Baseline requirements for broker connectivity are accelerating. It is no longer acceptable to have a static series of standard connections, and have those stay the same for years. But even when companies understand the need for better, more customized liquidity options, implementing these solutions is not necessarily a simple task. Sitting behind these changes are fundamental shifts in both the operation of the FX markets and the relationships between actors in these markets. In order to understand what’s behind these rising demands, it’s necessary to look at the market structure shifts behind them.
A market both growing and spreading out
A high level view of the trading landscape shows concurrent change on several fronts – some made clear by the most recent triennial survey by the Bank for International Settlements that confirmed that trade execution in foreign exchange is changing rapidly. Electronification continues to gather pace in more corners of the market and there are new market participants that are streaming into both retail and institutional segments. Automation is now replacing manual functions – one estimate suggests that algorithmic trading went from less than 5 percent to 75 percent of trades in less than two decades. Trading venues are also multiplying.
The BIS identified two additional downstream impacts from these shifts worth pointing out: a growing intermediation within dealers’ proprietary liquidity pools, contributing to a decline in visible share of FX trading in spot markets, and a response to market fragmentation through executing across a larger number of electronic venues. The foreign exchange market in sum is now growing not just in size, but also spreading out in complexity. To find the necessary liquidity for a diverse range of customers, brokers need to evolve their operations and infrastructure.
The need for a smarter infrastructure
The infrastructure needed to service the requirements of today’s brokers and markets is thus changing. We see three main ways the direction of foreign exchange infrastructure must evolve to meet the needs of its clients.
First there needs to be a greater pool of connections to draw from, and the ability to add more (and take ones away) as change demands. This isn’t a linear process as inappropriate connections can lead to greater inefficiency. Additionally brokers need flexible sources such as Hubs with low latency, high throughput and stability without sacrificing the flexibility necessary to accommodate changing market requirements. And finally there’s a need to create and develop new liquidity sources. These sources of synthetic liquidity – financial instruments engineered to simulate other instruments while altering key characteristics – allow for greater customization, ensuring every broker can have their own customized set of liquidity providers and connections.
We advocate brokers take a less didactic look at their liquidity streams. Today, brokers typically try to segment flow as being either high or low impact based on uninformed views of their customers, but that often is less accurate than data driven approaches. This leads to inefficiencies as liquidity providers tailor the streams to the lowest common denominator of trades they are presented with which prevents tighter pricing which may include – sending leans and axes from reaching those customers with softer flows.
Analytics show this is an overly simplistic way to form liquidity. Most trades executed on streams are split quite evenly between sharp and soft, so a stream that might be designed to handle sharp flow might in fact be pricing a significant minority of customers at wider spreads than they would receive if more accurately categorized. Brokers and liquidity providers could mutually benefit through more accurate segmentation of flow pre-trade, which can be directed through more robust routing logic, enabling greater customization, and introducing tighter pricing for low impact trades.
The technology now exists for brokers to analyze outcomes on customer, trade, and stream levels, and then take corrective action. This opens up new options: perhaps to pursue a more passive hedging style on a particular stream or use that flow to internalize risk. This allows brokers to segment clients and be able to organise streams aligned to the trading strategies of individual customers.
A more nuanced approach allows for deeper relationships. With dynamic, quantitatively produced insights, brokers can build ongoing client relationships by showing the reasons behind prices offered and start conversations that may allow for that relationship to expand.
When it comes to the massive foreign exchange market, one individual broker – no matter how large – cannot impact the overall course of the market. What brokers can do, however, is accept that the increasingly complex nature of the market requires an increasingly nimble approach. With the right technology and partnerships in place, brokers will be in a position to more easily set a course towards long term stability and success and be in a better place to help clients regardless of their size or strategy.