By Peter C Wadkins Sr Foreign Exchange Research Analyst, Aite Group
By Peter C Wadkins Sr Foreign Exchange Research Analyst, Aite Group

Summary of Electronic FX Market, 2018: Midsize-to-Large Buy-Side Firms’ Needs

Global buy-side volumes have grown faster than any other category of FX trading since 2004, more than 300% to over US$1.3 trillion according to our estimates. A strong contributing factor was the buy-side’s increasing usage of sell-side prime brokerage credit lines which has helped pump up transaction volume. Changing attitudes towards FX, now considered an investable asset class, have also contributed to the growth in real money FX volumes. Between 2010-17 London and New York buy-side volumes leapt almost 80%.

First Published: e-Forex Magazine 82 / e-FX Industry Report / September 2018

Global buy-side volumes have grown faster than any other category of FX trading since 2004, more than 300% to over US$1.3 trillion according to our estimates. A strong contributing factor was the buy-side’s increasing usage of sell-side prime brokerage credit lines which has helped pump up transaction volume. Changing attitudes towards FX, now considered an investable asset class, have also contributed to the growth in real money FX volumes. Between 2010-17 London and New York buy-side volumes leapt almost 80%.

Not only have buy-side firms’ FX volumes increased, their share of the global FX market has grown dramatically and accounts for an estimated 44% of global FX turnover.  Between 2013-16 buy-side volumes surged 32% whereas hedge fund volumes slumped 32%. Tighter credit conditions and a reduction in credit lines to leveraged accounts in the wake of the SNB’s decision to abandon the EUR/CHF floor, sharply impaired hedge funds’ FX activities.

MiFID II

The growth in real money’s FX footprint on the global FX market has been evolutionary but the introduction of MiFID II on January 3, 2018 has put buy-side firms in a classic profitability squeeze. Management fee compression due to the popularity of passive investment vehicles and higher technology costs that stem directly or indirectly from increased regulation of OTC and derivatives markets have taken their toll. The pressure is on at all levels of buy-side firms to run efficient, lean operations across multiple asset classes, jurisdictions and both listed and OTC marketplaces.
 

The after effects of MiFID II are likely to focus buy-side firms’ attention on streamlining operations and reducing the cost of transacting business. Consequently, demand for programs that enhance transaction cost analysis (TCA) is on the up-tick. The Aite Group report incorporates analysis of multi-dealer platforms’ TCA capabilities and reveals the best multi-dealer platforms’ offerings in the TCA arena. 
Some single bank platforms have TCA capabilities but the MDPs seem to have the edge at this moment in time. The UK’s Financial Conduct Authority (FCA) will most likely forbid passing on TCA costs onto investors. TCA costs are expected to be as much as 12% of buy-side technology budgets, a primary incentive for the buy-side to become more efficient. Post-trade TCA is essential for platforms in today’s FX environment. Absence of post-trade TCA infers real-time TCA won’t be coming on that platform any time soon.

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The mode of transacting business in FX has undergone a sea-change and electronic trading is now estimated to account for 60% of average daily turnover. The migration from transacting business via phone to E-platforms, whether single dealer or multi dealer platforms, continues en masse, but voice trading is not dead. In fact, buy-side participants transacted over US$500bn per day globally in 2016 according to the BIS. 

Aite Group sees this as a consequence of increased intra-day volatility which has followed diminished participation in liquidity provision by banks following regulatory changes since the 2008/09 financial crisis. This has driven larger buy-side players with big FX tickets back to their primary bank liquidity providers to avoid market disruption when executing large transactions.

Algo trading

Prior Aite Group analysis suggests algo trading is probably being under-reported and that official data on algos and HFTs understates the influence of these participants. Supporting this theory, Aite Group research uncovered the fact buy-side firms using automated order management systems and/ or execution management systems have now passed 50% in utilization of algorithms in transaction execution.

Of those firms utilizing algos, over 10% conducted more than 75% or more of their company’s FX business via third party (broker) provided algos in multi-asset order management or execution management platforms. We believe the migration of volume to multi-trading facilities and mandated flagging of transaction types over European MTFs, as well as “smart data” management will detect much higher volumes via these sources than today’s date reveals.

On the sell-side, bank trading rooms have suffered attrition in their senior staff since the multi-faceted FX scandals. Banks have cleaned house and the ranks of senior traders, either voluntarily or involuntarily, have decreased. The so called “juniorization” of trading rooms has seen a spike in “quote and cover” strategies, particularly as the aforementioned regulatory changes, specifically the Volcker rule and aspects of the Dodd-Frank Act, have degraded banks’ appetite for speculative trading. 

