Cost efficiency without sacrificing access to liquidity

FX Week talks to Richard Elston, head of institutional at CMC Markets, about the transforming landscape of foreign exchange, including structural changes and fragmentation in FX markets, organisations’ varying liquidity needs and a shift towards cross-asset trading on the buy side.

Institutional foreign exchange markets have seen widespread change in recent years as the pace of market structure evolution has accelerated. The shift in behaviour has affected the full trade lifecycle, with examples including large dealers internalising flows as well as the reduced appetite from prime brokers to deal with smaller entities. The search for cost efficiency has been a significant driver of these changes, but it has left many small brokers, hedge funds and institutional asset managers struggling to access liquidity.

As large banks withdrew from servicing smaller clients, non-bank service providers stepped up in both the liquidity provision and credit intermediation spaces. Earlier this year, CMC Markets Institutional consolidated its liquidity services offerings, providing many marginalised counterparties with a single point of access to its liquidity relationships across multiple asset classes. 

 

What are the key underlying structural changes in FX markets driving execution behaviour in institutional markets?

Richard Elston, CMC Markets: The changing supply of liquidity and where counterparties source it from has without doubt resulted in the FX market having to adapt to some significant evolution in recent years. Historically, CMC Markets has had a pool of prime brokers that would quite happily deal with a great number of the entities that made up the global FX ecosystem, but this landscape has changed quite markedly. Internalisation of flow among a number of bigger banks, the withdrawal of some prime brokers from the market altogether and a diminishing appetite for risk – often in response to regulatory change – means the industry has had to reduce its reliance on large banks as direct providers of liquidity.

Instead, non-bank counterparties are now stepping up, acting as prime-of-prime brokers to the wider market. It’s worth bearing in mind that this term has become somewhat over-brokered in its own right, but it means that better-capitalised non-bank entities with strong institutional relationships that are on a solid regulatory footing have been able to step up and fill the glaring liquidity gap that has emerged in the market. 

 

How different are the liquidity needs of smaller brokers, hedge funds and asset managers compared with corporates or smaller sell-side players?

Richard Elston: As a top line, there is little difference. There’s a universal demand for high-quality liquidity to be served up at an efficient price, but there are some subtle differences, which typically revolve around risk. CMC Markets’ application programming interface (API) is targeted at broker aggregators, banks and other proprietary trading firms. It delivers consistently competitive pricing via its spread and guaranteed market depth. Counterparties know exactly what is on offer up to the maximum order size, which will be traded on a ‘fill or kill’ basis as a single clip. This is then complemented by CMC Markets’ Prime FX solution, which offers comprehensive market access from multiple liquidity providers. Clients can potentially access tighter spreads and receive more competitive pricing, although large orders may need to be split into multiple lots. 

Counterparties wanting the best of both worlds should consider a hybrid solution of these two components, delivering the optimal combination of pricing and liquidity from a single provider.

 

Is the level of fragmentation in the market an issue for liquidity takers and how can they overcome this challenge? 

Richard Elston: The proliferation of companies claiming to offer prime-of-prime services has presented a very real challenge here, meaning critical counterparties have a good understanding of where the source of any liquidity they are being offered actually lies. CMC Markets – in common with a number of other non-bank legacy institutions – is able to provide counterparties with access to its prime liquidity relationships. The risk of fragmentation occurs when you have smaller brokers recycling liquidity and claiming to be providing a prime-of-prime service. 

So, check with any counterparty offering liquidity where the original source sits. Can they sculpt that liquidity in a way that suits your needs, only drawing from certain pools if necessary? And what guarantees can they offer over both pricing and depth of market? Prime brokers have taken deliberate action to reduce the number of counterparties they are willing to deal with, both to better manage risk and reduce administrative resource requirements. 

 

Have you seen a shift towards cross-asset trading on the buy side in recent years? How does this impact liquidity access decisions? 

Richard Elston: Absolutely. The Swiss National Bank event on January 15, 2015, may have been the catalyst for change when it comes to FX liquidity, but as CMC Markets expanded its operations in this area to help fill the liquidity gap, institutional customers were quick to point out that they faced similar challenges across all asset classes. To account for this, CMC Prime Derivatives was launched to sit alongside the FX API and Prime FX liquidity solutions, again leveraging CMC Markets’ balance sheet and institutional relationships, while opening up access to more than 9,000 single-stock contracts-for-difference, completing the comprehensive CMC Markets’ Liquidity Solutions suite.

CMC Markets is keen to help clients beyond just providing access to liquidity, so it offers a comprehensive suite of reporting and analysis tools. These enable clients to have a single view of all outstanding position exposure and can then be customised to deliver the most appropriate format – globally – by sub-account, by currency or even by individual position. This significantly improves functionality when it comes to risk management, end-of-day reporting and performance measurement, with the opportunity to deliver the data either via a standalone graphical user interface or API for those looking for integration into existing middle- or back-office systems. 

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