Optimal FX platform selection

For some time, major FX banks have accepted that effective servicing of their client base requires a portfolio of delivery channels, typically consisting of an in-house FX portal, multibank portal presence(s) and phone dealing. Some may also add a dash of order-driven business, via a platform such as Hotspot, but the generic recipe is usually broadly the same.

The inevitable downside of the multibank portal and order-driven elements in this mix is that different clients want their banks in different places – and some seem to want them everywhere. From the bank viewpoint, this spells narrower dealing spreads, higher technology/support costs and a liquidity management headache. Worse still, it can also leave the bank prey to predatory cross-platform trading strategies.

“There is now a very real risk that banks that are trading across multiple portals with some clients will almost certainly experience losses,” says Octavio Marenzi, CEO of financial services consultancy Celent. “Those such as hedge funds are often better informed and have better trading models, resulting in the banks losing money on what is effectively toxic order flow.”

This leaves FX banks confronting a number of awkward questions: which platforms should they support? Should they support all clients equally on all platforms? What size should they quote? How can they identify which clients on which platforms are disruptive and/or unprofitable? And, having identified these clients, what are the appropriate servicing alternatives for them (if any)?

Everywhere, all the time

Despite the downside associated with maintaining a multiportal presence, there is a lingering belief in some quarters that being omnipresent and omni-quoting is still necessary. One reason for this indiscriminate willingness to provide liquidity has been the desire to capture transaction volume. This is based on the received wisdom that maximising volume also maximises FX flow information, which thereby informs banks’ own proprietary position taking.

This made sense when much of the volume consisted of conventional asset managers or corporations taking a long-term strategic view on a currency pair, or perhaps the odd macro hedge fund placing a huge directional bet.

Not any more. An appreciable slice of global FX activity now comes from hedge funds and others with far shorter time horizons and very different intentions. Some will be trading at extremely high frequency (perhaps thousands of trades a pair, each day) based on quantitative models and holding positions for a matter of minutes, or even seconds. Others will simply be looking to exploit errors or inefficiencies in the way that banks quote their prices across multiple portals.

In information terms, this type of activity is effectively noise – it does not contain significant market intelligence and it contaminates (and has to be separated from) other order flows that do.

All banks appreciate the need to be where clients want them; but many do not see this as a reason for blindly chasing volume. “Although there is always somebody who wants to top some league table or other, there is a growing realisation that liquidity is a valuable commodity and has to be focused where the value can be reciprocated,” says Martin Spurr, head of integrated treasury services at Royal Bank of Scotland (RBS). “We are very much driven by relationships and not volume for its own sake. We are therefore more supportive of portals where good customers are active.”

Albert Maasland, senior business manager at Standard Chartered Bank

Albert Maasland, senior business manager at Standard Chartered Bank, takes a similar line. “We will use whichever mechanism is the most appropriate for the customer in question,” he says. “For example, we are active liquidity providers on FXall, particularly for less liquid currencies, and some bank clients transact with us via that.

“However, for others we may use an entirely different mechanism – for instance, where we have a relationship with a client bank that is very active in trading in major currencies and in large size, we will propose that it uses EBS Prime.”

Roadside assistance

Choosing which FX platforms to support is only part of the problem. The next step is deciding the extent of that support, which is sometimes less than wholehearted. Particularly where they are using automated pricing engines, some banks have resorted to defensive quoting (smaller size, wider spreads) on a blanket basis. During periods of volatility, such as when major economic reports are published, this quoting becomes even more defensive, which hardly benefits clients.

Arbitrage target

Although some portals have functionality that allows the quoted spread to be adjusted to each client, not all sellside participants are able to take advantage of it because they are using different pricing engines for different portals or platforms. This results in inconsistencies that outweigh the ability to adjust spreads and makes such banks prime arbitrage candidates.

