Foreign Exchange at Vontobel

The 2019 BIS Triennial Central Bank survey measured average daily volumes in the FX market worldwide at around USD 6.6 trillion, dwarfing even the global stock markets combined and making FX the largest financial market in the world. But where, and how, is all this volume traded? And by whom?

Chart 1: Global foreign exchange market turnover. Source: BIS “Triennial Central Bank Survey of Foreign Exchange and Over-the-counter (OTC) Derivatives Markets in 2019.” bis.org/statistics/rpfx19.htm

Historically, the interbank market was where professional market participants would meet and trade, either on behalf of their clients or to take on risk on their own books. The liquidity available was provided by market makers, typically the investment bank arms of various Tier-1 global banks, continuously quoting two-way prices with the goal of capturing the bid-ask spread and of profiting from short-term price action. Unregulated and decentralized, Reuters Dealing and EBS Market became the two main electronic platforms where interbank participants would meet and trade before rapid digitalization really kicked off toward the late 90s.

This development saw a host of new venues and electronic communication networks (ECNs) enter the market space, which, along with prime-broker-based credit solutions, significantly reduced the cost of entry to a reasonably sophisticated FX marketplace for many smaller participants who previously only had indirect access to the market via larger banks. For the first time, asset managers, regional banks, retail brokers, hedge funds, and HFTs could now gain direct access to the FX markets.

The rapid digitalization and emergence of new types of market participants have made sourcing high-quality FX liquidity ever more challenging – extreme fragmentation, predatory HFTs, and a high percentage of “ghost” liquidity provided to the market by aggregator resellers on various venues can make today’s FX market a very difficult environment to navigate. Best-execution requirements mean market takers can no longer rely on single counterparties and need to source liquidity from multiple providers, which is typically done by trading on the various multidealer platforms (MDPs) available on the market.

Many of these multidealer venues do not charge the market takers at all, which may look very attractive at first glance. There are often significant brokerage fees payable by the market makers however, fees which undoubtedly get passed back to the client in the form of wider spreads. This means that even if trading on such venues might look cost-effective, or even free, the true cost is included/hidden in the liquidity and pricing quality you receive as a client.

Skew – what is it and why is it important?

The concept of skew is best explained using an example in which we assume the role of a liquidity provider. As an electronic market maker, we continuously quote two-way prices to our clients. Say one of our clients hits our offer to buy, which results in a short position on our book that we have to manage/exit, ideally in a profitable fashion. One way to achieve this is to buy back from the market at a lower price, which we can try to do by adjusting the bid price we show to our clients. For example, say we are quoting EUR/USD at 20/22 and a client hits our offer to buy 1 million at 22. Now we have a 1 million short position at 22 and want to buy back lower from the market. We can try to do this by adjusting our two-way price to 20.5/22.5, hoping our improved bid will be attractive enough to generate client flow to close out the original position at a profit.

Stepping back into the role of a client trading on an aggregator platform, this price adjustment (or skew) received from a market maker would typically result in tighter spreads. The skewed bid received at 20.5 is now top of book, and the overall spread has been compressed – good news for the client. If the skewed bid is attractive enough to generate flow to offset the original position, it is also very good news for the market maker, as he can exit his position at a profit. Showing skew is a very important tool for an LP to manage risk while at the same time providing clients with attractive and competitive liquidity – a real win-win situation for both the client and the LP.

However, there is a caveat here. By adjusting, or skewing, the price, the LP is essentially signaling to the market that he has a position to work. The reason why this is problematic is that there are market participants (read: HFTs) out there seeking to exploit this information. Once a skew has been detected, they will try to leverage this information by anticipating the next immediate price ticks, often resulting in moving the market against the LP’s original position. This obviously makes it much harder for an LP to exit the position profitably, and, unsurprisingly, LPs are growing increasingly reluctant to show skew on venues/platforms where there is a risk that this information could be detected and used to move the market against them. In market jargon, this is commonly referred to as “skew leakage.”

