Choosing the right counterparties

As volatility starts to pick up it’s time to brace for the storm that lies ahead and for market participants to ensure the counterparties they work with can deliver the services needed.

Take a look at the global macroeconomic picture today and there’s no shortage of indicators that the underlying conditions for currency markets could be poised to soon become much more volatile. After the turmoil of the global financial crisis a decade ago - and admittedly with a few notable exceptions such as the fall-out of the UK’s Brexit referendum or the SNB’s removal of the peg - currency markets have been comparatively lacking in volaility as many major central banks pushed interest rates down to near zero and flooded the market with cheap money in the form of quantitative easing. This era however appears to be at an end. 

Indeed, the rhetoric from central banks is increasingly bullish and there are mounting expectations that we will see the frequency of interest rate actions accelerate as we move towards the end of the decade. Add to this the growing risk of protectionist policies emerging from major economies - in other words trade wars - reversing the tide of globalisation that has been observed in recent years, and we have yet more reason to believe the lower volatility era for currency markets could be coming to an end.

Currency markets are poised to become more volatile
Currency markets are poised to become more volatile

The right counterparties

All this is certainly being well telegraphed, so the market has no excuse for being caught out, but now is the time for market participants to ensure the counterparties they work with can deliver the services needed. Be that in terms of appropriate risk mitigation, or for those wanting to trade the volatility, the assurances that appropriate levels of market access can be expected, are now being sought.

Clearly this won’t be the first time markets have seen heightened levels of volatility, but it’s critical that we remember there has been an array of fundamental changes in terms of market access over the last decade or so. The number of Prime Brokerage providers out there has reduced significantly, whilst those banks who still operate in this space are now far more selective over who they will actually work with. During the generally quiet markets we’ve seen of late this has been less significant as many participants have been able to take an appropriate attitude towards risk, but as volatility picks up, demand for access to the underlying market is likely to increase. 

Financial markets are well versed when it comes to adapting to change so it’s no surprise that we have seen the emergence of companies badging themselves as prime of prime liquidity providers in recent years. Whilst this serves a useful role given the falling number of prime brokers - and the higher requirements they are placing on counterparties - if your intermediary isn’t directly tapping into tier one liquidity, will there be sufficient flow available when you need it most? And if they are providing access to genuine T1 markets, do they have sufficient leverage on their own balance sheet in the event that a swathe of their customers start making simultaneous requests for liquidity? 

It’s time to brace for the storm that lies ahead
It’s time to brace for the storm that lies ahead

A good example

Prime FX from CMC Markets for example, has been designed as one such solution to provide a reliable source of liquidity, designed for those entities seeking both true market depth and consistently competitive pricing. Counterparties benefit from a proprietary, institutional trading interface, along with a comprehensive suite of reporting and analysis tools to allow them to manage their positions. It’s important to bear in mind that this approach isn’t the result of recycling liquidity that has already been aggregated elsewhere, then badging it up as ‘prime of prime’. Prime FX is helping meet a growing market need, giving access to tier one liquidity and helping fill the gap that has arisen as a result of many major banks dramatically scaling back their prime brokerage services. 

The popularity of services like this is driven by the fact that big firms like CMC Markets are enabling those smaller entities - asset managers, hedge funds and some of the smaller retail FX brokerages - a route back to accessing tier 1 liquidity. These large companies come with FCA regulation, a London stock market listing and a strong balance sheet, making them an obvious choice to act as counterparty, whilst also being able to collate volumes which are still of interest to the Prime Brokerage community. 

The FX market has been changing in recent years and whilst the shift hasn’t gone unnoticed, as volatility starts to pick up and counterparties decide that less risk can be internalised, it’s critical that they understand the new landscape. Can all of those who have been reliably providing market access through the last few years be expected to cope as volatility accelerates? By all accounts, it’s time to brace for the storm that lies ahead and ensure you know exactly how robust your broker’s proposition will be. Those with direct access into tier 1 liquidity will find themselves at a natural advantage.