Liquidity management continues to be a critically important topic in the FX market due to persistent market fragmentation and the spawning of more players, venues and platforms. Added to that is the pressure on FX trading firms from clients seeking more reliable access to liquidity and a diverse range of liquidity providers as opposed to the single provider approach of the past. Throw in some regulatory tailwinds, such as best execution rules and the FX Global Code of Conduct, and the list of catalysts is complete.
Fortunately, technology has advanced to offer some assistance to market participants – from brokers to liquidity providers to liquidity takers. The key developments have been around data. For example, application programming interfaces (APIs) have enabled data to be exchanged between counterparties, and more advanced analytics have allowed this data to be turned into actionable insights that can not only improve performance and increase transparency but also help to foster a more productive relationship between liquidity makers and takers.
“..the only sustainable approach is to invest in proper liquidity management, where source flows are segregated according to flow profile and priced by a cultivated set of liquidity providers..”
Bailey White
Technology advances
That said, advances in technology have also led to the complexity that makes the FX market so challenging. Technology has bred fragmentation in the FX market and led to an ever-increasing number of liquidity providers, venues and platforms, says Bailey White, director of electronic trading and execution at Australia-based multi-asset prime broker 26 Degrees Global Markets. “Most platforms offer functionality to consume liquidity from multiple liquidity providers (LPs) and venues. It is easier than ever for a liquidity consumer to over-aggregate or execute inefficiently. This is particularly relevant in the retail broker market, where spreads receive a disproportionate level of attention due the competitive nature of that market. There is always a temptation to add liquidity to improve pricing in the short term. In the long term however, the only sustainable approach is to invest in proper liquidity management, where source flows are segregated according to flow profile and priced by a cultivated set of liquidity providers who specialise in managing that type of flow,” says White.
“In the retail broker space, regulation and client expectations are also driving the requirement for additional redundancy. All aspects in the chain of market access must be made highly resilient with multiple levels of redundancy. Prime brokers, LPs, application programming interfaces (APIs) & platforms. Ultimately, redundancy has become a critical differentiator for providers, such as prime of primes or platforms, in the FX market.”
A key development in liquidity management is the increasing reliance on data, says White. “Consumers are using data to better understand the value of their flow, and therefore demand better pricing from liquidity providers. Likewise, LPs are providing more advanced feedback on inefficiencies in execution that lead to market impact. In combination, these factors are contributing to more efficiency in liquidity provision and consumption. Different flow profiles are being more optimally priced, rather than subsets of impactful flow resulting in higher execution costs for benign subsets. This is an area where 26 Degrees has placed significant emphasis with its retail broker client base and panel of liquidity providers,” says White. “Brokers with access to the best pricing have a competitive advantage, and the best way to access the most competitive pricing is to segregate hedge flows according to flow profile and market impact. 26 Degrees helps our clients to identify different flow profiles and execute the corresponding segregation to ensure different flow profiles access a pool of optimal liquidity – whether that be for benign skew-safe flow, or flow exhibiting greater market impact,” says White
“Liquidity management is now much more about the use and communication of data than it is about relationship alone. This applies to both the buy and sell side, and those that do not commit to a data-driven approach are being left behind. Data analysis and increasingly machine learning techniques are critical to the flow segregation process that enables liquidity consumers to demand more competitive liquidity and lower execution costs,” says White.
“Similarly, liquidity consumers are more actively using data to optimise their liquidity panels for different flow profiles. For example, data can reveal that the cost of rejects for a particular LP may necessitate their removal or replacement. In addition, the post-trade market impact profiles for different LPs are also scrutinised by sophisticated liquidity consumer/aggregators to ensure that the risk management of LPs is in-line with expectations for that pool. It only takes one LP to exit risk more aggressively for market impact to be amplified, leading to wider spreads and higher total execution costs in the long-term,” says White.
