Quality versus Quantity - Tipping the balance in FX Liquidity

Nicholas Pratt examines why fewer but deeper relationships between FX brokers and LP’s holds the key to accessing superior liquidity.

First Published: e-Forex Magazine 83 / FX Brokerage Operations / November 2018

Over the last 10-15 years, there has been a realisation among brokers, prime of primes and liquidity aggregators that linking to as many liquidity providers as possible on the basis that price is everything is not the optimum approach to liquidity provision.

Of course, the majority of brokers will maintain that they have always looked to establish long-term, quality relationships. However, the advent of electronic trading and the phasing out of phone-based trading has certainly changed the dynamic and created what Noel Singh, Head of eFX Business Development at Sucden Financial calls “a more data-driven relationship between brokers, prime of primes and the liquidity providers”.

Long-term relationships

“Others may chop and change their liquidity providers but at Sucden Financial we prefer long-term relationships,” says Singh. “One limitation of using a large number of liquidity providers is that it increases the potential for market impact. There is a general market preference for liquidity providers that have skin in the game and to internalise some of that risk.”

At the same time that brokers focused on consolidating their LP relationships, a number of FX banks have become more circumspect about their own counterparties. “Liquidity providers can be quite harsh in who they term as a good client,” says Singh. “It can be difficult to define their tolerance so it is important for brokers to provide a good blend of flow to liquidity providers.”

Noel Singh

Noel Singh

“The use of analytics allows us to have more meaningful discussions with liquidity providers rather than a unilateral relationship where the liquidity provider is able to dictate terms and define whom they term as an ‘unpreferred’ client.”

These developments have made FX brokers’ role as a conduit between liquidity providers and takers even more important. The advancement of post-trade analytics has been especially influential in helping brokers to strengthen their relationships with counterparties, says Singh. 

“Clients will continue to be more demanding as they become even more sophisticated and informed. The use of analytics allows us to have more meaningful discussions with liquidity providers rather than a unilateral relationship where the liquidity provider is able to dictate terms and define whom they term as an ‘unpreferred’ client. It has levelled the playing field somewhat because we have more information that we can use in those discussions.”

That said, it can still be a challenge to understand what influences a liquidity provider’s tolerance. One factor is the model that they adopt for allocating P&L, whether it is allocated directly to the sales desk. Another factor is the use of internalisation engines. “It is not a binary topic,” says Singh. However, liquidity providers have also looked to customise the liquidity they offer and provide multiple streams dedicated to different client sectors in order to help match like with like. 
 
The relationship with liquidity providers may be more data-driven than in the past but there is also an element of trust involved, says Singh, in order to make it mutually beneficial. “They want to know that we have done our due diligence.”

Ramy Soliman

Ramy Soliman

“If done correctly, customised liquidity relationships should give you a much better outcome in terms of better pricing for customers, better and more reliable flow for liquidity providers.”

Quality liquidity

The changing nature of FX relationships is a really pertinent matter, says Ramy Soliman, Chief Executive of Stater Global Markets. “We believe that fewer relationships with liquidity providers produces quality liquidity. We can have a close relationship with each liquidity provider and understand exactly what they require. We believe this is the best approach. It is the same with clients. By focusing on a deeper relationship with liquidity providers, we can give them a better quality feed.”

Stater Global Markets is an STP broker that does not internalise its trades. Consequently it has to manage and maintain its Direct Market Access (DMA) status and focusing on the quality rather than the quantity of liquidity provider relationships is one way of doing this, says Soliman. 
 
“That has been the process from the outset. I have been at a large global bank and seen how liquidity providers work. There are diminishing returns from an increased number of bank relationships. It should be possible to get all the liquidity you need from relationships with six or seven providers. We want to focus on what each liquidity provider offers in terms of the stability of pricing, spreads, the ability to customise and the different products they can offer.”

FX has become a more crowded and competitive marketplace
FX has become a more crowded and competitive marketplace

Soliman says it also important to be open and transparent with a liquidity provider about a broker’s own relationship with its trading clients, especially in terms of trading risk. “They want to know if that risk will get passed on. If so, are you warehousing that trade? Are you able to police your customers? Do you know if your underlying customers are aggregating their profile with another prime of prime because double-hitting degrades the ability of the liquidity provider to provide a stable price.”

Brokers are increasingly using technology to monitor their customers’ fill rates and to provide liquidity providers with feedback from end clients so as to enable them to improve the liquidity they provide. “We have always had tools to monitor their liquidity providers’ performance,” says Soliman. “But the software has improved massively recently to show more analytical and qualitative information.”

