“The Bank for International Settlements (BIS) survey states that turnover is a rough proxy for liquidity and, if it is, liquidity is at an all-time high,” said Gavin Wells, moderator of the FX Day at Sibos on 23 September 2019. “Yet if you talk to market participants, they would tell you that the capital implications have led to a reduction in credit, which has reduced market access, which means they have less liquidity. So how can both conditions exist?”
Increased capital requirements have certainly cut the number of banks willing to make markets. The 2019 version of the triennial BIS survey of FX found the top five banks account for half of daily turnover. The health crisis and associated financial turmoil have inevitably had impact on liquidity in the FX market. We therefore felt it would be instructive to go back to the experts who contributed to the recent Sibos debate on Liquidity to see if their opinions had changed or if there are now new insights into the supply of liquidity.
In September 2019 the experts position was that most banks now source liquidity for buy-side clients from other banks rather than publish a firm bid and offer process of their own. This “recycling” of liquidity may even be prompting the shrunken class of market-making banks to widen spreads. Chris Purves, head of the Strategic Development Lab at UBS, confirmed the bank is using “watermarking technology” to identify counterparty banks recycling its liquidity. “That is absolutely necessary these days to understand how the market itself is working,” he said.
True market-makers are hard to find. The mis-named non-bank liquidity providers (NBLPs) have not replaced the lost banking liquidity either, because they are themselves dependent on bank credit. Richard Turner, a senior currency and equities trader at Insight Investment, insisted asset managers are supplying liquidity. “The assumption has always been the sell-side provide the prices and the buy-side consume the prices,” he said. “We have definitely looked at ways that we can be the market-makers at times, if it suits our flow and what we are doing.”
Are the widening spreads in this crisis actually keeping the markets liquid by encouraging more risk taking in search of gains?
It is felt that spreads are reflecting changing liquidity and volatility conditions and are not encouraging more risk taking. Speculating/hedging activity goes on as before but in this environment there is probably a tendency for clients to shy away from running algos and prefer to trade risk transfer.
“Widening spreads are a function of the fact that market makers are taking more risk to offer liquidity and also to warehouse risk. Ultimately, market makers are providing a service, and what they charge needs to be proportional to the risks they are taking. Liquidity is always going to be at a premium at times like this.” Saeed Amen
Asset managers supplying one-way prices are not, of course, the same thing as banks making two-way prices. Quantitative asset managers believe the key to liquidity, as to trading opportunities, is data. “The style of client that we are talking to now has absolutely changed,” explained Chris Purves. “They are typically voracious consumers of data. Normally, any conversation starts with, ‘What data sets have you got? What can we have that we do not have already?’ Asking how much liquidity you have got in foreign exchange is often an afterthought now.” The industry therefore needs data on flows, not just spreads.
As it happens, more plentiful data has boosted liquidity, in the sense that streaming price feeds and trading algorithms make it easier to find. But the potential of data is still constrained by the fragmentation of the FX market, resulting in discrete packets of data that are useful for transaction cost analysis (TCA) but useless to traders making day-to-day decisions.
Xavier Porterfield of New Change pointed out that market impact is the most important determinant of cost - and understanding it well enough to build a trading algorithm requires data on flows as well as spreads. “You need to know – or at least have an idea – of how much liquidity was available when you came to market,” he said.
Data also means different things to different institutions. “The liquidity that you see is not the same as the liquidity that other people will see,” explained Saeed Amen, a quantitative FX researcher and founder of Cuemacro. “So you do need to do your own customised analysis. Just because a large pension fund can execute a certain order doesn’t mean that you can.”
Has this crisis revealed deficiencies in current FX datasets?
“I think that it certainly highlights that data is important. Comprehensive intraday volume data could help us understand if trading patterns are changing significantly during the crisis, and hence where we might be better able to source liquidity at these difficult times. Data is key in understanding where the market is trading, in an input into transaction cost analysis, or to backtest trading strategies.” Saeed Amen
Technology has added liquidity, by multiplying the number of trading venues and spawning aggregation services to overcome the fragmentation they create. At the same time banks are now furnishing buy-side clients with automated execution at firm but streaming prices. In fact, for trades of normal size in major currency pairs, the stability of spreads indicates that liquidity is no longer a problem for the buy-side. The liquidity problem is largely confined to emerging market currencies, with “flash crashes” largely attributable to trades occurring outside normal trading hours. Besides, “flash crashes” of that kind seem to be abating.
However, Chris Purves thought the “flash crash” problem could reappear in a more damaging guise, as technology and data increase correlations between FX and other financial assets. “Over time this is clearly going to affect the dynamics of the market,” he said. “If it becomes so utterly inter-connected that a trader in equity is going to affect a trade in credit, which is going to affect a position in FX, if we think we have had some flash crashes so far, you ain’t seen nothing yet.”
How serious is the risk that Emerging Market currencies need to either shut down or fundamentally crash?
It is commonly agreed that at times of stress emerging market currencies always tend to overshoot given their illiquid nature, but eventually market forces will bring them back in line with valuations. At the extreme some emerging markets central banks may well resort to capital control measures.
“Levels of FX volatility have been high over the March period, but are no way near the levels seen in 2008.”