It is important for FX trading firms to be able to prove that FX liquidity management is being performed effectively, says White. “It can be an expensive and time-consuming function. Ultimately, success is measurable though – for many firms, this may be a reduction long-term execution costs, for others it may be the competitiveness of quoted spreads across the trading day. These measures of success can be tracked via data to audit the success of the liquidity management function.”
“It is fundamental that the management of liquidity be dynamic and evolve with client and regulatory requirements, changing almost daily.”
Antony Parsons
In terms of future developments, White foresees a continuation of the existing trend of fragmentation. “Trade flow will be increasingly segregated based on impact profile and execution method. Likewise, we expect an increase in the number of venues and platforms through which FX liquidity is commonly accessed. It is important that liquidity providers can simplify the liquidity management function and provide data that supports decision-making. Traders and liquidity managers should be able to access analytics on their execution quality, including market impact. They should also be able to discuss with their providers about how different execution styles or flow segregation might change the quality of liquidity that they can access,” says White. “The latest generation of liquidity analytics are key to this process.”
Higher standards
The sheer variation of client requirements, as well as increasingly high standards expected of pricing and execution, means managing FX liquidity is even more important than ever, says Antony Parsons, head of liquidity at prime broker and liquidity provider Finalto. “Ensuring that the most sustainable liquidity is sourced from genuine market makers who limit market impact is imperative to providing great liquidity to clients. Avoiding the temptation to over-aggregate, but instead building core relationships with fewer LPs who will build directional skew into their price is vital to construct a competitive book to clients. This asset needs to be protected by ensuring liquidity is only passed onto specific clients where pricing will not be recycled through ECNs. It has become very easy for market participants to access trading venues as both a maker and a taker which can lead to skewed prices being leaked. If an LP identifies this, they will pull their liquidity, ” says Parsons.
There is also more pressure on trading firms to seek more reliable access to liquidity, acknowledges Parsons. “With greater market access to transaction costs analysis (TCA) systems, it is very easy for firms to see if they are paying too much in execution costs and so will have the need to look for alternative liquidity sources. While having a single provider is not ideal for reliability reasons, it makes sense to diversify to create healthy competition among LPs. Ensuring access to a broad range of liquidity helps when the requirement for bespoke setups arise from clients.”
Data has become more important than ever and the ability to share certain statistics automatically is becoming more popular among many relationships, says Parsons. “A real transparency about origination of flow helps to ensure liquidity is constructed in the most optimal way. A proactive approach to ‘liquidity & tag’ management by consumers is now expected by providers as analytics packages are now almost standard within the industry. As always, trust and track record of historic performance from both sides still hold merit to the future relationship,” says Parsons.
There is also a technology angle to the increasing demand for more data and analytics, says Parsons. “Post-trade analytics systems and access to raw trade/price data are the core to any good FX liquidity setup. The usage of a front-end system to monitor aspects such as market impact & execution costs makes day to day running efficient. However, the ability to view and query raw data sets takes analysis to a higher level – this gives the ability to ‘slice and dice’ data in customised ways which may not be included within the standard package platform. APIs between consumers and providers for data sharing is becoming more popular as it allows providers to make informed decisions on their pricing metrics very quickly without the need for manual file sharing,” says Parsons.
There are many ways analytics help consumers beyond execution benchmarking, from simple monthly LP rankings or indicators of pricing changes from a specific provider, says Parsons. “It can allow providers to spot patterns in consumers trading styles that may need to be addressed but also give consumers the ability to highlight specific ‘opportunities’ for the provider. TCA is necessary for any trading firm so using the specific tools will help ensure the liquidity sourced is the most optimal – any smart order routing will take these analytic results into consideration to minimise execution costs. A great benefit of shared data and analytics is its ability to open a dialogue between both sides and further enhance the liquidity and relationship,” says Parsons.
“Data science represents the core of the activity of a liquidity manager as it allows us to have a clear picture of performance both on the liquidity provision and consumption end,”
Andrea Sanna
On the subject of auditing FX liquidity management activity, Parsons says it is important that procedures are reviewed often to ensure what was relevant yesterday is still useful today to maintain competent liquidity. “It is fundamental that the management of liquidity be dynamic and evolve with client and regulatory requirements changing almost daily. Efficient and easily changeable reporting based on raw data sources for topics such as ‘best execution’ is certainly an advantage.”