Alexander Talei

Alexander Talei

“FX is still a relationship business, regardless of whether it is manual or automated.”

So what factors are important when it comes to assessing the quality of a liquidity provider? Has this assessment moved beyond simply the price of execution? Soliman says that there is now a greater awareness of information leakage among trading firms. There is also a more selective approach from FX banks in terms of to whom they provide liquidity.  “So it is a two-way street. In the prime of prime space we are a top conduit for the smaller hedge funds, with the kind of flow that is benign and profitable for liquidity providers. At the same time we can be a marketing agent for the liquidity providers.”

It is all about customisation for different trading firms and strategies and technology has helped, says Soliman. For example, a broker may look to use a manual, point and click approach for large size tickets, an aggregated stream for retail traders and separate streams for more complex retail flow. “If done correctly, customised liquidity relationships should give you a much better outcome in terms of better pricing for customers, better and more reliable flow for liquidity providers.”

Competitive marketplace

One reason for the increased focus on client relationships within the FX market is that it has become a more crowded and competitive marketplace with a greater need for all market participants to differentiate their offerings. There are more prime of primes in the market today but there are greater differences between the various players, says Alexander Talei, Chief Executive of Price Markets UK. “It is not just about the cost of execution but about the added value offered to clients.”

There are also an increasing number of liquidity providers all looking to differentiate themselves. Furthermore, brokers are equipped with a greater number of tools to analyse these various factors and traders are becoming more selective about their liquidity providers, says Talei.

Liquidity providers are encouraging deeper relationships with their clients
Liquidity providers are encouraging deeper relationships with their clients

Market impact is becoming a much more important factor when it comes to liquidity provider selection, says Talei. “Traders want to know how the liquidity providers price their various customers. Do they generate their prices like everyone else? Or how long is their hedging window? Those with a larger inventory are able to manage a wider hedging window, which trickles down to benefit traders or takers. This interest in market impact is no longer just in the institutional world, it is also coming from retail brokers.”

Another factor of increasing importance is the tolerance of liquidity providers in relation to certain traders and trading strategies, says Talei. “It is not simply the size of liquidity providers that is important, it is their tolerance of certain flow and what they consider to be ‘toxic’. Brokers do not want to spend time and money establishing a link with an liquidity provider only to be told to close down certain end users.”

A lot of liquidity providers have typically taken a look at a simple decay curve and then decided what is healthy or unhealthy for them. There are other factors that influence their tolerance, says Talei. “They are looking at their inventory and how they can offset it without having to hedge too much of their exposure. So they are looking for a well-balanced diversity of flow.”

Prokopios Katsoros

Prokopios Katsoros

“Liquidity providers not only have to focus on the product itself but also on delivering exceptional customer care and being consistent with what they promise.”

Brokers therefore have a matchmaking role to play in ensuring that they pick the right type of liquidity providers for their clients and their respective trading strategies. Typically the largest providers will have the lowest tolerance for so-called ‘toxic’ flow, while the liquidity providers with the smallest balance sheets will have more tolerance. “They have to compete on ground other than the size of their balance sheet, such as the health of their liquidity, the spread on their type of business and the extent of their tolerance. Yet as they grow bigger, this tolerance diminishes,” says Talei. 

Ultimately, it is down to the trading strategies employed by the end clients that has the greatest impact on tolerance says Talei. However, it is very difficult to tell a trader to change their strategy in order to suit a certain liquidity provider.

For example, the broker might run a classic market making strategy but the pricing mechanism gets abused and they then look to push that on to the liquidity provider. Or clients may be using single prop trader algos designed to exploit inefficient pricing. Such an opportunist strategy can only have a limited shelf-life and are rarely sustainable. Policing such algos is therefore a necessity that brokers are able to advise clients on the scalability or sustainability of their chosen trading strategy. 

Ryan Nettles

Ryan Nettles

“Best execution has required the liquidity provider to provide fair treatment across all their clients and TCA tools have enabled clients to measure the value of each LP they do business with.”

“It can be difficult to explain to an end client that finding a new liquidity provider is a waste of time with certain strategies and it is typically easier to find ways to fix the problem and accept that some trading strategies simply won’t work with most liquidity providers,” says Talei.
Is it possible to differentiate between the liquidity providers that prioritise deeper client relationships from those that don’t? “After a few months, you can work out which ones are just selling their name and which ones genuinely believe in the client relationship,” says Talei. 
 
