Live from the Finance Magnates Virtual Summit 2020: Riding the liquidity wave
More flash crashes, multi-asset volatility and how to risk manage. The liquidity provision sector is the vital lifeblood of the FX industry. Here is the current landscape directly from the minds of the liquidity sector’s leaders
Access to Tier 1 liquidity has been a bone of contention within the OTC derivatives industry for many years now.
Beginning in 2015, when Citigroup issued an internal memorandum to its prime brokerage division speculating that the extension of counterparty credit to OTC derivatives firms would likely result in a 57% default ratio became wider knowledge across the banking sector, resulting in the curtailment of prime brokerage agreements, and the requirement of huge capital to be displayed on balance sheets by any brokerage wishing to have a direct prime brokerage account with a Tier 1 bank.
In some cases, banks required over $100 million to be displayed on a balance sheet in order to maintain a prime brokerage agreement. This led to a huge rush toward the b-book for many brokers who were not only disillusioned with the banks’ disdain for what had previously been their core business providers, but also highlighted a one way street between banks and OTC firms with regard to last look execution, rejections and slippage, all areas which a retail broker would be absolutely decimated for, but which are common practice at the banks.
Since then, the banks have lost their number one market share slot to XTX Markets, a non-bank market maker that understands our industry very well, gives fast execution and doesn’t resort to the tactics displayed by the banks.
Therefore, the question is, how do liquidity relationships work today?
To explore this, panelists at today’s Finance Magnates Virtual Summit went into great detail, as we report live from the event.
Discussing this important topic were seasoned professionals Manu Tripathi, FX Strategy and Sales at JB Drax, Benjamin Robson, Head of Leveraged FX at the Malaysian bank Maybank Kim-Eng’s London operations, Andy Biggs, Head of Liquidity at CFH Clearing, Alexei Jiltsov, Co-founder of Tradefeedr, the charismatic and affable Richard Elston, Group Head of Institutional at CMC Markets Institutional, and Hormoz Faryar, Head of Institutional Sales at Emirati brokerage ADS Securities.
Mr Hormoz began by asking what happened to physical gold, and the variation in spread.
Mr Jiltsov answered “The interesting thing about gold is that from a pure trading perspective is a well defined and well known intraday pattenr that never disappears, it goes down after the London session then goes up overnight. If you want to buy gold, it’s better to buy in the afternoon and sell in the morning. It has something to do with bank activities but this pattern seems to have been the same for ten years or so. Not much to say about liquidity, I will leave that to Richard.”
Mr Elston then replied “Who would think that the transportation of physical gold to New York was unprecedented time zone, we never thought that would happen until it happened. Gold went to $70 and beyond in terms of spread, and in some cases it was possible to do better than that as there were so many providers that were pricing so widely. The top ten feeds that we could reference, two of the Tier 1s we could get a price from, and perhaps one of the ECNs. We were looking at futures sources at the time and were able to continue pricing to our customers, but it was certainly an unprecedented situation. If you look at price, there are moments where it falls away again for certain.”
Mr Biggs was then asked if clients were complaining about gold this year. “For us, during March we got quickly wrapped up in the negative oil, but it was the first thing that was a surprise to us, as Richard said. The Swiss closed a region that had several refineries, and the physical gold situation had a massive impact on the liquidity we could offer clients. We had to constantly re-evaluate these to ensure we could give a price. We were also surprised that it didn’t really stabilize. For example the COMEX delivery not accepting London bars was very new to me. I don’t think we are back to where we were as there is some trepidation as it could happen again.”
In terms of the Asian market, Mr Robson said “Gold is inherently volatile, and we as a Prime brokerage division of a bank, we are margined heavily by our prime, and we have to compete with brokers that will compete on narrow margin and will sell gold for 10 to 12 cents. Gold has dropped on one occasion, and the situation in March was a short squeeze for people wanting to sell gold on exchange. Essentially on the OTC side, the gold market is a retail market and people are discounting the risks. I think risk managers should impose greater margin requirements on gold.”
Mr Hormoz said “The non-banks have done so well in the industry. Richard, what happened with the non-banks?”
“It is hard to get away from, there is always a sentiment in the air. When things are going smoothly, the algo at the non bank is pricing you smoothly as a taker. Where gold is concerned, we had a slight advantage over the Tier 1s. We did a white paper and released it the other day as a regulatory exercise. We see ourselves in a situation that we feel that we are a non-bank market maker rather than a recycler of other liquidity, so taking that ability to generate our own liquidity and utilizing our own client base – we have 40,000 clients trading every day. It is difficult to say that the non-banks are always going to be there in times of crisis, however from our own point of view we were able to get pricing out there as a result of the multiple pools of liquidity we can draw on” said Mr Elston.
Mr Robson said “I’m not against non-bank liquidity. XTX Markets we know is the biggest non-bank market maker, and last time you held a panel, Virtu came across well. There are really only 10 banks that stand out as liquidity providers, and many other liquidity providers regurgitate this liquidity and call themselves liquidity providers. Years ago, liquidity was given out by banks and we went out to the banks to get liquidity. I worked with a USDJPY trader who had Japanese banks covering the liquidity.”