The relationships between liquidity providers and consumers are shaped by price competitiveness, skew safeness and performance monitoring
So what will the next generation of FX liquidity management tools look like and what steps are being taken to realise these ambitions? On this Parsons agrees with White. “Data is important and the ability to routinely share between providers/consumers is growing even more popular which should allow for further systematic liquidity enhancements on both sides in the future,” he says. “It will open up new avenues of conversation which leads to decisions being even more data driven rather than relationship based.”
Market fragmentation
FX liquidity management remains challenging due to several factors but especially because of market fragmentation caused by an increasing number of players, venues, and platforms and a lack of centralized flow, says Andrea Sanna, head of execution and liquidity management at ALP Financial (AlpFin).
“This aspect makes it difficult for dealers and brokers to access consistent and reliable channels. An additional layer of complexity is represented by regulatory changes, market volatility and the ever-evolving technological landscape,” says Sanna. AlpFin addresses these challenges by focusing on its distribution channels and liquidity sources with the aim of competitive pricing and low execution times. “This approach helps mitigate the impact of market fragmentation and ensures efficient liquidity management,” says Sanna.
Competition has made liquidity management a critical issue and led trading firms to seek a more diverse approach that is not reliant on a single provider. “Trading firms in the FX market face pressure to maintain a competitive edge and ensure reliable access to liquidity,” says Sanna. “Relying on a single provider can expose firms to counterparty risk, limited price competitiveness, and liquidity shortages during volatile conditions. Diversified sources of liquidity across products and regions reduces dependency on a single provider, enhances price competitiveness, and mitigates risks associated with market volatility.”
The relationships between liquidity providers and consumers are shaped by price competitiveness, skew safeness and performance monitoring, says Sanna.
Reliable data and enhanced analytics – including benefits from the adoption of artificial intelligence (AI) – are key to improving FX liquidity provision outcomes
Consequently, AlpFin has looked to partner with analytics firm Lucera to provide data to both liquidity takers and makers. According to Sanna, these analytic capabilities allied with reliable liquidity “foster strong and credible relationships with clients, ensuring mutual benefits and long-term collaboration”.
“Data science represents the core of the activity of a liquidity manager as it allows us to have a clear picture of performance both on the liquidity provision and consumption end,” says Sanna. “At AlpFin we put all our focus on providing to our customers and LPs actionable information that enables traders to take immediate actions to improve their pricing competitiveness or reduce the market impact of their flow. The focus on transaction costs analysis is paramount for us at AlpFin and we do think that pre and post TCA metrics will become a pivotal tool in the coming years also for the less sophisticated players.”
Technology, including application programming interfaces (APIs), is crucial for FX liquidity management as it enables seamless integration, real-time data exchange, and automated trading strategies, says Sanna.
“APIs facilitate direct communication between trading platforms and liquidity providers, enhancing execution speed and accuracy in pricing. The adoption of FIX API communication standards delivers benefits such as improved operational efficiency, better risk management frameworks opening the door to efficient algorithms that optimize liquidity sourcing and execution, ultimately leading to reduced execution costs and enhanced trading performance,” says Sanna.
It is also helpful for trading firms to audit existing FX liquidity management activities because it identifies inefficiencies, potential risks, and areas for improvement, says Sanna.
“At AlpFin we put a lot of effort in improving our internal liquidity management processes to provide smoother services to our clients and to guarantee stable liquidity provision. Further steps to achieve a successful audit include defining clear objectives, gathering comprehensive data across all liquidity management activities employing advanced analytics to scrutinize data whilst benchmarking performance against industry standards. Engaging independent experts for an unbiased evaluation and regularly updating audit processes to adapt to market changes are also critical.”
