A notable trend of recent years has been the withdrawal of major banks from market making in various asset classes. The fixed income market has been particularly affected by this withdrawal, which is due to both banks’ aversion to risk and also capital charges that penalise banks for holding certain assets on their balance sheets.
This withdrawal has created concerns about a liquidity crisis in corporate bond markets as the primary dealers reduce the size of their inventories. At the same time, investment in fixed income mutual funds has doubled to $3.5 trillion and asset managers are now expected to take on a greater market-making role and provide more liquidity given that they are the primary holders of capital.
The fixed income market is not alone in seeing an emergence of non-bank liquidity providers. The FX market is also seeing a similar trend with a number of high frequency trading firms stepping into a liquidity vacuum caused by banks’ retreat from market-making duties.
This change in dynamic may have a number of implications. For one, what will it mean for liquidity? In the fixed income market, the concern is that asset managers taking on the responsibility for market-making may not be fully committed to their new role and may only provide liquidity when it suits them.
The FX market is lucky in that it is generally liquid at all times but there are also occasions when volatility is so high that it becomes difficult to find trading partners – such as the SNB event in January 2015 or the Brexit vote in June 2016.
Will the non-bank liquidity providers take these opportunities to fill a conspicuous void and provide much-needed liquidity when others will not?
Filling the void
As the traditional bank market makers have been restricted in the amount of risk they can take on, the non-bank market makers have stepped in to fill that void, says Joe Conlan, Global Head of FX Sales at INTL FCStone Markets. “Low latency trading firms have operated on the basis of being the first to be hit in the markets and they are extending their reach by connecting to more markets and ECNs,” he notes.
At the same time, there are a number of banks withdrawing from the same space, creating a vacuum that needs to be filled. “Banks are generally pulling back in risk taking,” says Conlan. “There is a reduced risk-reward equation and much greater scrutiny. They are still servicing clients but they are not competing for every trade.”
Conlan believes the growth of non-bank liquidity provision is a long-term development. “These are sophisticated players capable are deriving spot rates out of futures contracts, ARDs or options strategies. As long as they get hit at their rate, there’s a risk lay-off that is profitable. They are able to create a reliable market.”
The credit component is something that has underpinned the prime broker infrastructure in the FX market, and this is something that non-bank liquidity providers will have to manage. There are other developments in the FX market that play to non-bank participants’ strengths – such as the ease of connecting to popular ECNs and also the existence of last-look, which Conlan says is powerful tool for algorithmic trading providers, in that it provides a safety net should the market suddenly turn against them.
Non-bank liquidity providers are also helped by an increasing agnosticism among liquidity takers as to the source of their liquidity. As Conlan says, “They have no obligation to the banks, only to their investors.”
The market-makers need to be creative at times of market stress and this is something that non-bank liquidity providers have improved on. Market events that spark high volatility in the FX markets have given non-bank liquidity providers the opportunity to shine, as demonstrated by the aftermath of the UK referendum on EU membership and the Brexit effect, says Conlan.
“I heard from various ECNs that in the Brexit vacuum many non-banks were particularly good at market-making. There’s a maxim that when risk rises, so should reward. Algorithms understand that logic, and are making constant approaches in times of volatility while the banks’ general aversion to risk has seen them withdraw from the market at times of high volatility.”
As the market for non-bank liquidity grows, it will become even more competitive in terms of pricing, says Conlan. At the same time, the fills on the other side of the book will hopefully grow to create an even market and sustainable liquidity.
One issue, however, for liquidity takers is that it can be hard to differentiate between the various non-bank liquidity providers because some are very new to the market and have no track record to speak of.
So how is the provision of non-bank liquidity evolving as a result of the changes in both the retail and institutional FX markets? The retail brokerages took a big hit in the aftermath of the SNB event in January 2015, when several under-capitalised and over-leveraged brokers were exposed and liquidity was withdrawn at a crucial time, when many retail traders needed it most to unwind their precarious positions, says Conlan.
For institutional investors, there is an added complication when it comes to choosing their liquidity providers in that they may have a long-standing relationship with one or more of the major market-making banks that carries with it a number of explicit or implicit implications.
