Over the past 18 months, GreySpark Partners has observed that the structure of the flow FX market – consisting of spot FX and vanilla OTC swaps, forwards and futures – has continued its incremental evolution. Nonetheless, the overarching structure of the spot FX market by and large remains the same in form and function as it was in 2015. Specifically, GreySpark observed in 2016 and through the start of 2017 that:
• the majority of spot FX trades take place on dealer-to-client (D2C) trading venues rather than on dealer-to-dealer (D2D) platforms;
• spot FX volumes traded on an inter-bank basis continued to decrease, even as the market share of the leading D2D venues stabilised;
• the provision by both D2C and D2D trading venues of API and FIX connectivity as well as prime brokerage (PB) and direct electronic access (DEA) services to non-dealers has become increasingly necessary rather than just acting as a competitive differentiator;
• algorithmic and high-frequency trading (HFT) continue to drive the majority of spot FX volume volatility;
• so-called real money asset management and institutional investor market participants comprise an increasing share of spot FX transactions;1
• only the top-10 Tier I investment banks continue to hold currency risk on their balance sheets, and even then at ever-lower risk thresholds, with both Tier I and Tier II banks increasingly internalising currency flows and moving to an agency trading model wherein they quote and cover; and, in their place
• currencies risk is increasingly being held by sophisticated buyside hedge fund and proprietary trading firm market-makers.
Despite the minutia of the rate of change observed between the start of 2016 and the start of 2017, the FX market – and the spot FX market, in particular – generated plenty of heated debate following the most recent release of the Bank for International Settlements (BIS) Triennual FX Survey in September 2016. Specifically, the BIS statistics showed that overall flow and non-flow volumes shrank by 5% between April 2013 and April 2016, and overall spot FX volumes shrank by an eye-watering 19% over the same period. At the heart of the debate surrounding why the volume of transactions across the entirety of the FX marketplace declined is the question of whether the 2016 BIS spot FX figures represent a one-off aberration or the emergence of an overall divergence between liquidity trends in the spot market and the rest of the currencies trading landscape.
Total Spot FX Volume and Channel Composition Depend on Volatility
GreySpark believes that, while the 19% drop in spot FX volumes recorded in the 2016 BIS FX survey represents an aberration in the long-dated volumes trend, the findings of the survey are representative of a temporary state of shallow liquidity in the marketplace caused by a confluence of factors. Among those factors is the increasing prevalence of algorithmic trading and HFT market-making business models, which are increasingly being utilised by banks and non-banks alike, as well as a decrease in real trade over the periods of time surveyed by the BIS in 2013 and 2016. Based on an analysis of quantitative and qualitative sources, GreySpark believes the drops in volumes are likely an anomaly, and that spot FX volumes levels will return to nominal levels in the future. Nonetheless, when underlying trade and volatility levels are low, further anomalous periods of spot FX volumes decrease could be expected.
This conclusion derives from two key drivers of the low spot FX volumes recorded in the 2016 BIS survey:
• the altered global real economy trade environment has supressed the need for FX transactions; and
• the effect of low volatility on a market driven by automated trading, both algorithmic and HFT in nature, in which a scarcity of price signals often leaves these systems dormant for long periods of the trading day.
The BIS spot FX figures are highly correlated to transnational trade in goods and services such that changes in global trade are reflected by and amplified in the BIS numbers, which GreySpark estimates suppressed spot FX volumes between 2013 and 2016 by 14%.
In GreySpark’s view, the remaining drop in spot FX volumes is largely the result of the role automated e-trading – which, over the three-year period, decreased far more precipitously than either voice or manual electronic trading – plays in the global spot market. To understand this difference in outcome requires an understanding of the purpose and applicability of different execution methodologies under various market conditions, particularly the best execution and HFT algorithms execution methodologies deployed in automated spot FX e-trading.
The utility and benefits of best execution algorithms, which are used to minimise adverse outcomes during trade execution, depend on the volatility and speed of trading; simply put, the more volatile and fast a market is, the greater the benefit derived from the use of algorithms. Best execution algorithms thus serve to offset – or at least mitigate – price volatility. The efficacy of this offsetting action is bounded on both the lower and the upper end of the volatility scale. In very low volatility markets, best execution algorithms are not used because best execution parameters can be achieved by voice or manual e-trading. At the upper end, once volatility reaches a certain point, best execution algorithms no longer fulfil their stated purpose, and traders move to bilateral, negotiated trades. These negotiated trades were historically voice executed, but they are now increasingly undertaken though manual electronic channels.
