In 2020 there was sizeable increase in investors’ interest in emerging markets (EMs). According to DMALINK, the FX-focused ECN, client demand for emerging markets FX and equities rose to its highest peak since 2017 thanks to a sliding dollar and the prospect of a global recovery in 2022 – a process accelerated by the global rollout of Covid 19 vaccines.
For electronic FX platforms, this demand has led them to consider how to cater for a broader universe of emerging market currencies and to improve client access to these instruments. “We rely on regional access to risk-warehousing market makers to match with client orders,” says Michael Siwek, co-founder of DMALINK. “Local pricing gives clients an edge by tapping into skewed liquidity pools and full amount feeds, underpinned by independent reference-rate data to quantify results and best execution.”
One of the most important roles for electronic trading platforms is to reduce the operational risks that are potentially greater in emerging markets where liquidity is thinner and volatility is greater.
“To eliminate market friction, venues can help by introducing automated responses to clients across restricted EM pairs,” says Siwek. “In addition, e-venues can help market participants transact EM currencies by streaming tailored two-way pricing from a collection of risk warehousing market markets to provide continuous pricing during times of greater volatility. Segregated pools of liquidity may be created to reduce market impact. Peer-to-peer pools are an alternative when liquidity is thin. Knowing when to trade and with whom can be key to getting filled. Finally, electronic solutions are less prone to error through the trade execution, clearing, and settlement lifecycle,” he states.
Siwek believes that new digital services can help to solve the complexity and manual intervention problems that are inherent in emerging market custody FX processes. “In restricted EM currencies especially, the use of direct API integration or an execution front-end between counterparties to deliver streaming prices, coupled with STP solutions, provides greater efficiencies and reduced trade lifecycles,” he says.
“Digital and electronic solutions often help in disintermediating access to the market, thereby opening a more direct form of access to more participants. We are currently developing a model that will enable central banks of developing nations to better manage their currencies and the associated credit component through use of technology and swift communication systems.”
Siwek also believes that decentralised finance, or DeFi, technology will play a major role in the development of digital workflow innovation. “As blockchain and smart contract technologies become more mature, we believe that financial markets will enter the next evolutionary phase,” he says.
“We are working with our sister company DeFinity to provide FX market participants with faster settlement times - these can currently take from one to three days. We feel that the process of transfer of ownership can be expedited substantially using technology and an increase of direct transactions between buyers and sellers can be enabled.”
Central banks are also taking greater interest in decentralised finance in both developed and developing economies. This has led to the development of central bank digital currencies (CBDCs). In the UK, the Bank of England has looked at the possibility of a so-called britcoin while Bank of Korea governor Lee Ju-yeol has said that the emergence of CBDCs will reduce the high demand for cryptocurrencies. Bank of Korea is planning to debut a CBDC later this year, as are central banks in China, Russia, Turkey and Jamiaca.
Siwek says that the intervention of central banks of emerging economies can help stabilise and control the exchange rate of an underlying currency through monetary policy. “Central bank digital currencies can help governments introduce more efficient controls, such as negative interest rates, which would apply to all money in circulation should the elimination of physical cash become a reality. Alternatively, the evolution of decentralised finance and the effects of its underlying technology can bolster the relevance of emerging market currencies within a global economy, optimise efficiencies, and remove risk. It can also enable buyers and sellers to clear and settle with each other in near real-time without the intervention of third parties,” he states.
When it comes to choosing a suitable EM trading provider as a partner, Siwek believes that trading venues can differ greatly in their offering and clients should make a decision based on their underlying requirements such as access to currencies on offer and API vs GUI systems to cater for automated vs manual trading.
“Speed of execution, server co-location across strategic geographical locales minimising latency, availability of liquidity across time zones, cost of credit of transacting on a given venue coupled with the ability to match orders with sustainable uncorrelated quotes are critical decision-making points.”
Siwek also says that clients should consider measuring their true cost of execution and use a system to provide independent benchmark services through independently verifiable reference rates. “We feel that providing quantifiable data to demonstrate the actual cost of trading is essential, as many of our new and existing clients are starting to discover.”
