Editorials
Taking a more holistic approach to the business of FX Liquidity Management e-FOREX - April 2011
Liquidity distributing banks are looking to build more holistic liquidity management systems that are able to cater for a faster, more diverse, more complex and more competitive marketplace. Nicholas Pratt examines some of the challenges involved and the ways they can be resolved.
Quality of liquidity sources
One of the challenges in the liquidity management space is how to add qualitative analysis to what is essentially a quantitative process – how do you rank the quality of various sources of liquidity? In theory you could use an enhanced pricing engine that employs complex event processing (CEP) technology to assign a weighting factor to particular liquidity providers, in particular currency pairs in addition to the price of any sourced liquidity, to decide which liquidity provider to execute against. While this may work in theory, we are yet to see a fertile market for such an approach, however there are a rising number of application developers providing exactly this mix of qualitative and quantitative information.
“We are primarily focused on liquidity redistributors that deal with 18 or 19 of the top banks and then feed that liquidity down to their clients,” says Yaacov Heidingsfeld, founder and chief executive of TraderTools. “We gather and provide a wealth of statistics to both the providers and the distributors that tells them who were the most successful trading partners over the course of a month in both specific currency pairs and in all currency pairs – i.e., who offered the best price and who was able to fill the highest percentage of both orders. By using this information and this technology, both liquidity providers and liquidity redistributors are able to monitor and improve their relationships.”
The developments in technology has forced banks, to some degree, to deal with non-traditional participants such as high-frequency hedge funds and multi-asset traders who are able to place electronic orders through ECNs and compete with the traditional FX banks for business. The new participants are using CEP engines to enter the market and while they do not have the long-established relationships with liquidity takers that the major FX banks have, they are able to offer highly competitive pricing in an increasingly transparent world. And they are being included in the aggregation engines of the liquidity providers.
Two consequences of the increasing number of non-traditional FX participants are an increased focus on technology and greater adoption of the kind of trading tools that have been more commonly used in the equities market, for example. “The technology is constantly pushing the industry to new speed limits. It is not so much a question of latency but if you are using algorithms, the faster you can generate orders, the more successful you will be,” says Heidingsfeld.
New trading models
One of the biggest changes in the FX marketplace that has resulted from the increased use of algorithms, is the fact that not all participants are posting two-way prices, says Heidingsfeld. A lot of the new algo-driven trading models are creating orders that are either buy or sell, but not both, and posting them on multi-party anonymous platforms. This is a fundamental change from the traditional trading model where banks post bid and offer prices – a change that has sparked a debate between the traditional and non-traditional participants in the FX market, says Heidingsfeld. He goes on, “The traditional players think that all participants should be forced to issue two-way prices and the non-traditional players disagree, arguing that just because this is the way things have always been done, does not make it right. They argue that they are providing extra liquidity, even if it is one-way, thereby satisfying market demand. If that were not the case, there would not be anyone executing against their offers.”
But from a technology perspective, liquidity management systems have to cater to both models and this is where there can be a knock-on effect in the shape of the liquidity mirage. “A lot of these algorithmically-driven execution systems generate a lot of orders in the same areas. The liquidity mirage applies to any institution that does not understand that when they make the same price available on multiple venues, they create the potential to be traded against, in a much larger way than originally intended. That is why I need to have faster algorithmic ability – because if my price is traded against, I can adjust my positions and prices accordingly,” notes Heidingsfeld.
This is not to say that the order-driven market described above, and created by the new participants in the FX market, will ever exceed the quote-driven market operated by the major FX market-making banks. But it is indicative of the trend for trading practices and models to be imported from one asset class to another. One such trend is the growing penchant among traders for multi-asset trading and including FX within these strategies.
Heidingsfeld does not see this trend as having a major impact on the FX market. “It is good to have a multi-asset approach to viewing P&L and managing risk but, in terms of trading, I think most participants will continue to position themselves in what they’re good at,” says Heidingsfeld. “So I don’t think liquidity management will become more holistic, it will become more specialised. While the larger players may be able to be all things to all people, their smaller counterparties will be driven towards specific liquidity providers. I think the FX market is big enough to cater to all of these different approaches – quote-driven or price-driven; single-asset class or multi-asset class – without affecting the price dynamics. The most important thing is that liquidity begets liquidity.”
