Internalisation in the spotlight? Don’t hold your breath

Every so often a report from the Bank for International Settlements lands on the laps of market participants to highlight some structural risk is on the rise.

Sometimes, these papers trigger a chain reaction and practitioners take stock of ways to solve the issues raised. Take the topic of settlement risk rising in foreign exchange, for example. Within months of the BIS publishing the results of the first industry survey on the subject, a wide variety of stakeholders rolled up their sleeves and began working to find a solution.

In other cases, such as that of a recent BIS paper on high internalisation ratios at large banks, the topic fails to take centre stage. The report, published in October last year, raised an interesting question: is more internalisation leading to a deterioration in the quality of prices available on platforms used by market participants to calibrate their pricing models?  

For this month’s cover story, FX Markets spoke to 18 sources, including non-bank liquidity providers (LPs), trading venues and 10 banks that internalise spot FX flows looking for answers to that question.

While some acknowledged that less volume going through public venues means price discovery becomes more difficult, few expressed serious concerns about the issue. 

It’s hard to blame them. 

Liquidity providers are more than happy to keep increasing the share of trades matched internally as it saves them from crossing spreads and paying brokerage fees. Clients can also sleep easy, as higher internalisation often means getting a decent discount from the LP that’s offsetting their flow with that of another client without ever hitting the lit market. 

While some acknowledged that less volume going through public venues means price discovery becomes more difficult, few expressed serious concerns about the issue

As for the two historic primary venues in FX – EBS and Refinitiv Matching – which, at least on paper, would lose from this big structural change, LPs say that no matter the level of internalisation reached by market-makers, enough flow will continue to pass through them bringing in enough revenue to keep everyone happy. 

Does this mean the BIS is barking up the wrong tree? Not quite. The question posed by the regulator is a serious one, and as such it deserves proper attention from all market participants. 

But unlike other structural changes, the direction of travel here seems harder to reverse: LPs will continue to internalise as much flow as possible, even if it means primary venues will receive a growing share of so-called toxic flow in return. After all, they have been working on the technology behind it for years and they are unlikely to stop now. 

Like most things in life, it’s often a matter of priorities. Settlement risk seems to be a more pressing issue in FX than the rate of internalisation, which explains the rush to tackle it.

But it’s also a matter of who has something to gain or lose. And as long as the majority of players are happy with the status quo, interest in addressing the issue will remain close to zero.