The move to electronic trading for EM currencies has happened at a quicker pace than for G10 pairs many years ago, says Ashvin Parkash, global head of eDistribution at Nomura. “With clients wanting to trade as much as possible electronically, the sell side has sped up the development of these to offer EM as much as possible. With more sources of electronic liquidity for EM – the sell side is able to leverage this to accurately automate pricing directly instead of relying on voice broker lines to estimate levels. This in turn allows clients to confidently execute EM via platforms.”
There is also a role for new technology and digital solutions to reduce manual intervention in EM FX processes, says Parkash. “For now, larger sized EM requests will be priced on an RFQ basis by traders. But we have seen the gradual growth of auto-price levels and this continues to move upwards as connectivity, accurate benchmark checking, auto-skew abilities and further technological enhancements give both the sell side and buy side confidence that EM pairs can be largely executed and autopriced ‘hands-free’ by both counterparties.”
The use of electronic platforms lends itself to solving the operational risk problems that come with voice trading and naturally this is greater in the EM space, says Parkash. “As users become more comfortable with using platforms, they tend to broaden out their usage to different products or currency sets. The pandemic has only accelerated these moves and we expect a continued move to electronic platforms for EM currencies eventually reaching G10 levels of execution.”
When it comes to the development of digital workflow innovation in EM EX platforms, it is likely that we will see the growth of the NDF algo over the next two years, says Ian Daniels, Head of eFX Distribution, EMEA at Nomura. “There is certainly client demand, but take up has been relatively slow, often due to cost and the fact that the algos had a limited set of venues for liquidity, but that is set to grow and will lead to better performance, as well as more competitive pricing. Clients who are already using algos for other products will naturally gravitate to NDF algos in our opinion. This is a growth opportunity in the EM FX space,” he says.
Local expertise and risk appetite are key factors when it comes to choosing a suitable EM trading provider, says Daniels. “At Nomura, we are naturally focussed on Asia and are in a unique position to offer our intellectual capital and risk appetite across currencies in the region. Having a provider who is able to absorb the size you want to execute, however large, is important.”
Singapore is at the centre of the development of the emerging NDF marketplace, says Ludovic Blanquet, chief product and strategic planning officer at smartTrade Technologies. In an effort to become a player in the FX pricing market and displace Tokyo as the APAC hub for FX trading, Singapore has set up the SG1 data centre and has already attracted a large number of sell-side providers initially focusing on the NDF market.
“A lot of EM currencies in Asia are traded via NDFs,” says Blanquet. “The trading is becoming more automated but you cannot just take execution algos and just apply them to the NDF market. There are more liquidity exceptions and a higher concentration of liquidity providers. There are also fewer latency requirements and settlement issues.”
The building blocks are all there to develop a fully electronic EM FX marketplace in the likes of Singapore and across the APAC region, says Blanquet. So what is holding this back? “There is a lack of electronic tools among the regional banks. They are not investing in advanced trading platforms. For full automation to occur, the banks need to make that investment in the next two to five years. There are the large liquidity providers that have these tools, but you need the local correspondent banks to participate and at the moment these local banks have a relatively low level of automation and the market is currently constrained by that,” says Blanquet.
In the meantime, FX trading firms will need to build some flexibility into their trading set-up, says Blanquet. “Firms will need to be more nimble. The size of the trades will be smaller in EMs as opposed to G10 currencies so firms will need to a find a way to balance human oversight with electronification.”
In the past five years, there has been a huge evolution in EM platforms for FX in terms of liquidity and accessibility, says Stephane Houriez, global coordinator of local markets rates and FX e-trading for BNP Paribas.
“Emerging market FX is now well developed on major electronic distribution platforms for the top EM currencies, having overcome major obstacles related to local regulations and market conventions,” says Houriez, who is based in Hong Kong. “When looking at the availability of FX liquidity tradable electronically, the gap between G10 and EM has tightened uniformly in global markets while in domestic markets the evolution was less even due to local specificities.”
One area of the market that has developed quickly in recent years is listed FX products, especially Futures in Chinese yuan offshore, Indian rupee or Mexican peso, while Brazil and Korea had an active FX Futures market for a longer time. For example, in April, the HKEX announced the launch of the Mini USD/CNH Currency Future, to complement their offer in RMB listed derivatives, catering to the needs of some market participants who prefer cash settled contract and/or smaller contract size. With the ample liquidity and competitive bid-ask spreads, the MCS Futures contract can provide trading convenience to different market participants and individual investors.
