SUITS YOU SIR?
Russell J. Dinnage, Analyst Consultant at GreySpark Partners looks at redefining the optimal FX sellside business.
In November 2012, a group of London-based currency fund managers held private discussions with one another about a growing mismatch they saw emerging in the structure of the FX market.
In dealings with their buyside clients, the currency fund managers agreed that the inherent value in their businesses had become less focused on the advice they could give to institutional and real-money corporate investors on how to structure, price and execute large FX trades. The fund managers concurred that pricing, across the G10 market for currencies, was too uniform, spreads were too small and quality of trade execution was not a concern for real-money investors that were primarily concerned about finding evermore new counterparties to trade with.
Instead, the currency fund managers agreed that, in the future, the necessity of their place in the market would be their ability to connect cash-rich companies, investment houses or even individual investors with the right sellside investment bank. Doing so would allow the fund managers to redefine their place in the FX market from the long-standing role of bespoke, large trade designers into a new role as specialised facilitators of the client trades that generate higher beta for the client than the currency fund managers could provide.
Meanwhile, on the sellside of the FX market, the currency fund managers agreed that the natural proclivity of Tier I and Tier II banks to focus on eeking out a measure of proprietary profitability in FX dealing during a period of record low inter-bank market volumes was becoming increasingly frustrating for institutional and real-money corporate clients. In an effort to assuage this buyside anxiousness, the fund managers agreed that what these banks really needed was the ability to secure – almost on a daily basis – new pools of FX liquidity, especially if these pools held exposure to emerging markets (EM) or exotic currencies that could be utilised to revive the ailing practice of carry trading.
For the group of currency fund managers, the question then became: how would they go about better connecting their clients with banks searching for new pools of FX liquidity? In December 2013, this question remains unanswered, and the largest FX dealers are becoming increasingly concerned.
Take, for example, the Nov. 29 comments of Deutsche Bank’s global head of FX Kevin Rodgers at an event run by FX Week in London. In a classic sellside critique of the provision of FX liquidity by high-frequency trading firms, Rodgers opined “don’t call it liquidity” when HFT trading outfits act as non-bank FX market makers on daily basis within so-called dealer-to-client, multi-dealer platforms (MDP) like Thomson Reuters Matching/ FXall or HotspotFX.
“The market has moments when liquidity falls away and then comes back again, and [liquidity] is a lot patchier than it has been historically. There are fewer market-makers and less risk capital being deployed, and you are already seeing the consequences [of these factors] in the market,” Rodgers said. He added that if there was another financial crisis akin to the events of 2008, then the experience of market-making banks being solely responsible for keeping liquidity flowing in the wider FX market would be “unpleasant.”
Luckily for the FX market Deutsche Bank is not the only large dealer on the street with an acute awareness of the challenges posed by Rodgers’ concerns for long-term sustainable G10 currency liquidity. Based on GreySpark Partners’ observations of leading sellside FX dealers, several banks were beginning at the end of 2013 to take a top-down, reorganisational approach to their long-standing business models for G10 and EM FX.
In doing so, the banks could effectively kill two birds with one stone through refinements to e-FX strategies for pricing clients into emerging or exotics currency markets that will likely result in better buyside client retention across the board.
Resolving the FX liquidity conundrum
It is no secret that the majority of Tier I FX banks recognise that, in order to drive growth in EM currencies business and the wider base of clients this focus yields, a strong base of voice and e-FX G10 dealing capacity is required. And while many of these banks are already taking steps to reorganise their FX businesses so that they intermingle with rates and credit trading, there is at least one large European sellside firm that sees a deeper level of opportunity created by this reorganisational move.
The opportunity for the bank in question lies in the standardisation of FX options pricing via a single-dealer platform (SDP) for EM clients by packing the options into structured derivative products. In seeking to include more of these structured FX options derivative products on its SDP, the bank hopes it will be able to provide e-FX services to a wider base of EM clients under one, consolidated dealing framework through the commoditisation of sophisticated products that are notoriously difficult to price electronically.
The opportunities for banks with an SDP capable of pricing clients trading FX options into structured derivatives products that can be commoditised over time are clear. According to the 2013 edition of the Bank of International Settlement’s annual FX market survey, non-dealer financials accounted for 61% of the total volume recorded in FX options and other products in 2013 (see Figure 1).
Of that 61% of FX options turnover in 2013, hedge funds were responsible for 21% of the non-dealer financial counterparty volumes.
Organisational or structural changes by banks to increase their ability to electronically price FX options for clients reflects the sellside’s desire to remain nimble in EM regions where trading in a number of asset classes remains largely over-thecounter and, as a result, unregulated. In the EU and US, the new normal of the best execution-focused regulatory environment has led many leading FX dealers to tell GreySpark that they are increasingly frustrated at the need to provide clients with spot or forward FX pricing on MDPs because the bid/ask spreads in the requests for quote they receive on many FX SEF platforms are too narrow.
Instead, further development of a banks’ e-FX business on its SDP is becoming the priority as FX trading is reorganised to better partner with the rates and credit businesses. There are a number of innovative, SDP-focused solutions in the works to address these needs.
Suits you, sir?
These types of sellside developments are good news for the currency fund managers seeking new avenues of investment opportunities for their institutional and real-money corporate clients. According to a report published recently by US private bank Brown Brothers Harriman, investment managers want their sellside partners to offer more access to bespoke trading opportunities that can be commoditised over time. The reason is simple: as operating expenses rise and investment risks generally increase in regulated and unregulated environments alike, many buyside firms are considering ending the in-house management of their FX exposures, according to the BBH report.
The final frontier then becomes the provision of FX transaction cost analysis (TCA) in an effort to quantify the effectiveness of best execution regulatory standards in the EU and US. However, FX market-consensus on what the final form of the ideal currencies trading TCA solution should be remains a long-term challenge.
Ironically, as the sellside banks work to further commoditise their FX structured product offerings in a bid to streamline the electronic provision of EM and exotics exposure, there are also several currency fund managers in London that are developing FX price benchmarking and indices for general consumption. These new attempts at a baseline of FX data could one-day lead to the creation of a new, market-leading currencies TCA solution, according to one of the fund managers. The fund manager added that if his firm did not develop this type of trade transparency solution first, then the sellside would.
©Best Execution 2014