“Institutional investor rely on market intelligence from the banks’ and analysts’ trade ideas,” says Conlan. “I don’t know how a non-bank would be able to compete with that offering. Investors also get a level of comfort from banks because of their balance sheets and long relationships. And then there is the credit relationship and the ability to scale. For the non-banks without the balance sheet of the large banks, I don’t know how they will manage the scalability and credit provision issues. But non-bank liquidity will be a valuable and much-needed service now and in the future.”
Regulatory reforms have undoubtedly been the biggest influence on the rise of non-bank liquidity, says Gavin White, CEO of Invast Financial Services, an Australia-based, multi-asset prime broker. These reforms have severely impacted the ability of banks to warehouse risk by making it a more capital-intensive activity for the banks – particularly with regard to OTC products such as spot FX and commodities.
The reforms have been a long time coming and the banks have been particularly slow in responding, says White, therefore strengthening the case for non-bank liquidity provision. “I think the next decade will be the ‘Age of the Non-Bank’, as regulatory reforms increasingly constrain the activities of banks. This is the case with regard to liquidity and prime services provision.”
Non-banks are rising in prominence. This is not a temporary phenomenon. It is a long-term, fundamental change in the industry. It is a change which is being driven by regulatory reforms that are far-reaching, permanent and aimed squarely at banks. These reforms began being implemented in 2014 and have incremental implementation dates stretching through to 2019. Prior to 2019, it is expected that even more restrictive reforms will be put forward, curtailing the activities of the banks even further. When it comes to Liquidity Provision and Prime Services, it seems pretty clear that we are entering the “Age of the Non-Bank”.
The non-bank liquidity providers may also prosper when it comes to the more diverse currency pairs, says White. “They have invested heavily in technology which seems to give them an edge in the more peripheral pairs, where risks are of a greater magnitude, but are less easily quantified. The banks are more competitive in the major pairs where there is less of a need to warehouse exposures in order to be profitable.”
The ability to hold larger inventories may also see non-banks become important liquidity providers in times of market stress and volatility, says White. “Again, non-banks seem much more capable of warehousing risks over longer timeframes, particularly as the regulatory constraints on the banks become tighter. This means the non-banks seem better placed to perform well during thin market conditions and times of uncertainty.”
The SNB crisis and the Brexit vote have undoubtedly increased all measures of the volatility of FX as an asset class, says White. “The 40% move of a major currency which we saw during the SNB crisis was something I have not seen in my 30-year career in FX. It was something I thought would never happen. Overnight, FX suddenly became a much riskier asset class according to all volatility models.”
As the banks are being subjected to increased capital and liquidity requirements according to the volatility and risk of each asset class they participate in, the increased volatility in spot FX caused by the SNB and Brexit events has definitely made the banks less competitive in providing liquidity in spot FX. This has given the non-banks a huge lift, as they are not affected by the bank-centric regulatory capital requirements.
And the appetite of the banks to internalise will continue to diminish as the bank-centric regulatory reforms continue to bite deeper and deeper. The upshot is that dealing with a non-bank liquidity provider can often prove to have less market impact than dealing with a bank with a low internalisation threshold. This is important to all large volume traders, but particularly quantitative practitioners.
Multi-asset class factors
The next decade could also see a growing demand for multi-asset class liquidity across both retail and institutional investors, says White. Furthermore, many could be looking for a single, multi-asset broker rather than aligning with a different prime broker for each asset class.
“All buy-side participants want multi-asset liquidity/access from the one provider. It provides administrative and capital efficiencies, amongst other benefits. Institutional players have been demanding this for years, but what is interesting is that retail players are now appreciating the benefits of coordinated multi-asset investing and are making a bee-line toward multi-asset brokers. This is forcing the single-asset FX brokers to rethink their offering,” says White.
In addition to including multiple asset classes, prime brokers will also have to expand their pool of liquidity providers to include a mix of banks and non-banks.
“At Invast Global we aggregate, or blend, streams from almost 20 bank providers and half a dozen non-bank providers. Not only that, we take numerous streams from each provider, with varying volume tiers and execution parameters. We then cut and splice these feeds to provide the bespoke aggregated stream which is most appropriate to a client’s needs. Hedge funds and retail brokers have very different requirements. Different hedge funds will have very specific requirements from other hedge funds. Our job is to work with our clients to determine their needs and how they may be changing and then construct and dynamically manage the liquidity mix to ensure the stream the client is receiving is optimised for their needs. Within an aggregated stream, the willingness of the LPs to internalise is very important and the non-banks really shine in this context.”