“Certain liquidity providers will take a commercial view of your overall business even if you take a loss on some individual end-tags. Others are more quantitative in their view of their clients. Decisions may not be made at the senior management level but at a more junior level where they are led by the numbers and whatever automated rules are in place.”

However, any brokerage firm that invests in technology that can accurately assess the quality and performance of different liquidity providers and goes beyond the analytics offered by the typical bridges even if it is not always immediately evident to demonstrate the benefits of the analysis to end clients.

“It is very challenging to show how the technology works. Many users are used to certain technology and are not keen on adding middleware. But it does get through to certain types of firms – the difference in P&L with a smaller amount of flow, we try and sell our liquidity for free, to guide them and let them make the decision,” says Talei.

Brokers are increasingly using technology to monitor their customers’ fill rates
Brokers are increasingly using technology to monitor their customers’ fill rates

“FX is still a relationship business, regardless of whether it is manual or automated. People have to be comfortable with their liquidity providers and have a relationship with their counterparties that goes beyond the exchange-based relationships. The technology allows the various market participants to subject these relationships to more transparency, discipline and rigour.”

Increased costs

The reasons buy-side firms have been able to partner with a smaller number of liquidity providers is mainly due to the increased usage of anonymous ECNs, access to Transaction Cost Analysis (TCA) tools enabling them to measure liquidity provider performance and increased costs of maintaining liquidity providers, says Ryan Nettles, Head of eForex Trading & Market Strategy at Swissquote Bank.

At the same time, liquidity providers are encouraging deeper relationships with their clients through development improvements to their existing platforms, increasing their product ranges, introducing new trading tools and providing faster support, says Nettles. “The top liquidity providers are able to sustain clients by making it easier to do business, providing reliable liquidity and technology, and easy access to products and credit when needed. The liquidity providers that invest heavily in their client relationships demonstrate to the client that they have invested in their technology, product offering and service.”

Deeper relationships also help to encourage client feedback that can then be translated into richer and more bespoke liquidity provision, says Nettles. “Liquidity providers encourage client feedback by sharing trading analysis, helping clients identify ways to optimize trading performance, and update clients on new or forthcoming improvements to products, technology and services.”

Richard Elston

Richard Elston

“The most sophisticated liquidity providers have the ability to serve up flow only from selected sources should the counterparties so desire - this doesn’t have to be a one-size fits all approach.”

The changing relationship between liquidity providers and their clients has also had an impact on the FX market structure and its liquidity landscape, says Nettles.  “Best execution has required the liquidity provider to provide fair treatment across all their clients and TCA tools have enabled clients to measure the value of each LP they do business with. This has resulted in more transparency for all participants within the FX market and has helped in a way change the structure of the liquidity landscape.”

Solid foundation

The basic objective of every business, including the type of trading and investment firms we are talking about is to acquire new clients and retain their existing ones, says Prokopios Katsaros, Head of Brokerage at FX prime broker Top FX.  “Building and expanding your client base ultimately depends on the quality of your offering, the competitiveness of your pricing and the transparency of your service. Brokers should aim to constantly improve these three key factors by building steady and mutually-serving relationships with their liquidity providers. Having fewer providers often means that the broker filters their liquidity via a thorough selection process in order to guarantee that their price feed will be steady and uninterrupted. It also means that they can reduce their costs without compromising any trading conditions or the quality of their overall service.”

However, Katsoros says that while respecting the terms and the culture that each business operates under, is a first step in establishing a strong relationship that can last through time, it is not necessarily the relationship that dictates the quality of the liquidity and services that a liquidity provider will offer to clients. “Rather it is each organisation’s core values that define how key relationships will develop.” 

That said, the key to forging a deeper relationship is consistency and true transparency, says Katsoros. 

There are an increasing number of liquidity providers all looking to  differentiate themselves
There are an increasing number of liquidity providers all looking to differentiate themselves

“An institutional client needs to know that their business is being built on a solid foundation, therefore, if top-tier liquidity providers and primes of primes stay consistent to the terms of the agreement and deliver the level of services that is expected, then clients develop trust and the relationship becomes steadier. Apart from the consistency factor, liquidity providers should be able to respond to the increased industry demands and needs of their clients by constantly improving their offering. 