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Consequently, liquidity provision has also declined as speculative trading and liquidity provision go hand-in-hand. As noted earlier, an increase of intra-day volatility (aka “volatile around a stable base”) has increased the likelihood of more frequent mini “flash crashes” which “VWAP” and “TWAP” algo strategies exacerbate when those “flash crashes” materialize.

Model Code

There’s been much attention spent upon the introduction of “The Model Code.” However, as its predecessor, the ACI’s “Code of Conduct”, it is not enforceable. It is a suggested pattern of conduct promoted as a path to follow, but without enforceability, it has no teeth. The legal prosecutions of various market participants in the FX fixing scandals was the primary deterrent, but lack of firm evidence has drained many of those investigations of vitality. The billions of dollars of fines though have dampened FX trading banks appetite for proprietary trading or liquidity provision.

MiFID II has not only impacted the sell-side, it has had a fundamental impact upon the buy-side. Regulatory best execution obligations (which are not just “best price” but also quality of research) have affected buy-side technology choices, counterparty choices, credit clearing brokers, their choice of global custodians and quality of systems and procedures. The buy-side is being forced to up its game and is consequently seeking improved efficiency to pay for the additional costs of compliance (given the likelihood they will not be able to pass them onto their investors).

Aite Group’s vision of where the buy-side is heading in 2020 and beyond foresees increased flexibility in their systems, operational procedures and ability to absorb increased market volatility and stress. This will need superior connectivity to multiple liquidity pools, superior analytical tools and alert risk management policies that are highly actionable. 

Liquidity

At the top of everyone’s list is liquidity and buy-side firms are seeking new sources of liquidity, new trading venues and are looking for them in many places including multi-asset venues. Despite this, traditional sources of FX liquidity continue to dominate today’s FX market - Currenex (State Street), EBS (NEX), FXall (TR), FX Connect (State Street), FXGO (Bloomberg), Thomson Reuters Matching/ Dealing.

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Three challengers to the hierarchy – Cboe Global Markets’ Cboe FX (i.e., Hotspot), the CME and 360T (Deutsche Boerse) - are attracting strong growth in volumes and are fresh liquidity sources. The strong growth in non-bank liquidity providers is forcing many participants (banks and the buy-side) to review their policies and tech offerings.

Cboe FX uses prime brokerage mediation to fill out its offering, an added attraction is pre and post-trade analytics to ensure optimal maker/taker relationships. Orders can be left in the book using FIX, API or CBOE FXGUI. CBOE also offers a “full amount” RFQ and includes Cboe’s SEF product. CBOE volume is over USD 41bn daily. 

FX Connect’s (State Street) client base is mainly real money and given their heavy weighting in global turnover is a valuable source of liquidity. 360T has the best access to non-bank liquidity providers and they anticipate accelerated growth in the aftermath of recent regulatory changes. Estimates for non-bank liquidity providers vary between 10-20% of average daily global FX turnover. CME FX futures outperformed all other OTC FX products in terms of growth in 2017 further emphasizing the need to have varied liquidity sources on tap in today’s markets. 

Data

This report provides a clear view of the buy-side’s growing need for technological support to accommodate regulatory change but that technological support will emphasize clean data collection with the minimum of human intervention. There’s already an evolution in the managed funds world toward “smart data’ driven largely by demands from half a dozen European regulators. This month’s SEC launch of a live data interface with thousands of funds managers has doubled the systemic risk reporting required by the SEC and asset managers are embracing technology solutions to meet those new requirements.

MiFID II has had a fundamental impact upon the buy-side
MiFID II has had a fundamental impact upon the buy-side

Given the growing role of buy-side firms in the foreign exchange market, it’s logical they’ll want the same ability to clean, warehouse and disseminate digital reports on their FX activity efficiently to meet the many regulatory requirements already in place in Europe as well as the new wave of automation sweeping the funds industry in the United States. 2020’s FX market is more likely to be more automated than less and FX platforms, either single dealer platforms or multi-dealer platforms will focus on quality of data and flexibility of systems to provide “smart data”. 

Given the growth of buy-side volumes in recent years, any other FX market participants should be monitoring what these businesses are doing and how their technology requirements are changing with the added regulatory burdens.