In Sanna’s view, next-generation FX liquidity management will be characterised by increased automation, advanced analytics and greater use of tools that allow to digest and interpret large datasets. “We think that artificial intelligence will play a pivotal role in this respect together with the possibility to distribute and consume data via API. The usage of spreadsheets and standard reports will instead become less common but still human intervention and bespoke analysis will be requested by liquidity consumers and liquidity providers. These technologies will enable more precise liquidity analysis, real-time risk management, and proactive decision-making.”
Challenges and opportunities
The large and still growing number of FX trading venues is creating both challenges and opportunities for trading clients, says Stephen Totten, managing director – head of institutional and quantitative products at oneZero. “There are dozens of ECNs and a very large number of bank makers, each with their own protocols, matching rules, order types and liquidity styles. An experienced technology partner can help firms to navigate this complex liquidity environment in a more efficient way, not only from a connectivity point of view, but also with respect to data, where our analytics and reports can really help customers understand how to optimise their liquidity and execution.”
“Ideally, FX trading firms should be having conversions with their LPs on a regular basis so that they are able to implement technology-assisted improvements in their pricing and risk management,”
Stephen Totten
The adoption of more sophisticated algorithmic trading strategies is also placing a premium on the use of technology that can help algos to deliver their full benefits, says Totten. “In addition, the trend towards different native order types being offered by competing venues is also creating opportunities for clients, particularly where we see an increasing number of market makers allowing selected customers to access their end franchise, by posting liquidity.”
The pressure on FX trading firms to seek more reliable liquidity access is steadily increasing, says Totten. “Renewed macroeconomic volatility means that there is greater disparity between liquidity providers in various currency crosses at different times of the day, and under market conditions that can be significantly affected by factors such as the release of key economic data, like the US payroll or inflation announcements. Fortunately, increasing numbers of banks now have more access to sophisticated technology tools that allow them to run complex FX risk management strategies with a robust set of automated controls, show trading axes on a disciplined basis and provide high quality liquidity on a 24×5.5 basis.”
Reliable data and enhanced analytics – including benefits from the adoption of artificial intelligence (AI) – are key to improving FX liquidity provision outcomes, says Totten. “The ability to turn trade data into actionable insights empowers our clients to understand their client flow, associated hedges, and the intricate relationships they have with their liquidity providers.
“Creating reliable data pipelines is challenging and many industry solutions are undermined by weak data sets and unreliable connections and data collection points. We record every liquidity provider tick that enters our system, amounting to over 10 trillion quotes monthly, for example. This wealth of data is securely stored in the cloud and made readily available to our clients,” says Totten.
OneZero has also developed tools to monitor LP performance, such as its Maker Pool Replay tool which tests new liquidity configurations without assuming the risk of real-world implementation. It is also useful for firms to audit their existing liquidity management activities, says Totten. “Ideally, FX trading firms should be having conversions with their LPs on a regular basis so that they are able to implement technology-assisted improvements in their pricing and risk management, and ensure they’re continuously adapting to market conditions and changes in their own franchise or trading strategies.”
This regular review, combined with analytics, helps a bank spot both problems and opportunities in their liquidity, and to work with their providers to ensure both sides have a mutually beneficial relationship, says Totten, “Maker Pool Replay helps clients undertake a deeper audit of their providers, where we can backtest historical trades against a range of makers and liquidity streams, and deliver accurate models of how any changes would impact PNL and other key metrics.”
FX liquidity management decision making will become increasingly automated as market participants collect larger, richer data pools, and as execution becomes even more electronic, says Totten of the future for liquidity management. “There are many examples of next steps that can be taken to extract greater gains from automation, such as helping liquidity consumers to select the best off-the-shelf algo from the alternatives offered by oneZero, by banks and by other LPs,” says Totten.
However, Totten adds that there is still a need for manual involvement. “We are still in a liquidity management environment where some manual oversight is required, partially for compliance reasons, but also because data sets may not be rich enough to inform performance in certain market conditions, such as trading of less liquid FX pairs or when a major shift in sentiment occurs.”