sharing on a monthly basis with every counterparty some analysis to monitor closely the changes in the liquidity,” says Hajibe.

Richard Elston, group head of institutional at CMC Markets in London, says the ability to integrate technology is vital as a means of deepening LP relations. “Regulatory reporting requirements are as stringent as ever and competitive pricing leaves no margin for error,” he says. “Those liquidity providers who have invested heavily in proprietary technology will typically offer an API to plug directly into a broker’s existing systems, providing a seamless solution. Not only does this make for better visibility over open positions and the state of the underlying market, but it also provides easier risk management.”

Raj Sitlani

Raj Sitlani

“Brokers and institutional trading firms that opt for multiple prime of primes risk poor fills, delayed execution, high rejection rates or even worse, disappearing prices when you need them most,”

Optimal liquidity flow

In terms of the key attributes top-tier LPs need to have, Lauerman says being able to optimise collateral is increasingly important for an LP, as brokers and institutional trading firms seek to obtain access to liquidity via as few intermediaries as possible.

Hajibe says a top-tier LP must manage the tripartite relationship and be also reactive to changes in market conditions, given the time-sensitive nature of FX markets. “They definitely must have an appetite to continually provide insights in order to monetize the flow,” he adds.

In terms of the effective management of liquidity flow, Sitlani of ISAM Capital Markets says having the correct technology in place is key. Even if liquidity is sourced from “the best panel of LPs in the world,” deficiencies in the underlying technological architecture can have a huge impact on the profile of the flow, according to Sitlani.

“Our technology ensures that we are able to correctly handle flow to protect our LPs and therefore we do not see spreads degrading,” he says. “It is these spreads that enable us to act as the sole liquidity provider to some of the largest brokers globally and to offer some of the most competitive pricing in our space in both NY4 and LD4, delivering locally sourced liquidity at the point of execution.”

Liquidity data analytics can help providers to strengthen relations with clients
Liquidity data analytics can help providers to strengthen relations with clients

Think global, act local

Saxo Bank leverages a strong global footprint to bolster its FX liquidity provision. Lauerman says the bank has as strong a presence in various regions in Asia as well as in Europe, highlighting its operations on the Chinese mainland, as well as in Singapore and Tokyo. “I think it is difficult to sit in Sydney and support Europe,” says Lauerman. “It is also difficult to sit in Europe and support Japan. You need to be in these locations in the local language, understanding the local requirements. A Japanese intermediary would have as much trouble servicing Europe as a European intermediary trying to service Japan.”

Copiuk of X Open Hub says understanding differing “mentalities and expectations” is key to servicing customers effectively across different global jurisdictions. “We are well aware of the cultural difference,” he says.

Hajibe of Swissquote Bank also highlights the importance of being attuned to the requirements of clients based in different locations, in order to adapt tailored services to meet their specific needs. For example, in some regions, Swissquote offers additional services to its bilateral partners, including credit facilities, interest on assets via different vehicles such as fiduciary deposits, term deposits and bonds. As a bank, Swissquote Bank also has the capacity to offer clients a Swiss bank account. As part of its global footprint, Swissquote Bank has a presence in Dubai and Hong Kong, and is also in the process of setting up operations in Singapore. “The US is more time sensitive while Europe is more price oriented,” says Hajibe. “On the other hand, Asia and the Middle East are definitely relationship oriented. It’s key to meet your client and be close to them.”

Quality LP is king

The only constant in the provision of liquidity across FX markets is the continual evolution of the LP services offered to market participants. “New regulations and client feedback are strong forces influencing the shape of the market,” says Copiuk of X Open Hub, who points to fierce levels of competition among LPs that spur product innovation.

Hajibe of Swissquote Bank emphasises the importance of getting access to  a diversified pool of top Tier 1 banks and regional non-bank LPs. He highlights the importance of deeper, richer and more bespoke liquidity solutions in building strong – and effective – client relationships. “The challenge is to filter the flow, avoiding recycling one, having advanced discussions concerning the nature of the flow in order to put it with the most appropriate liquidity,” he says.

Lauerman of Saxo Bank sums up saying that while the “liquidity mirage” is an established source of debate within the FX industry, the importance of not recycling liquidity should not be understated. “It is essential that people are aware of the pitfalls of aggregating a large number of relationships that are not well managed,” he concludes.