Streaming with the enemy: banks turn to non-bank liquidity

In the popular imagination, public trading venues are the domain of predatory high-frequency traders, feasting on the flows of banks and their clients.

The truth is more complex. Firms that are often seen as an enemy of the banks are now – at times – their strategic partners. The idea is that banks can use liquidity from prop traders as a supplement to their own through bilateral streaming arrangements. This gives banks a chance to hedge themselves or source liquidity for their clients without venturing onto a public venue, where information leakage can push prices against them.

“Having a non-bank market-maker as a partner is great because we can obviously trade liquidity between ourselves without hitting any tape – without giving information to the market – and it provides a much different exchange of liquidity than we could get on some of these external venues,” says a foreign exchange trader at a large US bank.

Citadel Securities and Virtu Financial are among the non-bank liquidity providers (NBLPs) to have signed liquidity partnerships with bank FX desks.

NBLPs that trade FX – and could potentially be in the partnership game – include Flow Traders, Jump Trading and XTX Markets. All three declined to comment for this article.

Tie-ups between banks and NBLPs are not new, but have often been cast in simple terms, with regional and mid-sized banks taking advantage of white-labelled pricing to give their local clients access to global markets. But concerns about declining liquidity on public venues are also prodding some tier one dealers to consider these strategic alliances.

It’s a more common feature of the FX algo business, allowing orders to be filled against non-public prices and therefore limit market impact – the danger that the price will move as an order is sliced up and executed over time – but has also been considered by banks’ principal trading desks.

“Although they’re non-bank market-makers, some of the big ones have the same liquidity profile as the banks on how they manage your flow. If they are de-risking our business and it suits my interests, then our algo will trade with them,” says the head of FX algo trading at a large European dealer.

Having a non-bank market-maker as a partner is great because we can obviously trade liquidity between ourselves without hitting any tape

FX trader at a large US bank

Citadel Securities is one of the firms seeing growth in this business. It reports market-making volumes to banks increased 65% year-on-year in the first half of 2022, while liquidity provision specifically to bank algo products climbed by more than 94%.

“We feel we have a compelling value proposition, including differentiated pricing and strong execution quality. Some banks have chosen to leverage us as a strategic partner for supplementary liquidity to enhance their franchise and better serve their client base,” says Kevin Kimmel, global head of eFX at Citadel Securities.

Key planks of the NBLPs’ sales pitch are their willingness to take risk – holding positions rather than immediately seeking to offload the exposure – and to provide specific, bespoke pricing. If the alternative is to trade on one of the FX market’s primary venues, EBS or Refinitiv Matching, those arguments can be appealing, says a senior FX executive at another US-based prop trader.

“Primary venues are all anonymous, but direct disclosed trading allows for segmentation and discrete pricing – and discrete pricing gets better prices for better flow,” he says. “People realised that while there are a lot of uses for primary anonymous venues, there’s also a lot of activity that’s highly price sensitive, and for your most price-sensitive activity, you’re going to get the best prices by trading over a trusted, disclosed relationship.”

Trust is a key word. In recent years, Citadel Securities established what it called ‘exclusive risk partnerships’ in which it becomes the sole liquidity provider to a bank in certain currency pairs. In this scenario, Citadel Securities’ liquidity is white-labelled – the bank’s end-clients are not aware the firm is the ultimate market-maker, and the stream of prices must be reliable.

It can take a while for both sides of a liquidity partnership to become comfortable.

“There’s a lot of diligence around choosing a liquidity partner, and a bank won’t take on a partner unless they know they can rely on execution quality. Who the partner is really matters on both sides of the relationship – it’s a very customised approach,” says Kimmel at Citadel Securities.

Arguably, partnerships with the larger banks could become more common as their technology is better equipped to receive pricing from a wider variety of liquidity sources, including NBLPs – and some have become increasingly frustrated by what they see as high fees and declining depth at the primary venues.

However, many banks still regard the primary venues as a key source of liquidity. In addition, platforms are making a play to win back the banks. Refinitiv, for example, recently launched a market-making rebate scheme on its Matching and Pricestream venues for active dealers.

And there is still scepticism over the ability of NBLPs to consistently provide liquidity in times of stress, which could deter some banks from setting up bilateral connections.

“I guess it’s always been our experience that the non-bank LPs, maybe with the exception of one or two, are quite quick to step out and pull their liquidity whenever things get a little bit tough. It’s kind of what we expect from them as they’re not there to be service providers – they’re here to make money,” says the global head of electronic FX at a second European-based dealer.

Editing by Duncan Wood