Invast Global provides clients with a GUI and a dashboard report giving them feedback on the performance of each liquidity provider within their stream, says White. “We report on parameters such as response times, rejection rates and average spreads. We provide pre-trade and post-trade transparency, disclosing the names of each liquidity provider within their stream. We allow our clients to take control and choose which liquidity providers are in their stream and which they want to remove. We also advise our clients on ways in which they might transact differently in order to have less market impact and more effective execution.”
Lower the barriers
The over-the-counter nature of the FX markets is also beneficial to non-bank liquidity providers because the barriers to entry are so much lower than those of an exchange-traded product, says Kurt Hoeksema, head of Risk and Trading at FX broker Alpha Capital Markets. “This allows new participants to more easily begin making markets to a diverse customer base that is looking for new and different liquidity than what they are used to seeing. Traditional bank market makers historically price based on very traditional type of corporate and commercial order flow. That worked in the FX markets of the past, but now market makers that price based on different non-bank related factor is a legitimate need.
This is why we are seeing the non-banks increase. You can only have so much of the same type of liquidity before you no longer add value which is ultimately boiled down to spread or price.”
Customers of all types are demanding access to more markets than ever, says Hoeksema, including more diverse currency pairs. “Trading is no longer limited to G10. Customers are looking to trade FX exotics, bullion, cash indices, and energies in an attempt to find market opportunities. Retail traders are looking for opportunities, and as they start to understand the dynamics of trading and how they are actively trading FX markets they realize that those same principles are relative to other markets. Retail brokers understand that, so adding multi asset liquidity for them is really just about getting a larger share of the customer overall trading activity. The catch is that pricing and making a market on non FX markets is quite a bit more difficult. So you have to choose wisely which whom you are trading with.”
For active investors trading in diverse currency pairs, access to non-bank liquidity will become much more in-demand, says Hoeksema. “Traders crave consistent liquidity and historically that has been the challenge in trading non G10. At times liquidity is strong and at other times liquidity is thin and has a significant impact on execution quality. Non-bank liquidity has filled the gap in non G10 currencies and has made trading these pairs more efficient. Bank liquidity originates traditionally from the same type of sources. Each bank will have a slightly different variety but it’s roughly the same across the group with certain institutions specializing in certain geographic pairs. Non-bank prices are based on non-traditional factors and influences so this will result in a slightly different price than traditional providers. This cuts spread width adds needed liquidity and overall improves the trading experience.”
Non-bank liquidity will also create more benefits under certain thin market conditions and in times of stress and volatility, says Hoeksema. “Non-bank liquidity is by design different in make-up than typical bank liquidity. This allows non-bank liquidity to provide depth and price consistency during thin markets because their price is not reliant on another provider. Volatility and uncertainty breeds opportunity. Events like Brexit provide the opportunity for non-bank liquidity to shine and provide needed liquidity in the market when traditional providers are unwilling to do so.”
Prime broker role
For the growing number of non-banks holding more inventory and providing robust two-way markets, FX prime brokers are the gateway to important trading flows, says John Miesner, Managing Director and head of global sales at GTX. GTX operates an FX ECN, swap execution facility (SEF) and registered swap dealer.
Recently concerns have been raised about the dependence of non banks on prime brokers, which may decide that non-banks are cannibalising their business and existing client relationships. However, the current regulatory and capital pressures on banks make this unlikely, says Miesner,
“We see the current balance as symbiotic, with non-banks filling areas of the maket that have been ceded by banks for a host of non-financial considerations,” said Miesner.
Instead, the non-banks appear to be in the market making game for the long haul. Furthermore, they have demonstrated that they tend to add liquidity where certain traditional market makers no longer participate, including times of market stress, says Miesner. He puts some of this down to the fact that non-bank liquidity providers operate systematically.