In contrast, HFT strategies rely on volatile, fast-moving markets in order to capitalise on the rapidly changing market environment; that is, the greater the movement in markets, the more opportunity HFT algorithms have to identify trade opportunities and execute them. This is particularly true where the underlying trading strategy relies on speed advantages and arbitrage between counterparties or venues. Such HFT strategies are bounded on the lower end of the volatility scale because these strategies are not designed for low volatility environments. At the upper end of the volatility scale, HFT strategies withdraw from the market when volatility exceeds their pre-programmed parameters.
GreySpark’s analysis shows that the variance in spot FX trading volumes that are not due to underlying global trading volume change were driven instead largely by the presence or absence in the market of HFT actors. HFT is not a constant presence in any e-traded market; instead, its use varies based on the volatility and speed of the markets wherein it is deployed. The utilisation of the voice, electronic manual and electronic best execution algorithms is also dependent on volatility. Figure 1 provides a schematic view of these dynamics and the trade channel composition based on volatility.
The Changing Face of Spot FX Liquidity
Even as the spot FX market share of D2D venues has stabilised, the significance of D2D trading on those platforms continues to decrease (see Figure 2). The new PB and DMA services available to buyside users of the platforms empower traditional price-takers to become price maker-takers at the same time that banks are retrenching and are therefore unable to provide the liquidity levels that they once did. Consequently, the share of transactions on D2D venues with bank broker-dealers on both sides of the transaction reached an all-time low in 2016 of 28%.
Although this decrease in D2D transactions is no longer accompanied by a decrease in D2D venues’ volume as a share of spot FX transactions – D2D venue market share has stabilised after almost 20 years of decline – GreySpark analysis suggests D2D transactions through dedicated D2D venues were only 10% of trade volume in 2016, and they are expected to fall further in the future.
The challenge of sourcing liquidity in the absence of the traditional sellside liquidity provides is further exacerbated by the rapid speed of spot FX trading in 2017. Despite a number of different types of buyside firms stepping in to supply spot FX liquidity to the markets, the sourcing of high-quality, large-size liquidity is an increasing concern for buyside market participants, especially for institutional investors.
Tools such as best execution algorithms aim to help market participants circumvent some of the market impact effects of taking significant orders into 2017’s diminished spot FX liquidity environment. However, quantification of the diminished spot FX liquidity problem is largely absent from public discussions of liquidity sourcing, in part due to the segregated and disaggregated view of the overall spot FX market available to most participants.
Taking an aggregated view of the market and breaking down available spot liquidity by time and currency pair, available volumes on a millisecond basis are small for most currency pairs at most times.
Given the rapid rate of price turnover in the market, which on most platforms is a matter of milliseconds, the challenge of bringing block-size trades to market without dramatically influencing liquidity remains pertinent; even the most liquid of currency pairs – for example, the EUR/USD – trades with a maximum liquidity of USD 10,162 per millisecond or roughly USD 10m per minute, according to analysis of the market conducted by independent mid-point FX price benchmarking provider NewChange FX (see Figure 3).
Understanding these challenges associated with block-size orders illustrates why GreySpark has observed that, despite the overall trend toward low-touch, e-trading business models within the buyside and the sellside, most large-size volume players in the FX market continue to maintain a number of bilateral, voice brokerage counterparties. As e-trading venues often lack sufficient liquidity levels to complete block-size orders, such bilateral relationships permit execution at pre-determined prices while minimising market impact. Large-size volume players indicate they will continue to maintain or expand such bilateral relationships in the future until such time as e-trading venues can reliably provide sufficient liquidity depth to move block-size orders without significant market impact.
What happens next?
GreySpark believes that the spot FX market currently finds itself suspended between its historical, dealer-centric structure and a more balanced market in which all-to-all (A2A) trading will dominate.
The search for currencies liquidity has led platform providers from discreet liquidity pools to universal liquidity aggregation and toward A2A trading support, with D2D trading largely excised from the market as banks retrench from holding risk. Nonetheless, the additional liquidity provided by non-traditional liquidity providers remains inadequate to meet demand in the high-speed trading environment that prevails in spot FX trading in 2017.
The challenge in sourcing liquidity is due to time-based liquidity fragmentation, yet the prevailing platform matching methodologies of request for stream (RFS), request for quote (RFQ) and the central limit order book (CLOB) remain unchallenged in this environment despite their manifested shortcomings. GreySpark anticipates that market structures will continue to migrate toward A2A in an attempt to ingest as much liquidity as possible.
However, GreySpark expects that the greater incorporation of buyside liquidity providers in the future will prove insufficient to the resolution of structural problems currently manifested by perceptions of shallow liquidity and that new trading models will emerge that aggregate time-fragmented liquidity by extending the time window for liquidity sourcing, such as running block-size auctions over a period of seconds, minutes or hours.