‘Improving’ in our industry is a multi-layered concept and it may entail adding new services, new instruments, new asset classes or upgrading the quality of their overall services. Remaining responsive to our client’s needs is a key ingredient of a good relationship,” says Katsoros

“Liquidity providers that treat their clients with respect and invest in relationship building end up establishing a solid, long-lasting presence in the industry. Those who are entirely focused on the profit motive and sacrifice the culture of transparency for faster gains, end up losing clientele and might not progress successfully in the longer term.”

The greater focus on client relationships has helped promote competitiveness in a positive way, says Katsoros. “Liquidity providers not only have to focus on the product itself but also on delivering exceptional customer care and being consistent with what they promise. If transparency becomes the rule, then the involved parties will consider it as a prerequisite when starting a business relationship. That means that the overall standards of the business relationships in the industry will rise higher and those who play a fair game will be able to establish a lasting presence.”

Prime of primes

Although it’s possible for brokers to try and strike direct deals with multiple liquidity providers, this presents several challenges, says Richard Elston, Group Head of Institutional at CMC Markets.  “Changes over the last few years in the way this market operates means that such relationships are typically dependent on high levels of flow, but a single, traditional liquidity provider will unlikely be in a position to consistently serve up the best prices. This is driving the growth of prime of prime liquidity services.”  

Similarly, a greater focus on client relationships can help liquidity providers offer improved services and engender greater client loyalty, says Elston. “A top tier aggregator of liquidity can take the time to understand a client’s precise needs and work with them to ensure they’re getting the most out of any relationship. From assisting with integrating technology to having lower minimum flow requirements, there’s a wide array of potential benefits on offer. What’s more, the most sophisticated liquidity providers have the ability to serve up flow only from selected sources should the counterparties so desire. This doesn’t have to be a one-size fits all approach – it’s one where genuine value can be added to the relationship.”

The trend for fewer but richer client relationships has become a global trend, says Elston, as the market continues to commoditise. “From a technical perspective, the entire industry is working to the same set of global standards, so integration processes are the same, irrespective of the geographical location. There are some select instances where pricing can differ across the global data centres, but these can be largely mitigated by having a liquidity provider who is already connected to a wide range of order flows. Beyond that however, this is a truly commoditized industry and parallel working practices are shared globally.”

Similarly the needs of smaller brokers do not differ drastically from those of corporates or smaller entities on the sell-side, says Elston.  “We have universal demand for high quality liquidity to be delivered at an efficient price, but there are a few subtle differences, which typically revolve around the concept of risk.”

However, all things are cyclical and the ongoing commoditization and resultant fee reduction could threaten certain market characteristics such as the widespread provision of DMA services that has helped to created fewer but richer and more transparent client relationships, says Elston.

“Although volumes being seen by non-bank liquidity providers are rising, fees are coming down and that poses questions as to whether there may be attempts by some to move away from a genuine, DMA model. The risk is that a number of smaller counterparties may be pushed towards an over the counter approach, something which will have the potential to boost profitability for the liquidity provider but simultaneously see a return to a less transparent market for their users,” he concludes. 

Unique Liquidity Solutions

With the increasing technological complexity and market understanding from clients, liquidity providers are having to adapt the products, services and trading technology they offer.

Raj Sitlani
Raj Sitlani

Raj Sitlani, Managing Partner, IS Prime explains, “Historically brokers were able to buy an off-the-shelf aggregator, connect to a Prime Broker, and start onboarding clients based on their relationships alone, but times have changed. With even retail traders now able to measure execution speed down to the microsecond, the focus of LPs is now on optimising the overall execution experience, as well as the liquidity they are delivering, in order to differentiate themselves from their peers.” 
 
These factors have always been a focus at IS Prime, an FCA regulated Prime of Prime which prides itself on its unique solutions and the ability to customise both the trading experience and the pricing which it delivers to clients. It is IS Prime’s ability to correctly profile, route and execute trades in real time which enables the firm to maintain extremely close relationships with its Liquidity Providers and, as a result, deliver market leading spreads. 
 
Raj Sitlani continues, “The key takeaway here is that LP relationships are, arguably, the most important part of any broker’s offering. Having the technology to most efficiently work with providers is essential to maintaining these relationships long-term.” 

“We understand that not all flow is soft but if your provider is not able to effectively route flow then core spreads will widen over time as you continually hurt LPs. Our technology ensures that we are able to correctly handle flow to protect our LPs and therefore we do not see spreads degrading.” 

“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, more recently, our new proprietary matching engine in LD4 -   delivering locally sourced liquidity at the point of execution.”

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