“Almost everything they do is systematic. There is no emotion or sentiment. The banks, conversely, are much more cautious because of the implications for other businesses and individual client relationships. From that standpoint, non-banks can address any market condition purely as an opportunity to make money and often can be more agile and take on proportionally more risk.”
The systematic approach of the non-bank liquidity providers can also provide a diversification benefit for firms taking a more quantitative approach to trading, such as hedge funds and alpha-seeking boutiques. “For a buy-side market participant, access to new, truly differentiated liquidity flows is extremely valuable. So the trend to systematic, non-bank liquidity has this important driver behind it in addition to the current market and regulatory factors redefining the liquidity paradigm,” says Miesner.
“This is not to say that banks aren’t heavily involved because they still are. Even though the SNB event accelerated the participation of non-banks as liquidity providers, top-tier bank market makers still remain.”
Events such as Brexit has only encouraged more acceptance of non-traditional liquidity providers because they have proved that they are there through thick and thin. But they are not about to replace the traditional market makers, stresses Miesner. For example, global macro funds will different execution methods, venues and liquidity providers for each of their trading strategies. They are consequently very disciplined about who they trade with and are using the non-bank liquidity providers as an extra rather than alternative source. “It is an additive process not one of replacement.”
It could be argued that the FX market, spot FX especially, is perfectly suited to non-bank liquidity, says Miesner. But he is seeing non-banks evolve into other areas, particularly through GTX’s position as a registered swap execution facility (SEF) and swap dealer. “Institutionally, any registered SEF that has already begun actively trading FX NDF’s is poised to increase activity over the next couple of years. We are seeing interest from non-bank liquidity providers in pricing swaps and forwards, which is something we wouldn’t have expected to see even six months ago.”
Additional asset classes that are available via registered SEF’s are Interest Rate Swaps (IRS) and Credit Default Swaps (CDS). Demand for these non FX derivatives would seem like a natural progression as firms continue to diversify their product base.
For the likes of GTX, providing clients with a blend of traditional and non-bank liquidity has become a key way to add value and differentiate their offerings. “No two streams are alike,” says Miesner. “Tailoring a hybrid of streams that formulate a liquidity profile for a client creates the optimisation that is critical to a positive execution experience.”
GTX uses fill ratio optimization, along with strict rules of engagement for both traditional and non-traditional market makers on its ECN. It is also being used by banks and non-bank liquidity providers to connect directly to asset managers and smaller banks on a bilateral basis. This streamlines operational, infrastructure and credit required to set up bilateral dealing structures, reducing time to market and ongoing operating expenses, says Miesner. “In the past, many firms wanted to take that liquidity but did not want to be disclosed. Now both sides are more willing to be disclosed in return for tight spreads and more liquidity. And non-bank liquidity providers want to reach more clients. It is optimal for both makers and takers.”
Diversifying the market
Non-bank liquidity providers offer multi-asset trading capabilities across international borders with a technical infrastructure that’s designed to manage risk efficiently with a low market impact and the ability to quietly move inventory in the market, says Steve Reich, head of FX and Commodity Liquidity Solutions at GTS Securities. “In an era where regulators are discouraging banks from carrying too much risk, firms like ours help to diversify the market and augment liquidity in the marketplace.”
Retail and institutional FX investors are both seeking increased market efficiency regardless of asset class, says Reich. “Whether it be rates, FX, or equities, investors want competitive pricing and simple access to the market.”
Active investors trading in more diverse sets of currency pairs are especially seeking access to non-bank liquidity, says Reich. “Active investors tend to trade more frequently and are more sensitive to spreads and slippage in the marketplace. This means that in their trading, they need to focus on obtaining the best possible execution. Non-bank liquidity providers bring exceptionally competitive pricing to the market, in many cases, because our relationships with counterparties are driven primarily by our ability to price aggressively, while achieving low market impact.”
Non-bank liquidity providers also offer the ability to provide continuous liquidity, even in volatile markets, says Reich. “Non-bank firms like GTS accounted for a large share of the trading in the FX market following the Brexit referendum on June 23, pricing competitively throughout volatile market conditions and providing continuous liquidity for our clients. The combination of best of breed risk management systems and access to diverse market liquidity leaves non-bank liquidity providers well positioned to manage volatile events in the future.”