Even where banks are using a single pricing engine, their network technology can leave them exposed. “Their prices may originate from the same source, but they then deliver them over internal networks with widely differing performance, so some prices are comparatively stale by the time they are published,” says Vladan Jovanovic, CEO of proprietary trading and technology consulting firm Communicating. “These days, prices stale enough to leave a bank at risk are measured in just a few milliseconds.”

There is also little chance of those stale prices going unnoticed. “The current asymmetry in the market means that clients can potentially see more prices and liquidity than many banks,” says Mr Spurr of RBS. “They can sit on half a dozen APIs [application protocol interfaces] from major banks and portals streaming liquidity, which gives them excellent visibility.

Martin Spurr: RBS is ‘driven by relationships’

“That is one reason why banks have recognised that the traditional model of providing ‘relationship liquidity’ can very quickly backfire in today’s electronic market places, as they can easily be hit by a large number of opportunistic players.”

Defending against predators

While proprietary technology for tracking this sort of activity already exists, bank concerns about predatory trading have also driven the evolution of specialised vendor solutions. These allow banks to identify aggressive customer business and the resulting impact on profitability in real time.

This type of product exploits the fact that trading practices such as arbitrage and trades made on the back of very strong trade knowledge are very apparent in short-term market movements immediately post trade. This type of activity can be flagged on a monitoring screen, which may also provide immediate statistical analysis for the clients/platforms concerned.

Although identifying predatory activity with such tools may allow a bank to protect itself by widening spreads or suspending quotes to specific clients at certain times, this raises a further dilemma. Such clients will not be prepared to accept these wider prices and will therefore probably become ex-clients. While this solves the immediate problem of losing money on client trades, it does so at the expense of a larger, longer term opportunity.

The type of client with trading behaviour that is either aggressive or provides no information value is also highly likely to be a commodity buyer, who regards price as the be-all and end-all. Such a client is unlikely to be interested in a value-added relationship with the bank, and would probably wish to deter the bank from gaining a better understanding of its business in order to facilitate such a relationship.

However, that does not automatically preclude these clients from being revenue generative, because they are natural candidates for FX prime brokerage. “Where clients are demanding the very best prices possible and will otherwise go elsewhere, the prime brokerage model makes sense,” says Celent’s Mr Marenzi.

Offering direct access to primary FX markets immediately affords this sort of client the opportunity for price improvement by making, rather than just taking, prices. On the other side of the equation, the bank benefits from more predictable fee-based revenues in return for the provision of credit and settlement services. It also avoids the risk of being picked off by aggressive customer activity and automatically cleans up the information it derives from clients still trading with it under the dealer model.

A further advantage is the freeing up of bank resources, which some regard as a major argument for platform pragmatism. “We simply want to find the most appropriate and efficient means for clients to automate their vanilla spot trading business,” says Standard Chartered’s Mr Maasland. “This releases sales people to concentrate on derivative and structured products that will allow customers to manage their exposures with greater flexibility and precision.”

Nevertheless, some sellside participants fear that the prime brokerage model is the first raindrop in an instant monsoon – all clients will immediately demand primary market access and the dealer model will become extinct overnight. However, that ignores the fact that the prime brokerage model confers no obligation of market support on the bank provider. This may not be a problem for a high frequency hedge fund, but will not suit clients such as real money managers who are trying to move large amounts in difficult market conditions.

In that sort of situation, many will prefer to stay with the scenario outlined by RBS’s Mr Spurr. “We endeavour to provide relationship liquidity for our clients – even if that incurs the risk that we cannot back their trade into the market or that it doesn’t suit our current inventory,” he says.

Support such as this prompts some commentators to predict a natural separation of clients based on their primary needs, with many still preferring the quote-driven option. “Spreads may be compressed by more aggressive participants seeking finer prices,” says Mr Marenzi. “That will prompt banks to move that sort of client towards a prime brokerage model. However, other clients will still value the comfort factor of the dealer model, which I think will be with us for a long time to come.