FX: Non-bank market makers are ‘vital’ for liquidity

A recent study published by Greenwich Associates refers to non-bank (LP) liquidity providers creating a more liquid, transparent and efficient foreign exchange market over the long term.

Of more than 1,600 global investors surveyed for the study, 5% had access to non-bank LPs – up from 4% in 2014 – while 20% of volume was executed by these investors through non-bank LPs last year , compared to 16% the year before.

These figures do not include transactions made with non-bank cash on an anonymous basis.

Non-bank market makers who allocate capital to have a proprietary backbone to their pricing facilities and not just “price recycling” improve liquidity and access to it, suggests Paul Chappell, founder and director of investments of the British currency management company C- See.

Frank van Zegveld, Head of Strategy and Investments at Solid Trading, agrees that it is important to distinguish between participants who are able to store risk and add unique liquidity to the market and those who to pre-hedge the flow in the market.

According to David Ullrich, senior vice president, execution strategies at FlexTrade, some non-banks bring together different players and locations, and provide significant new pools of liquidity in specialized areas such as USD/MXN.

“Others provide riskier liquidity provisions, which means they have the ability to fix the price and not necessarily clear immediately, like a bank,” says Ullrich. “This matters because banks’ ability to hold positions is being degraded by regulation and internal costs of capital, as well as the loss of experienced market makers.”

If non-banks cannot accumulate and hold large positions for long periods of time, they act as short-term intermediaries.

However, the current climate around the use of capital and risk tolerance within banks makes it unclear to what extent most banks behave differently – and intermediaries provide a valuable service when they bring together and effectively offset the liquidity demands of directional traders, observes David Mechner, CEO of Pragma Securities.

KCG is most active in the equity and ETF markets, where it is one of the few non-banks providing liquidity to counterparties more frequently, while banks remain the main intermediary, says Rob Crane, Head of Services of execution.

“There has been a shift towards non-bank sources of liquidity over the past two to three years, although the market remains fragmented in Europe with 40 members of the Principal Traders Association providing a range of liquidation solutions across classes of assets and geographies,” he says. .

David Puth, Managing Director of CLS, says the prevailing view is that increasing non-bank participation in the FX market will complement the traditional dealer model, adding: mitigating risk – and in particular risk settlement – has grown in importance.

Asked about the impact of internalization of liquidity by banks on the market, C-View’s Chappell suggests that it is debatable to what extent internalization actually occurs within banks as opposed to what is effectively laid off in interbank and between market maker transactions, while FlexTrade’s Ullrich claims that internalization helps conceal the amount of actual flows entering the market.

“If we take the banks’ word for it, 70% internalization means that a $100 flow now looks like $30, which helps control information leakage,” Ullrich adds. “Internalization has a positive impact on the market as long as spreads remain good and no last look takes place.

“At best, it slows down the execution process, minimizes market impact, and improves the best execution outcome for both the buy-side and the sell-side.”

Roger Rutherford, COO of ParFX, suggests that in a truly efficient market, banks would have the choice of insourcing or trading in a public market.

“Sometimes it will be wise to internalize flows; this allows banks to internally match (uncorrelated) flows from customers and leads to higher profits, lower brokerage costs and less reliance on external liquidity pools,” a- he declared.

“A dramatic increase in disruptive trading patterns on some platforms has forced banks to internalize, leading to a vicious cycle of further internalization that reduces liquidity, further degrading market efficiency.”

Some banks have decided to completely outsource their market making activities, but Ullrich does not necessarily expect this trend to accelerate.

“New solutions that simplify and reduce the explicit costs of LPs – such as term compression and collateral management requirements – can allow them to rethink and get back to market, or potentially allow non-banks to join this market segment in ‘renting a balance sheet'”, he concludes.