Pure FX: Market or mirage?

Rumours often tend to move the markets more than news. This phenomenon is perfectly illustrated by the buzz that 10 of the largest foreign exchange dealers are looking to form a bank-only FX trading platform to regain market share lost to non-bank high-frequency traders. The PureFX venture has been shrouded in mystery ever since the rumours started swirling last year. Banks are still reluctant to discuss it on the record, but most participants have an opinion about the idea.

If banks want to trade only with other banks and not high-frequency traders, electronic communication networks (ECNs) can already provide such a service, says Jim Kwiatkowski, head of sales for the Americas at FXall in New York. Since FXall’s anonymous spot trading platform relies on participants already having credit relationships in place with counterparties, it’s a way for banks to be selective about their trading partners and weed out any firms they don’t want to trade with. That view is shared by some banks in the FX market.

“The way the market is structured, there is nothing that stops any two market participants from connecting to each other. Whether it’s bilateral or by any other form, technology allows it to happen. Clients can connect to each other through a prime-broker intermediary, although this happens to a small degree at the moment. People are very creative in making it happen – they can build their own community and the FX markets have always had different pockets of liquidity, whether it be ECNs or other structures,” says Andrew Coyne, managing director and head of foreign exchange prime and G-10 electronic commerce at Citi in London.

Forex is already known for its fragmented liquidity, as ECNs and single-bank portals vie against each other to capture trade flow. A new inter-bank liquidity pool such as PureFX would further fragment the FX market, which has not seen the same level of consolidation among ECNs as some other markets.

“For the most part, they’ve maintained their market share and client base. We do see some providers that are aiming at the retail community and others that are looking to go after the investors. It’s logical because firms are trying to grow their businesses and expand their client base,” says Coyne.

Officials at Thomson Reuters, which operates one of the two primary interbank FX trading platforms, also do not expect to see consolidation among FX ECNs.

“For efficient execution of FX risk, it is in the market’s longer-term interest that liquidity not be fragmented any further. Algorithmic trading is now an important part of the market and will remain so – it is our duty and that of other ECNs to ensure the two can coexist. However, there might well be consolidation of multi-bank portals that are all competing for the same end customer. Consolidation in the retail segment would also come as no surprise,” says Jas Singh, global head of treasury at Thomson Reuters in London.

But while some might oppose the idea of another interbank platform, the case for PureFX is fairly clear – to recapture liquidity lost to high-frequency traders on the interbank trading platforms. Today, high-frequency traders provide a major chunk of the liquidity on the multi-bank systems, according to their operators.

“High-frequency trading now represents well over 50% of our daily volumes in our highly liquid markets such as GBP/USD, EUR/GBP, AUD/USD and USD/CAD,” says Singh.
Icap declines to comment but Citi, which is a member of the EBS platform, estimates 45% of the liquidity on the platform comes from high-frequency traders. “It would be difficult to say that EBS would be better off without high-frequency traders,” argues Coyne.

Other participants agree the entry of high-frequency traders into the FX markets has increased trading volumes and removed some pricing inefficiencies in the various liquidity pools in which they participate. “So many high-frequency traders are trading in all of the FX markets and arbitraging the price differences; I don’t believe those price inefficiencies happen any more,” says FXall’s Kwiatkowski.

Although FX ECNs know that by supporting high-frequency trading they are effectively exposing their platforms to a flood of liquidity, they have not forgotten the manual FX traders that might look to trade less often but in larger sizes. Thomson Reuters continually monitors the behaviour of its FX trading system to ensure manual and algorithmic traders can compete on a level playing field in terms of liquidity.

“We recently increased – and constantly review – our minimum quote life, and reduced our transaction-to-match ratio in several of our currency pairs to preserve the integrity and stability of the market,” says Singh. The vendor introduced these measures specifically to curb ‘tagging’ strategies in currency pairs with traditionally wider spreads, and plans to add depth-of-book data onto its FX spot matching service next year that may reduce the need to tag, Singh adds.
Icap launched a manual, bank-only block-trading facility on EBS at the end of last year with a pilot test comprising 10 of the largest FX banks. The new service, dubbed Continuous Match, matches trades using the EBS Smoothed Rate, a time- and volume-weighted average price.

But manual traders aren’t relying solely on the trading platforms to level the playing field and are making some changes themselves, says Singh. “It is becoming increasingly common practice among manual traders to now use liquidity aggregators that have built-in algorithms for order execution. They can be initiated directly from the graphical user interface (GUI), ensuring the manual trader can compete for liquidity against the black box.”

Meanwhile, most single-dealer portals tend to leave the high-frequency trading to the multi-bank platforms, while they address the needs of the manual traders. Coyne says banks have historically had mixed success providing direct pricing to high-frequency traders, and the GUI-based single-bank portals are geared more toward the needs of manual traders. Single-bank portals tend to be more about helping traders build a position or fix their books, he says.

“Not all multi-bank portals have streaming forwards, options or non-deliverable forwards. Single-bank portals have a greater breadth of product offering and a good track record over time,” says Coyne.