As a market taker, it is clearly very attractive to be exposed to LP skew, as this can have a massive positive impact on overall liquidity. But achieving this means finding a trading environment where LPs can safely show skew without risking information leakage into the wider market. The Vontobel eFX platform provides exactly such an environment. We have full and granular control over how liquidity is consumed (and by whom), and we can confidently guarantee our LPs that any alpha signals received via skewed price streams will not leak into the wider market place. The result of receiving full skew exposure from many LPs along with dedicated price streams/sessions is a truly unique pool of liquidity that we can offer to our clients.

Sweep the market or full amount?

An almost universal feature of today’s various FX venues and vendor platforms is some form of liquidity aggregation, e.g. the ability to build a single, consolidated order book made up of liquidity sourced from several different providers/venues. The main benefit of aggregation is an often dramatic spread compression, especially for larger sizes. Liquidity providers typically quote a price/amount ladder with a tight spread for, say, 1 million at top of book, but a significantly wider spread for 10 million further down the ladder. By aggregating all the different 1 million prices received from your various liquidity sources, you are likely to get a better price for 10 million compared to the price for the full 10 million from a single source.

The flipside, of course, is that to achieve an actual execution at this better price, you have to hit every individual quote that went into this particular aggregation. In market terms, this is called “sweeping the market,” where your smart order router aggressively tries to hit a potentially large number of individual quotes at essentially the same time. Aside from the risk/cost of rejects, another fundamental issue with this style of execution is that every liquidity provider targeted as part of a sweep ends up with similar positions from a directional point of view.

Depending on the number of individual quotes targeted and amounts involved, sweeping the market executions can cause significant market impact as market makers all try to manage/exit similar positions at the same time. While some LPs might have sophisticated risk-holding strategies and/or the ability to internalize flow, others might aggressively skew on the primary market or ECNs, which in turn can lead to significant market impact.

From a liquidity provider’s perspective, the effect of being part of an excessive sweep execution with nontrivial market impact is typically reduced per-trade profitability. It obviously gets harder to work/exit a position if the primary market moves against you. This is not a big deal if it only happens occasionally and as long as the overall relationship remains profitable, but if the LP finds it consistently difficult to monetize the flow generated, then the natural course of action is to reduce the pricing quality (e.g. widen spreads) offered to the client in order to avoid the unprofitable flow. As a market taker, subsequent reduced pricing quality means worse execution rates and a reduction of true value of the entire FX offering.

An alternative to sweeping the market is what is commonly referred to as full amount (or FA) pricing and execution mode. The core concept here is to keep liquidity marked as full amount segregated from the aggregated liquidity pool and never to use FA liquidity as part of a larger sweep execution across multiple liquidity providers. Instead, when FA liquidity is targeted, it is always done individually, meaning that the LP providing the FA stream does not have to worry about any adverse collateral market impact as described in the sweep example above. The effect of this is that the LP does not have to take potential adverse market impact into account in his pricing and can be more aggressive when quoting larger amounts.

From a market taker’s perspective, this means that a full amount stream may result in a price improvement compared to aggregated/sweepable liquidity.

Instead of solely using one of these pricing and execution styles, we have opted for a hybrid model where we run multiple full amount liquidity pools side-by-side with an aggregated/sweepable pool. The smart order router decides which liquidity to target. If the theoretical VWAP price generated from the aggregated liquidity pool is best, then we will sweep. If a full amount stream has the best price, we will send the full order to the LP providing this price. Essentially, this is a “best-of-both-worlds” setup and allows for a high degree of flexibility, both in terms of how we consume liquidity and from an LP’s quoting perspective.

This hybrid model means that we can offer both styles of pricing and execution to our liquidity providers, allowing them to choose what style fits their pricing and risk management strategies best. Some LPs prefer the sweepable style, especially if they only stream smaller amounts. Other LPs, who often rely heavily on internalization to exit risk, prefer full amount, as they can quote much more aggressively without having to worry about any collateral damage (and thus attracting more flow). Some LPs even have a dual setup, streaming both sweepable and FA liquidity into the FX platform through dedicated sessions, allowing for even further flexibility in regard to pricing. At the end of the day, finding an optimal setup is not trivial, and it is a continuous work in progress together with our liquidity providers to find the best solution for both sides of the trade.