Off the shelf algos at Tier 1 level! Major FX dealers go the third party route

The Tier 1 interbank FX sector has become almost subservient to the OTC derivatives liquidity takers that it has shown disdain for in the past, largely because quite simply, the traditional top tier institutions cannot survive without making sure they treat their core business with seriousness.

Last year, for the first time in history, a non-bank market maker took the top position in terms of market share globally for Tier 1 FX order flow by volume, surpassing giants such as Citigroup, which before issuing a damning risk aversity report in 2015, had been the world’s number 1 FX dealer by market share for 17 years.

This non-bank market maker was XTX Markets, which today, alongside equally eager NatWest Markets, the London-based investment banking and FX dealing division of RBS Group has gone down the route of invoking the use of third party algos for FX trading.

Perhaps this can be viewed as an institutional, top tier version of the trend 15 years ago for MetaTrader users in the retail sector using ready-made ‘Expert Advisors’, known as EAs or trading robots.

XTX Markets is, after all, a company which understands the retail OTC derivatives business very well indeed, hence its ability to gain the largest share of Tier 1 order flow. The company has proven that it fills more orders than the banks with which it now competes, and does so quickly without last look practice or ‘cherry picking’ and rejecting orders that it considers toxic for purely one sided reasons.

Perhaps even more similar to the retail sector is how XTX Markets and NatWest Markets are utilizing these off-the-shelf algos, that being by means of white labeling.

White-labelling, as it’s known, has become an increasingly common way for FX dealers to gain algo trading volumes quickly and cheaply. Perhaps this direction was inevitable, as XTX Markets’ Matt Clarke stated in the summer of this year.

Two months ago, Mr Clarke stated that Oaktree Capital’s Howard Marks wrote a memo on how investors should adjust their forecasts by considering what’s already priced in.

Mr Clarke stated that He calls this “second-level thinking”. If you believe a company’s prospects are good but the market thinks they’re great then you should expect its stock price to fall, he advises. This is not an intuitive reaction for most of us.

“Foreign exchange algos are currently a bit like that. There’s no question the outlook is extremely promising for this business, but an awful lot is priced in. Sustaining current growth levels may require a different approach to what worked in the past. We may find ourselves at an inflection point where the algo market and what clients require from such products is about to change” he told FX-markets.com

“Social media platforms offer an instructive analogy. From a low base, it was possible to grow rapidly in the early years simply by adding new users. As these platforms gradually reached pretty much all of the audience who were suitable for the product, year-on-year user growth numbers started to flatline. Hardcore distribution of product works at first but inevitably it stops being effective” concluded Mr Clarke.

The growth in FX algos can be seen as part of the wider shift in transferring more execution risk from the sell side to the buy side in fixed income, currency and commodity (Ficc) products. Almost every data point suggests algo volumes are growing at double-digit percentages annually. A relatively small business that compounds at 20% each year soon becomes a meaningful one, is Mr Clarke’s observation.

Indeed that is correct.

Additionally, the majority of last decade was spent by Tier 1 banks retracting counterparty credit to OTC firms, so specialists such as XTX Markets stepped up, and provided a far more aligned service to OTC counterparties. There were a handful of Tier 1 dealers that understood the importance of reaching out to smaller to medium agency brokers, and interestingly NatWest Markets was one of them.

FinanceFeeds met with senior executives of NatWest Markets at the company’s 25o Bishopsgate head office in London at the height of that period, where it was explained that despite the aversity to OTC derivatives shown by many other Tier 1 banks even though their livelihood depends on trading, NatWest Markets was very much open for business.

Clearly, risk management – namely the possibility of ‘going upside down’ on large prime brokerage accounts due to extending counterparty credit to spot FX companies that are placing trades in a highly liquid and volatile market – is one factor that has given the banks a reason to retract recently, but the other is compliance. If banks give counterparty agreements to all brokerages, they would be responsible for “Know Your Client” and “Anti Money Laundering” reporting to the prudential regulator and probably the non-bank regulator on the brokerage side.

Perhaps the banks have realized that missing out on such a huge part of their revenue stream is simply not commercially sensible, and are coming back to a now very well organized FX business in order to gain from it. This is all well and good, however it does not make money.

Meeting with RBS back then in the Square Mile, it was clear that the company is absolutely willing to do business with OTC prime of prime brokerages.

The executives that I met with at the company’s head office, along with its NatWest Markets division, show a very distinct interest in fostering prime of prime relationships with non-bank entities, as long as the relevant (and extensive!) due diligence is completed.

I followed this up with some London-based prime of prime brokerages, and it appeared at the time that most certainly, RBS has the lowest entry barriers and is actually willing to do business as a Tier 1 counterparty, however since then, very few brokers bothered to take this up and the b-book reigns supreme.

The bank realized that London’s prime of prime sector is very well organized and is operated by large, well-backed corporations and in some cases hedge funds, and that the rules are followed diligently, hence its willingness to open its doors once again and perhaps should it extend business, it would be able to take those not wishing to B-book their business into its fold as agency brokers for the retail market.

So, it would definitely make sense that if the retail sector is the target of these two bastions of Tier 1 astuteness, they would emulate the retail model of using white label solutions developed by specialists to handle that order flow.