A key reason for the development of the FX futures market is the financial crisis of 2008 which saw a global trend to focus on instruments with central counterparties (CCPs) rather than bilateral trading. According to Houriez, this trend is not limited to emerging markets but has been across the board ever since the crisis.
One benefit of this trend is that it enables more market participants to access emerging markets, especially institutional investors with investment mandates that preclude them from entering certain markets or trading certain instruments. And electronic trading platforms for FX futures can provide both more transparency and less operational risk, helping to reduce volatility in those emerging markets where liquidity is thinner.
Emerging markets are generally well represented on the major FX trading platforms. And margins have reduced in recent years. However, says Houriez, there is still progress to expect in certain markets. “The key enabler is the availability of quality electronic market data as opposed to quotes transmitted by voice. But as long as there is a deep interdealer market and the pricing is transparent, then the development of e-trading is possible.”
The NDF market has also been a key development in emerging market trading, says Asif Razaq, global head of FX Algo Execution at BNP Paribas. “The NDF market has traditionally been a voice-based market. However we are now seeing NDF’s being actively traded on the same electronic platforms (ECNs) as Spot FX where market makers are utilising the same technology to price NDF’s.”
As these markets become more electronically mature, we will start to see greater use of execution algorithms for NDFs, says Razaq. “It is a natural evolution in the use of algos – the G10 currencies, the EM currencies, and now the NDF market. Clients are seeking to optimise their FX trading efficiency by utilising execution algos to reduce the cost of NDF execution as these markets become electronically mature.”
In essence, it is about developing an electronic ecosystem for EMs and about making the entire transaction electronic, from price discovery to execution. However, for this ecosystem to take shape, the whole market needs to be electronic, says Razaq. “Every market participant has to go through an upgrade, from the ECNs to the market makers and the custody platforms, to be able to support greater use of algos in EMs and NDFs.” This is not a complex task from a tech perspective, says Razaq. “We are simply applying the same principles for G10 currencies and using the same technology to expand into EMs. It comes down to a cost-benefit analysis and how committed firms are to make that investment in EMs. There are various factors that influence this analysis, such as the availability of credit or the level of risk. The wider use of global settlement system CLS is helping to reduce settlement risk in EMs and make these markets more attractive.”
The final point that Razaq makes in the case for electronic trading of EM FX is the need for banks like BNP Paribas to have an onshore presence. “The onshore presence is fundamental and core for any bank’s platform,” says Razaq. “It gives you an edge in pricing and execution but also helps to provide market ‘colour from the ground’. Having this local presence comes at a cost but it is a key part of our EM FX strategy.”
NDF trading is playing a vital role in EM FX but how can the liquidity in these instruments be made more widely available? NDF instruments are critical in the world of EM, says DMALink’s Siwek. “Streaming NDF pricing through direct API connectivity using suitable credit intermediaries can help clients access a wider range of NDF pricing across time zones. Flexible broken-date NDF pricing is equally important and can add value. Algorithmic trading facilities can minimise transaction costs further by capitalising on more spread from passive orders vs other liquid currency pairs. Electronic venues can help NDF traders by providing deeper liquidity to facilitate such algorithmic trading models to minimise market impact,” he says.
“Finally, the fragmentation of pricing, especially in Asia (where many brokers churn the same price across multiple channels), can be countered by reverting a sustainable risk-warehousing model. Again, here market impact should be measured through benchmarked execution verified by independent mid-rates. Ideally, this solution should be made available through one portal where clients can transact and measure their trading costs.”
“Non-one month NDFs and NDS are going more and more electronic in terms of client execution preference, however it will be a while before the risk management becomes fully automated – hence the need for strong EM traders to manage this risk. We think liquidity conditions will continue to improve for clients, as the interbank market place expands and adds liquidity venues. This allows the sell side to extend out auto pricing parameters and connect clients via direct APIs, as well as the current multi and single dealer platforms,” says Daniels.