While the FX technology sector has made great strides forward in connectivity and execution efficiencies, the quality of liquidity is constantly being examined and analyzed. Liquidity providers (LPs) have found themselves being able to extend their unique price streams into many different venues with varying degrees of success. With the constant threats of global unrest and economic dislocation being played out continually, LP’s are being forced to play defense against an army of brokers, buy-side funds and clients clamoring for the tightest spreads, greater depth of liquidity and quickest executions. This demand for best execution from clients has forced LPs to split their pricing into disclosed (interest) feeds and non-disclosed (non-interest) feeds. So, which feed is better, and for who?
How Liquidity is formed in FX Markets
The Interbank FX Market is decentralized, with pricing derived through a number of primary top-tier banks and various non-bank liquidity providers who create markets by using their own order book flow, in-house risk parameters and often, predictive pricing algorithms. The primary market’s pricing is formed by utilizing the market participants credit lines to price into multiple ECN venues (such as EBS or Reuters) to create the base supply and demand. At the Interbank level, participants do not necessarily have to check if their bid or offer is in line with the rest of the market due to the fact that they are often making markets based on their own propriety order flow, so the practice of “No Last Look” can be applied. Once the FX price formation, or creation, has occurred, the interbank feed will be used by a hierarchy of liquidity providers; Top Tier Banks, Tier 2 Banks, Quantitative Market Makers, Prime of Prime Brokers (PoP), and finally Retail Market Makers, to create their own unique liquidity.
A Liquidity Provider can create their own unique liquidity, sourcing primary market participants’ feeds directly or by basing their price feed upon the primary interbank market combined with their own unique interest. This is called “secondary market liquidity”. The LP attempts to create revenue with their unique price stream by adding additional commission / mark-up or by internalizing their trading flow and ultimately providing it to willing participants. Their liquidity feed can be streamed onto a venue outside of the primary market, such as a GUI (MT4 or cTrader), a FIX API, or an ECN (such as Fastmatch, FXSpotStream or HotSpot). The LP can make their own determination on how they want to provide their pricing to clients unaware as to how other LPs are pricing their own feed. With many Liquidity Providers providing their own unique price streams into the market, the market takers (the end clients) find themselves in a very advantageous situation.
A client may use a Liquidity Provider’s pricing for several purposes; to hedge exposure, to create their own liquidity or to trade their own strategies (for example, position traders, swing traders, arbitragers, scalpers,and day traders). Clients trade on the “best bid/ask price” from their sole LP or by connecting to a software platform that aggregates a number of LP price streams and routes the best prices. When a LP’s price feed is used by a client (either directly or indirectly), the aftermath of the trade determines how that particular client’s trade flow is perceived. If the LP can immediately monetize the flow, or is provided with a safe window of time to absorb the flow without the position turning negative, then the flow will generally be deemed soft. Conversely, if the client trades in a manner where the LP has a relatively short time in which to monetize the trade then the client will be deemed sharp flow. The latter example is often due to what is called “market impact’ where a client places the same order across multiple trading venues at once creating a cascading, knock-on effect on market prices. This would normally occur with larger sized trades. The result of this soft and sharp flow, is that a liquidity provider needs split its pricing into two distinct streams.
Pricing: Anonymous vs Disclosed Pools
An anonymous, or dark pool, is intended to serve clients that have a need to keep their trading, decisions and strategies out of the public exchange where they might have the potential to cause market disruption (such as large orders). The trading participants may enjoy the firm price execution (No Last Look) and are only shown the counterpart after the trade is completed. The lack of transparency as to who is being priced, or where the price is being shown, makes a liquidity provider’s feed vulnerable to predatory trading practices, such as high-frequency traders (HFT) scalpers, news traders, latency arbitrage, and iceberg orders. If an LP does not know who they are dealing with, they will be forced to price defensively with a wider spread (non interest feed), to combat getting run over by toxic or exhaust flow.
A Disclosed Pool is considered a safer arena where a LP can have more visibility on where their prices are being shown, along with the transparency of who is trading on their pricing. If a client is willing to share their trading objectives and the LP determines the client propensity for trading is non-toxic, then the LP may decide to provide their interest feed. Typically, a LP’s interest feed can produce the tightest spreads along with consistent depth. With these desirable feeds, a LP may need to ensure their pricing is in line with the market, so the LP may enable the pre-trade controls of price checking or last look. The price validity check can provide a LP with the necessary confidence to ensure that the market has not moved adversely and that the price provided is line with the primary market. When a client’s trade request is received, the LP can determine to accept, reject, or apply positive or negative slippage to the execution price.
Clients will always demand the best spreads and quickest execution, while a Liquidity Provider must protect their pricing in order to remain viable and ultimately profitable. For a mutually beneficial relationship to exist between the client and LP, constant communication must exist between the two. A client should provide their trading strategies, including average trade size, frequency of trading and pairs traded prior to going live so that the LP can price them accordingly. Expectations are much more easily managed for both parties with open dialog.