When asked if they were always there when needed, Mr Robson said “Yes they were. Swiss banks made prices in CHF, British banks in GBP and so forth. One day, Reuters went down, and all of a sudden half of my banks disappeared and the spread widened. Now we move on to today, and we have a lot of people scrambling to be top of book in small amounts so when the market is volatile, the LPs aren’t interested in making a market, they’re only interested in small deals that they can risk manage. It is a progressive problem where you have millions of orders at top of book trying to grab small amounts of flow but when the market widens, this disappears.”
A heated and enthusiastic discussion on the flawed logic of using algorithms ensued, with Mr Tripathi saying that human intervention and manual operation of execution could resolve a lot of flash volatility.
Mr Biggs weighed in saying that “We rely on humans less and less. I completely agree with the comments said earlier but the human traders tend not to pay for themselves because they’re being outcompeted by 0.1 on the dollar by algos. I think flash crashes are likely to become more prevalent, however it is really not an easy situation with a simple solution.”
“Non-banks come in many shapes and sizes. We saw non-banks and banks struggle over the gold issue, and the weeks after saw non-banks change their pricing quicker, but the banks are extremely reliable and if you need to get out of a position it is likely that you’ll be able to get a price from a bank, but the non-banks might not be there. Many are changing so that their models can price better, but the banks will always be there so I think brokers need to have a mix of everything” said Mr Biggs.
“At ADSS we find that many clients came to us and wanted that analytical focus, ways to find out methods of dealing with things like this” added Mr Hormoz.
Mr Jiltsov said “What we see is that banks have a huge budget and of course non-banks have a much smaller budget, but all the non-banks vary but what is interesting is the usage of liquidity. If you use non-bank for a specific market environment, if volatility goes up you can easily do a switch in your liquidity management. If you think a specific source isn’t ideal for certain market conditions, use a different one! In effect, the changes in spread are caused by changes in volatility, and you can switch. If you are trading in a normal time with a non-bank market maker and know it won’t work well in a volatile period, then the best thing to do is switch to a different source for that period.”
“Traders operate in an electronic environment and are used to operating in that situation but now they’re working from home we can see that they aren’t as good and efficiency has been affected” he said
“How was the risk book?” asked Mr Hormoz.
Mr Elston replied “We have to consider ourselves lucky. Looking at this on a human scale around us, we are lucky to be in this industry during the COVID situation. We had a lockdown of all the traffic of all kind, and back in March the global shutdown caused aircraft not to take off and of course this caused a bizarre scenario which had never been seen before. Volatility has now come down, however we may see a return to volatility. As a provider of liquidity via API technology we can see that the takers of liquidity has gone up. The risk levels we took have been more than the equivalent period last year. We are taking more on.”
Mr Robson added “I cannot really commit to giving information on that sort of thing but I can confirm that we have had a busy year and giving liquidity to term customers is our balance sheet. We work with prime brokers and there is some comfort in volatile times that they have a big place that they feel safe with a big margin. Specifically relating to volatility, with regard to oil and elections, the volatility wasn’t so severe during elections but we may see more in future. Trump has been pro equity markets and has been forceful against the Fed, and that is his massive concentration risk.”
“NASDAQ 100 stocks are 20% made up of FANG stocks, therefore there could be huge economic distress starting in equity markets and this could filter through to commodities and currencies due to the concentration of those stocks” he said.
Mr Tripathi continued “The demand for specialized knowledge and execution quality has increased.”
“We didn’t take risk from a volume perspective, it’s been a fantastic year so far. Anecdotally, b books did well, so I expect people are increasing limits in b books, which is hard to blame them for but we are still seeing a lot more A book volume being processed to us” said Mr Biggs.
“The currency volatility index has got lower and lower since 2015. January started out as a record low and in January I said volatility is dead and its a disaster to be in the FX market, however I am surprised at how quiet in comparison to previous years we are” he said.
“Volatility only really jumped for a couple of months” said Mr Jiltsov. “Volatility is not what you would expect from a year which is more dramatic than all the way back to 2008. Volatility is nowhere near that level.”
“What was interesting is that high volatility demand for execution services in the institutional space, despite the b books making a lot of money on the retail market. More sophisticated institutional clients were demanding algos. Execution which is done in that space would theoretically be viewed as a time when human input would be needed due to the widening of spreads but algo demand was surprisingly high” said Mr Jiltsov.
“In terms of market making, I have quite a strong conviction about it. The market making element is doing the job for customers that it is designed to do. If you look at the DAX, for example, looking at what you see available, you are seeing a few lots in really good times, and I look at the added liquidity that market making brings to the table, for example we are able to offer 9 lots at top of book on the DAX, so market making is a positive thing from my perspective” said Mr Elston.
Mr Robson’s book “Currency Kings” was referred to by Mr Hormoz, when he said that it is likely that we will see far more flash crashes. Mr Robson referred to sterling flash crashes and rand flash crashes in 2016, the 2020 Australian dollar flash crash and of course the 2015 Swiss National Bank’s removal of the CHF peg on the Euro. He said that stocks are now in this frame. Twitter, for example dropped 21 points in March, and then the oil volatility. He is certain that we are going to get flash crashes as time goes forward.
Mr Biggs considers that margins may be increased across the board.
Certainly it is encouraging that the FX industry has such astute leadership within the critical liquidity provision and risk management sector. For sure, we need to engage more with this sector as it is the lifeblood of the electronic trading industry.