Could LPs explore renting out their client franchise?

Can you rent a liquidity provider? And not just any liquidity provider, but one like JP Morgan or Deutsche Bank, to gain access to their huge client franchises?

This idea was raised during the FX Markets Europe conference in London on December 3 (if you weren’t there, you missed an excellent event).

In outline, the rental arrangement might start with a regional bank that is seeking to execute an FX trade on behalf of a local corporate client. The bank could take that trade to a big dealer in the hope that the resulting, skewed price would entice one of the dealer’s own clients – maybe a systematic hedge fund – to take the other side of the trade, potentially allowing both sides to get it done at a good level.

If the alternative involves venturing into one of the market’s primary venues – increasingly avoided by the biggest dealers – then it has obvious appeal.

The picture that’s emerging of an FX market-maker is quite different to the traditional stereotype

It also raises some interesting questions. At the conference, this kind of arrangement was framed as a ‘rental’ of the dealer’s client franchise by the hypothetical regional bank.

The implications of this type of arrangement could mean the top LPs are evolving to become big distribution hubs where they manage a vast network of internalised flows and bilaterally streams across different segments of the market.

Of course, describing it as a rental scheme suggests that the regional bank is the one benefitting, and the one who should be paying.

But couldn’t it be flipped the other way round? The dealer is getting to see a trading interest that it would otherwise not have exclusive access to, and is able to facilitate offsetting trades as a result. Who gets most value from this arrangement?

Another question concerns the dividing lines between the rental trades and other, similar arrangements – such as white-label liquidity provision, which also connects big dealers with regional banks and raises the same kind of questions about who the biggest beneficiary is. The idea of placing passive resting orders within a dealer’s internal exchange also overlaps with both of these approaches – ‘renting’ a client franchise, and white-labelled liquidity.

Regardless of how these partnerships are arranged, the result is the same – the ultimate consumer of liquidity is the corporate at the end of the chain. But who is actually generating the price? Who is providing value? And how much should they get paid for it?

The picture that’s emerging of an FX market-maker is quite different to the traditional stereotype. In the old days, market-makers took price risk, liquidity risk and counterparty risk over varying horizons, and were paid for doing so. Perhaps, in future, success in FX market-making will be less about taking and managing risk, and more about building the biggest possible network of trading interests.