Buy side enjoys two consecutive quarters of narrowing spreads

The cost of trading currencies has declined for two consecutive quarters for buy-side firms, as banks narrow their bid/ask spreads in the most liquid currency pairs to attract flows in an increasingly competitive market.

Buy-side market participants say the pace of spread compression has picked up noticably in the past six to nine months, as FX trading has become a high-volume low-margin business for banks and liquidity providers, who are trying to compete on both multi-bank and single-dealer platforms.

"We execute trades on a variety of platforms, and using the data captured from this process we can measure very clearly our achieved spreads on spot and forward transactions. We've now seen two consecutive quarters of narrowing spreads, in Q3 and Q4 in 2013," says James Wood-Collins, chief executive of Record Currency Management in Windsor in the UK.

The rise of multi-bank FX platforms such as FXall and 360T is not a new phenomenon, but buy-side participants believe they have played a major role in forcing through this ‘spread compression'. "Multi-dealer platforms have had a big impact," says Lee Sanders, head of FX and fixed-income dealing at AXA Investment Managers in London. "We've seen a move away from the request-for-quote format towards a request-for-stream process. Providing streamed prices that can be viewed by any platform user encourages banks to display a much tighter bid/ask spread. Competition on pricing has become fiercer and more open."

The overall decrease in volumes on trading platforms in 2013 has also played its part. Although a Bank for International Settlements triennial survey released in September 2013 showed daily turnover in the FX market had jumped from an average of $4 trillion in 2010 to $5.3 trillion in 2013, FX trading platforms have endured a tough 12 months. In October, EBS reported average daily volume at a low of $77 billion. Thomson Reuters also reported a multi-year low of $97 billion. Analysis of historical volume data shows that, as a proportion of US and UK turnover, the share held by EBS and Thomson Reuters declined from 11.85% to 5.56% between October 2010 and October 2013.

"With lower volumes comes more competition between banks to get as big a slice as possible of that reduced market," says Sanders. "Banks don't really make money out of bid/ask spreads on an FX deal. They do it to get directional market intelligence so they can do their own trades. Maybe they'll use our trade to test the market to move it lower or higher. The more competitive they get, the more likely they are to win business, to see the flow and get a better sense of market moves."

Spread compression has been seen most clearly in the spot FX market, according to one senior trader at a large, London-based FX investment firm. "The main currency pairs to experience compression have been the spot G-10 pairs. For example, our best counterparty banks were offering us, on average, a two-pip spread on USD/GBP in the first quarter of last year. That has now dropped to an average of 0.8. The average across all our counterparty banks is now 1.2 pips. Similarly, we have seen a small tightening in USD/AUS – an average of 1.6 pips in the fourth quarter of 2012, now down to 1.1. We're not seeing the same pattern in the emerging markets space at all – banks only seem comfortable reducing spreads on the most liquid pairs."

Buy-side firms in a custodial relationship with banks have also seen spreads slashed by up to 50% recently, as a result of lawsuits launched by Californian pension funds that claimed they were being fraudulently charged inflated prices.

According to the London-based FX investment trader, buy-side firms have increasing power over sell-side pricing. "We and other buy-side participants are becoming more sophisticated in spread analysis. We can approach banks and tell them to improve their prices and bring it into line with other banks that have already reduced spreads if they want to win our business. It has helped us build a more price-friendly environment."