Eugene Markman

CME Group’s prime time changes and the ripple effect transforming global FX trading

May 2022 in Market Commentaries

By Eugene Markman, Chief Operations Officer, ION Markets (FX) and Chief Executive Officer, MarketFactory

FX trading has shifted on its axis and the interplay between global trading hubs, banks and ECNs is changing. The catalyst? Last year, CME Group, a global derivatives marketplace, announced that it would integrate EBS Market’s Central Limit Order Book and eFix Matching Service onto CME Globex. The idea was to create a single, global liquidity pool for spots, metals, and NDFs, with uniform access and matching priority across order book depth. The reality is that the impact on liquidity in the FX market will trigger a rise of ECNs and top tier banks which are best placed to be an alternative for the latency sensitive European spot FX market.

So, why does this matter? Previously, EBS (Electronic Broking Services), which was originally created by large banks as a consortium, was used by European traders as the primary market for EUR/USD, EUR/JPY, USD/JPY, USD/ CHF, USD/CNH and EUR/CHF. But with Spot (majors) and Metals Matching now taking place in New York (NY5), while Scandis, EM and ON/OFF SEF NDFs being matched in London (LD4), traded products are only available in a single location. For European traders, this means limited access to real-time quotations or trades from any major FX ECN (Electronic Communications Network).

Even though London remains the FX trading capital of the world, prices are now either delayed or come from the United States. For European dealers specializing in G10 currencies, there is sufficient latency to go back to New York to connect to EBS. Despite this, receiving data is now both a slower and more expensive process, which means SETS, London Stock Exchange’s electronic order book, becomes outdated faster. The challenge, however, goes beyond latency: for European FX traders, the real roadblock is knowing exactly where the liquidity is—which is in turn changing the roles of tier one global banks and ECNs.

Understanding the impact on liquidity

Forex is the most liquid financial market, and highly volatile. To insulate themselves against the change in time, most banks are now sourcing liquidity for buy-side clients from other banks rather than publishing a firm bid and offer process of their own. Fewer banks are now willing to take principal risk, with most feeding off the liquidity of others. Non-bank liquidity providers are proving reliant on bank credit and buy-side firms are primarily interested in data that can locate where the liquidity is – and is not.

The importance of CME futures data is therefore increasingly crucial as a growing number of banks are using this as a source for price flow formatting, and some of this is replacing EBS. Thus, having a fast-moving infrastructure is vital and will help both the buy-side and the sell-side.

Changing role of Tier-one banks

For top tier banks, their localized presence and large-scale operations mean that they will be able to better internalize FX flows, and therefore increase liquidity within the market. As a result, these banks are positioned to either absorb or replace a large portion of G10 trading that is currently on the EBS in European markets. By virtue of receiving so much flow, their ability to manage internal flow will become the source of liquidity in Europe.

Building on the scale of internalization and by managing risk, large banks will progressively be able to price competitively. By contrast, smaller vendors, who do not internalize FX flows, simply take a position and sell it back to the market. Larger global banks will be able to save on hedging costs by simply internalizing FX flows. They will also better manage other costs, offset trades and ultimately increase profits.

Furthermore, such internalization promises to check the spillover of low value transactions to competitors by providing both internal and external clients with more streamlines and efficient processes. Even high-value trades are better serviced by internalization as trades can be executed with a limited spillover of information, reducing the associated risks of market-making for the bank.

However, while the benefits of internalizing FX flows are many, it all boils down to execution. It’s not easy to set up the infrastructure needed to support such internalization but it’s exactly what will set the larger global banks apart from lower tier banks.

The growing prominence of ECNs

Since 1969, when the first ECN was established, such networks have played a pivotal role in transforming the financial markets, taking forex beyond over the counter. Although a loosely defined term, ECNs diverge from traditional exchanges as they also curate liquidity pools, maintain order books, and provide for bilateral trading as well as multi-dealer platforms. Fundamentally, their basic function has remained to act as an exchange where we have parties submitting resting orders. The ECN, like an exchange, matches buyers with sellers to facilitate the transaction. While this function has progressively become more critical for trading securities in the financial markets, the recent prime time change by the CME Group will further bolster the importance of ECNs.

However, since it is widely believed that the rise of ECNs was due in large part to the expansion of the American stock market in the 1960s, some hold that if the size of the market were to decrease, ECNs would largely merge or disappear. In spite of this, the migration of EBS Markets to CME Globex arguably changes the entire picture and reasserts the centrality of ECNs. With a shift in prime time for the forex market, traders will start to increasingly rely on ECNs, especially smaller ECNs, which can also replace the majority of G10 trading that took place on EBS in London.

This is because anyone trading spot FX out of the UK or Europe will now have to incur a certain latency to connect to their matching engine, now stationed in New York. Consequently, anyone trading out of New York will be at a comparative advantage as their capability to price will be stronger. For European and UK buyers, the market data will increasingly become stale as latency exists. Essentially, the snapshot of the order book can potentially change more rapidly than before.

This latency, or a delay in time between an order request and execution, is pivotal in the FX market, as there exists a natural financial advantage in low latency transactions. While there are other means of reducing this latency like direct market access (DMA), and general economies related to adjusting trading processes, ECNs remain the most efficient method. Although ECNs charge a certain fee and have high barriers to entry as they’re complicated for new beginners, they have certain extraordinary advantages. Apart from allowing traders to be active outside of trading hours, ECNs maintain a price feed transparency, a certain level of anonymity, and overall lower commissions compared to traditional brokers. Naturally, in light of the EBS migration to CME Globex, buyers and sellers will, instead of trading on the new EBS New York infrastructure incurring a latency, prefer to trade on smaller ECNs or directly with larger banks.

The most powerful effect will be on the role London plays as a crucial hub for FX trading. While it will remain the centre of the market, it will become increasingly characterized by trades in emerging markets and NDFs, as the change forces it to specialize. Often touted as a ‘win-win’, the market milieu will undoubtedly benefit from large banks internalizing FX flows as banks will not just heighten their profits, but provide lower commissions, a reduced dependency on external liquidity pools, and would ensure consistency in the liquidity in the FX market for clients in both volatile and stable environments. To conclude, the effects of the CME Group’s prime time changes and the impact on liquidity in the FX market will catalyze the rise of ECNs and top tier banks which are best placed to deal with latency in trades.